Why bond yields are rising, and why it matters

Bond funds haven’t enjoyed a great start to the year. The average UK Gilt fund is down 7.2% over the first three months, while the other bond sectors are also in negative territory*. But why Is this?

The key reason is inflation. For many years, bond managers have been blessed with low inflation and low interest rates and returns have been good as a result.

But the situation has now changed, points out James Yardley, senior research analyst at FundCalibre. “High inflation means central banks are forced to raise interest rates, which pushes down the value of existing bonds,” he said.

Rising yields

Concern over rising inflation has resulted in the benchmark 10-year US Treasury yield recently hitting its highest point in more than three years.

The yield on the 10-year Treasury note (US government bond) has risen to 2.8% in mid-April 2022 (it was 1.7% a year ago), while the yield on the 30-year Treasury bond is 2.9%**.

This may seem like good news on the face of it – after all, the income payments for investors are looking far more attractive.

How has this affected bonds?

But the issue for bond holders is that when yields go up, bond prices fall, and they lose money. This is obviously far from ideal.

Imagine you are choosing between a savings account paying 0.5% interest and a government bond offering 1.5%. It seems like a no-brainer to pick the bond.

However, if the central bank raises interest rates over the year – and high street banks follow – your savings account may end up giving you more.

If the savings account starts paying you 3%, the 1.5% rate that was fixed when the bond was issued won’t look so appealing and its price is likely to fall.

The impact of inflation

With most bonds you get fixed interest payments (called a coupon) and your money back after a set number of years. If the bond has a low coupon and is paying you back in 10 years, you’re at the mercy of inflation.

This is because, although you can expect to get the same nominal value back when the bond matures after 10 years, the rising inflation will have eaten away at the real value of the bond.

Looking at this in context today, with US government bonds yielding 2.8% and inflation in the US currently 8.5%, you can see the issue clearly!

Most bond funds are down year to date because inflation continues to come in higher than forecast. And, if inflation persists, these bonds may need to fall further in value and trade at lower prices on the secondary markets.

How managers see the outlook

According to Richard Woolnough, manager of the M&G Optimal Income fund, concerns about inflation and rising interest rates have cooled demand for bonds.

“The fund’s holding of corporate bonds was the main source of negative return this month,” he said in an update. “We have shifted some high-quality corporate bonds exposure into riskier corporate bonds, because we think valuations are attractive on the latter.”

According to a recent update of the TwentyFour Dynamic Bond fund, the team will pay particular attention to central bank rhetoric over the coming months.

“Future monetary policy [from central banks] needs to be balanced against the continuing headwinds of inflation and the knock-on effects of the current supply-side shock [whereby central banks are also selling bonds they bought during the pandemic], while maintaining economic growth,” it stated.

The managers plan to continue investing selectively in relative value opportunities, particularly in companies that exhibit pricing power in the current inflationary environment.

“In addition, the team will not invest in names with direct or material indirect exposure to the [Russia-Ukraine] crisis and will seek to improve the portfolio’s overall credit quality,” it added.

According to an update from the managers of the Liontrust Monthly Income Bond fund, the risks for financial markets are likely to remain elevated for the rest of the year.

“Inflationary pressures are set to continue and there is scope for further geopolitical uncertainty from the situation in Europe,” they wrote. “We believe the global economy will continue to rebound but have moderated our expectations for growth.”

While not expecting growth to slow as much as consensus, they believe there will be a moderation as interest rates rise at pace. “Inflation pressures continue to be broad-based across a range of segments, with the Ukraine conflict and reintroduction of strict lockdowns in China having a pronounced effect on energy and commodity prices as well as wider supply chain disruption,” they added.

The view on bonds

According to FundCalibre’s James Yardley, this is the reason for being negative on bonds. “We don’t think you are getting adequately compensated for risk and this is still our current view,” he said.

Bond markets have been heavily distorted over the last decade by central banks and quantitative easing, so the process of the market normalising is likely to continue to be painful.

However, that depends heavily on inflation. “If we are in a new period of higher inflation bonds will continue to struggle,” he said. “However, it is also possible that inflation peaks, supply chains normalise, and we go back to how we were before.”

There is also the chance that higher inflation and interest rates could drive economies into recession. “Safe haven risk-off assets like longer dated US government bonds could do well again as investors start to price in interest rate cuts rather than rises,” he added.

*Source: Morningstar Direct, 1 January to 31 March 2022
**Source: CNBC, 14 April 2022

This article was originally published 18 March 2021 and updated on 21 April 2022.