For long-term investors, the bond market may offer a different set of opportunities today than it did a few years ago.
Why have bond yields risen?
Several factors have contributed to the recent increase in bond yields.
Governments around the world are issuing larger amounts of debt to fund spending commitments, increasing the supply of bonds available to investors. At the same time, higher energy prices have raised concerns that inflation may remain above central bank targets for longer than previously expected.
Perhaps most importantly, economic growth, particularly in the United States, has remained remarkably resilient. Strong employment and consumer spending have reduced expectations of imminent interest rate cuts and, in some cases, prompted markets to price in the possibility of further rate increases.
The result has been a significant repricing of government bond markets. Long-dated US Treasury yields have reached levels not seen for more than two decades, while UK gilt yields have risen to their highest levels since the late 1990s.
Volatility creates opportunity
Bond prices and yields move in opposite directions. When yields rise, the value of existing bonds falls. This explains why many bond investors have experienced a difficult period over the past few years.
However, higher yields also mean higher future income and potentially stronger long-term returns. Investors purchasing bonds today can lock in income levels that would have been difficult to achieve during the era of ultra-low interest rates.
While further periods of volatility remain possible, today’s yields provide a much stronger starting point for investors than was available in recent times.
Government bonds or corporate bonds?
Higher yields mean investors once again have genuine choice within bond markets.
Government bonds can provide higher liquidity and historically acted as a safe haven during periods of high uncertainty, while corporate bonds offer the potential for higher income. Importantly, many investment-grade corporate bonds with lower or medium term maturities now offer yields comparable to long-dated government bonds without being overly exposed to dramatic market yield moves. In addition, credit quality is, especially with higher rated issuers, supported by healthy corporate balance sheets and strong cash generation.
Rather than choosing one over the other, many investors may benefit from holding a mix of both.
What should investors do now?
The current market environment argues for a balanced and selective approach rather than an aggressive one.
While long-dated government bonds may continue to experience periods of volatility, the significant rise in yields means valuations are becoming increasingly compelling. Investors who can look beyond short-term market swings may be rewarded over time as inflation gradually moderates and bond income accumulates.
Today’s fixed income environment may offer opportunities for investors seeking diversification and income. Selected higher-yielding issuers may also offer attractive income, provided investors remain mindful of the additional risks involved.
Understanding the risks
While today’s higher yields may be enticing investors back to bonds, it is important to remember that bonds are not risk-free. Bond prices can fall when interest rates rise, which means investors who sell before maturity may get back less than they originally invested.
Corporate bonds also carry credit risk, as companies can face financial difficulties and may be unable to meet their obligations. Inflation can erode the real value of both income and capital over time, while overseas bonds may be affected by currency movements. As with any investment, the value of bonds and the income they generate can fall as well as rise, meaning investors may not get back the amount originally invested.
The bottom line
The sharp rise in bond yields has undoubtedly been challenging for investors, but it has also transformed the opportunity set available within fixed income markets.
For the first time in many years, higher-quality bonds are offering levels of income that have not been available for some time. While volatility may persist in the near term, higher yields may provide a foundation for future returns and reinforce the important role that bonds can play in generating income and diversification within a well-balanced investment portfolio.
Rosie Briggs is director of Barclays Private Bank and Wealth Management