Bond Markets - The “safest of assets” could suffer losses we have never seen before

Ben Raven - Director
Our Chief Investment Officer, Christopher Peel, recently explained on CNBC that we may be on the verge of bond market losses larger than anything we have witnessed in our lifetime.
Why is this the case?
One of the issues facing the UK bond markets is that yields are low and duration is high. A yield is the return an investor will receive should they hold the bond to maturity. Duration is a measure of a bond’s sensitivity to movements in the level of the market. For example, if a bond has a duration of 5 years, its price will rise 5% for every 1% drop in interest rates. Conversely, its price will fall 5% for every 1% rise in interest rates.
Our Chief Investment Officer, Christopher Peel, recently explained on CNBC that we may be on the verge of bond market losses larger than anything we have witnessed in our lifetime.
Why is this the case?
One of the issues facing the UK bond markets is that yields are low and duration is high. A yield is the return an investor will receive should they hold the bond to maturity. Duration is a measure of a bond’s sensitivity to movements in the level of the market. For example, if a bond has a duration of 5 years, its price will rise 5% for every 1% drop in interest rates. Conversely, its price will fall 5% for every 1% rise in interest rates.
The UK bond markets currently have the following yields to maturity and durations:
How would clients be impacted?
It is widely expected that both UK inflation and interest rates will rise in the short to medium term. To give an idea of the potential losses on the horizon for UK clients investing solely in UK bonds, we provide an illustrative example below. If we assume that a UK bond portfolio comprises 50% Gilts and 50% Sterling Corporate Bonds, this means that from our table above a client would have an aggregate portfolio yield of 2.04% (average of 1.61% and 2.46%) and an aggregate portfolio duration of 9.77 years (average of 11.24 and 8.29 years).
It is widely expected that both UK inflation and interest rates will rise in the short to medium term. To give an idea of the potential losses on the horizon for UK clients investing solely in UK bonds, we provide an illustrative example below. If we assume that a UK bond portfolio comprises 50% Gilts and 50% Sterling Corporate Bonds, this means that from our table above a client would have an aggregate portfolio yield of 2.04% (average of 1.61% and 2.46%) and an aggregate portfolio duration of 9.77 years (average of 11.24 and 8.29 years).
The illustrative portfolio would therefore looks as follows:
The illustrative portfolio would therefore looks as follows:
Such a portfolio would perform as follows in the event of a 1% rise in interest rates:
As you can see the yield on the overall portfolio has risen from 2.04% to 3.04%
HOWEVER, the client has suffered a -9.77% loss on the value of their portfolio. Therefore, even with a yield of 3.04% and assuming compound returns, it will take the client at least 3 years to recoup the losses. Very few bond investors would be prepared for a loss of this magnitude.

If we look at historical trends in interest rates there is a likelihood that they could rise by considerably more than 1%.

Only a 2% rise would lead to the following scenario:
Now the client has a portfolio yield of 4.04%, however has an overall loss of -19.53% to recoup. Again, even assuming the power of compound returns, the investor is looking at a period of at least 4.5 years before they get back to where they started.

This trend continues and a 3% move in interest rates would lead to a staggering -29.31% loss, with a yield of 5.04% (the losses taking at least 5.5 years to recoup).

Aren’t bonds a low risk investment?

The crucial point to remember here is that clients typically invest in bonds when they are seeking a ‘safe haven’ asset class. Bonds are considered low risk and any client who comes out at the low end of their attitude to risk questionnaire will almost certainly have a significant allocation to bonds within their portfolio. Even more concerning is that as investors approach retirement, the ‘lifestyling’ approach dictates that they are moved out of equities and into bonds as they enter the wealth preservation phase of their life.

The conclusion is that there are millions of investors who are currently invested in bonds who do not have the appetite for this type of risk. These clients include average UK retail clients as well as large-scale pension funds. These are clients who cannot afford to suffer material losses on their portfolios. For them, whether interest rates rise by 1% (-9.77% loss), 2% (-19.53% loss) or 3% (-29.31% loss) the result is the same – a loss far greater than the client can potentially tolerate.

How can I invest in bonds and avoid Armageddon?
  • A greater investment in global bond markets. Exposure to the likes of Emerging Market Debt (both local currency and USD), US and Euro High Yield and US Corporate issuance can provide better risk/reward opportunities for a bond portfolio at present.
  • A reduced portfolio duration. High quality, short duration corporate and sovereign issuance will significantly protect clients in a rising inflation/rate environment.

These factors enable clients to access highly sophisticated and robust bond portfolios that offer the potential to achieve positive real returns which cash and traditional bond portfolios/allocations will fail to do over the coming years.

Crucially by investing in these shorter duration, global instruments, clients will have the chance to make money in bond markets, rather than lose it, whilst operating within the defined volatility (risk) band that they agreed to at the outset.
In the absence of such an approach, many pension funds and retirees will suffer – potentially to an extent that it will take many years to recover from.
This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Tavistock Wealth Limited, Thomson Reuters and Lipper for Investment Management.

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