It’s usually stock markets that dominate the financial headlines. Bond markets, or fixed-income markets, can be very dull in comparison. But, so far this year, it’s the latter which have commanded the most attention.
So what’s going on? Well, the market for government bonds has been especially volatile. Known as gilts in the UK or Treasurys in the US, government bonds are essentially IOUs to fund public borrowing. Governments agree to pay both periodic interest, or coupon payments, as well as repaying the principal at maturity.
Yields on bonds in the UK and elsewhere have been creeping up in recent months, and that upward pressure has intensified since the start of January. Ten-year gilt yields, for example, have approached 4.9% — a level not observed since 2008.
When yields rise, the value of the fixed-income component of a portfolio falls. Why? Because the issuing of new bonds with higher payouts makes existing bonds, with lower payouts, less attractive. As a result, the prices of existing bonds, and the funds that hold them, fall to stay competitive.
Why yields have risen
There are several reasons why yields have been rising. Globally, the biggest factor is a growing unease about levels of government debt in general. In the US, for example, where public debt recently reached $30 trillion, net interest on government borrowings is more than $3 billion a day. This rise in government borrowings has prompted a resurgence in so-called “bond vigilantes”, who sell off bonds to enforce fiscal discipline.
Investors are also worried about persistent inflation. By eroding the purchasing power of future bond payments, inflation makes bonds less attractive. Investors demand higher yields to compensate, which again drives bond prices down.
Here in the UK, concerns about fiscal stability and inflation have been exacerbated by a relatively gloomy economic outlook and fears that economic growth will be insufficient to sustain the Government’s spending and borrowing programme.
So where does all this leave investors? These are highly unusual times in the bond markets. Is there anything investors should be doing to take advantage of the situation, or perhaps to limit the damage?
The simple answer, as usual, is No, there isn’t. Instead, investors should abide by two fundamental rules of successful investing — first, by focusing on the long term, and, secondly, by staying diversified and periodically rebalancing their portfolio.
Rule No. 1: Focus on the long run
Behavioural experts have shown how investors are often heavily influenced by events in the recent past, and what is happening now. They seek relief from any fear or discomfort they may be currently feeling. But past returns are irrelevant; what actually matters is what’s going to happen in the future. That’s why it’s so important at times like these to take a long-term view.
Government bonds have been in a bear market since 2020, when central banks started raising interest rates in response to surging inflation after the COVID-19 pandemic. Bear markets, whether in stocks or bonds, are part of a normal market cycle. Yes, these downturns can be very severe, and they can last for a long time, but financial history shows us that, time and again, markets recover from setbacks.
Right now, bond investors are understandably feeling anxious. Few commentators doubt that there are significant challenges ahead for governments and policymakers in managing economic growth and fiscal health. But nothing lasts forever. No matter how grim things may look, they are bound to change for the better eventually, and possibly sooner than the so-called experts are expecting.
The fact that it’s been a very bad time for bonds is not a reason to sell them. On the contrary, it’s a very good reason for staying invested, or even increasing your exposure, because the damage already inflicted potentially lays the foundation for better times ahead.
Rule No. 2: Stay diversified
The second rule for investors to abide by on as bond markets wobble is to stay broadly diversified.
The main role that bonds play in a portfolio is that of risk reducer. They are essentially there to dampen the risk of equities. Yes, equities can and do produce impressive returns over time, but they are prone to volatility, and investors have to expect substantial drawdowns every few fears or so.
Usually, stock and bond returns are negatively correlated. In other words when one goes up, the other goes down, and vice versa. So having exposure to bonds as well as equities gives investors a smoother journey towards their goals.
Of course, if you are thoroughly optimistic about the future in the short, medium and longer term, you could invest entirely in equities. In the real world, however, there will always be setbacks — wars, political crises, economic recessions and so on — and if you feel discomfited at the prospect, of, say, a decline in equity markets of 40% or more, you would be well advised to invest in bonds as well.
It also pays to rebalance your portfolio periodically to restore its original asset allocation. By selling assets that performed well in the recent past and buying assets that did less well, you’re also doing what investors really want to be doing — selling high and buying low.
What about retirees?
What, then, are the implications of recent developments in the bond markets for retirees specifically? After all, unloved investments can remain unloved for a very long time, as anyone who was heavily invested in Japanese equities or property from the early 1990s onward will tell you. Retirees don’t have the luxury of time that younger investors do. Can they really afford to stick with bonds now?
The answer is that maintaining your bond exposure is even more important for older investors than it is for younger ones. As I’ve already explained, equity markets can fall very quickly. If you are unlucky enough to retire just before a market crash, that big drop in the value of your portfolio will have a lasting impact. This is referred to as sequence of returns risk — the risk that bad returns at the wrong time can be particularly painful.
In a worst-case scenario, sequence risk can lead to people running out of money later in life, and, as financial author Andrew Hallam explained in a recent article, one of the best ways to avoid that happening is to invest in bonds alongside equities.
The chart below shows the performance of two portfolios from the start of 2000 to the end of 2024, based on annual withdrawals of 4%. Although stocks performed far better than bonds over that 25-year period, a balanced 60/40 portfolio (in green) performed much better for retirees than a portfolio comprising just a global stock index (in blue). Indeed, the 60/40 portfolio would still be worth about $1.05 million after 25 years of withdrawals — that’s about two-and-a-half times more than a retiree would have today if they had invested purely in stocks.
Source: AES International
Why, then, did the 60/40 portfolio fare so well when stocks performed so much better than bonds?
“If stocks fell hard,” Hallam explained, “the retiree would sell more bonds than stocks. That isn’t based on clever manoeuvring. It’s simply the result of maintaining a consistent allocation between stocks and bonds.
“That means, when stocks fell from 2000 to 2002 and again in 2008, to maintain a consistent allocation (60% stocks, 40% bonds) the retiree would have sold far more bonds than stocks when making their inflation-adjusted withdrawals.
“Not only was the portfolio more stable during the downturns, but the retiree sold fewer stock market assets when stocks were down.”
The future could be worse than the past
With the benefit of hindsight, in other words, the late 1990s and the year 2000 turned out to be a very bad time to retire. Retirees who invested entirely in equities and kept their savings in cash accounts offering low rates of interest would have been better off investing in a combination of equities and bonds.
Could we see a similar scenario unfold over the next 20 or 25 years? Of course we could.
Hallam writes: “You might think, I’ll never own bonds. I only want stocks. The sequence of returns will never be as bad as it was from 2000-2025… (But) it pays to be prudent. The future could be worse than the past. That’s why retirees should diversify with global stocks and keep 20-40 percent invested in bonds.”
Of course, every investor is different. Your optimal asset allocation will depend on your needs, goals and circumstances, and your personal tolerance for risk. But, for most investors over the age of 50, it will almost certainly include an element of bonds, and reducing your exposure now could be a costly mistake.
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