Bonds have worked so well for so long that it can be hard to picture your portfolio without them. Yet, following the worst year for global bond markets in decades, there are real anxieties over their prospects going forward. The biggest threat they face is inflation. As prices rise, they erode the value of the fixed income you receive on a bond. This has been the worst year for US Bond losses since 1949 and investor sentiment has plummeted to its lowest since the financial crisis of 2008.

Bonds are generally held in portfolios to diversify and complement exposure to equity markets. They also provide a steady income stream. Historically, this complementary relationship has proved invaluable when an economy goes into recession as investors typically dump riskier assets, such as equities, and seek the safety of bonds in a flight to quality.

Why bother with Bonds

However, high inflation is the nemesis of conventional bonds in which the payments of interest and the repayment of capital when a bond matures are fixed because it erodes the value in real terms of both. As a consequence, bonds have provided no protection in 2022 as stock markets have tumbled.

Despite their shocking performance so far this year, we believe bonds still have an important role in portfolios. Indeed, the case for bonds is now actually more compelling because of their recent poor performance and the yields that are now on offer.

This does not mean that yields cannot go higher from this point, as economic risks clearly do still exist, but at these levels at least, the bond markets are beginning to look interesting. The case for bonds in portfolios is detailed below:

  • As fears about inflation give way to fears of recession and its damaging impact on corporate profits, there is no reason to believe that investors will still not seek out the traditional safe haven of high-quality bonds.
  • At the beginning of the year, 10-year gilt yields stood at 1%. The scope for them to fall (and prices therefore to rise) was therefore limited. 10-year gilts now yield close to 3.5% so the scope for profit is now much increased.
  • Although inflation in the UK is likely to remain close to 10% for the next few months, it is expected to fall significantly thereafter. The market expectations of inflation over 5-year and 10-year time periods are both currently at around 3.5%, meaning 10-year gilts are now close to offering a real (after inflation) return for the first time in many, many years.
  • The Sterling Corporate Bond market now also offers much more attractive yields. This is not only because gilt yields have increased but also because credit spreads (the extra interest paid by companies compared to governments) have widened from about 1% to 2.5% since the beginning of the year (as measured by the ICE BoA Sterling Corporate Bond Index). The average yield of high quality Sterling Corporate Bonds at the beginning of the year was 2%. It is now just under 6% and such a return is not to be sniffed at.
  • The same trends have given rise to similar opportunities outside the UK too. The intrinsically higher yielding part of the bond market (as in emerging market debt and lower quality corporate debt) is a diverse and disparate universe, but it has not been spared in the great bond market sell off. The US High Yield Bond market as a whole currently yields close to 9%. Great care is clearly needed when considering investments in emerging market debt, especially if that debt is a liability in US dollars.

Nevertheless, bonds will always provide some kind of buffer. They’re not as volatile as equities, meaning you’re less likely to lose as much on your bonds as you could on your shares.

There’s also an income argument here. Rising yields are bad for investors looking to achieve a capital gain on their bonds, but it does mean they finally offer a reliable income stream that’s been absent for many years. Rising yields could eventually become self-correcting – if they continue upwards, they’ll eventually become attractive to large funds which need an income allocation. That means higher demand, which in turn would push prices back up again.

The value of investments, and any income from them, can fall and you may get back less than you invested. Tax treatment depends on the individual circumstances of each client and may be subject to change in the future. Neither simulated nor actual past performance are reliable indicators of future performance. Information is provided only as an example and is not a recommendation to pursue a particular strategy.