Bond correction

Regular readers of our Viewpoint magazine will know that, while bonds still offer good diversification characteristics to a portfolio and are a source of income, we haven't be a fan of of the asset class for a good three years now. Bonds have been coming to the end of a 30-year bull run and had become very expensive. Last month saw the start of a long overdue correction in most bond markets – a correction which has gained momentum in the past week or so. However, we not think investors should panic unduly.

What has been happening?

Since the global financial crisis began, governments around the developed world have been printing money and buying their own government bonds in an attempt to keep economies going. This has had the effect of boosting demand and decreasing yields. This is not normal practice and has been distorting the bond markets.

Whilst central banks have kept interest rates low, the bond markets have had a stay of execution. However, when interest rates do eventually rise, the yields on bonds will also have to rise, otherwise investors will reject them in favour of other assets. When yields on bonds rise, the price falls though, and capital losses can occur.

In the past few weeks, the yields on longer-dated government bonds (those of 10 years or more), which have been very low for a long time now, have started to rise.

For example, the yield on the German 10-year bund has risen from 0.06% to 0.68%. This may not sound like much of a move, but as the price of a bond falls when the yield rises, it represents around a 6% capital loss. If it were to return to the heady levels of 1.5%, where it stood just 12 months ago, the capital loss becomes 13%.

Of course the European Central Bank (ECB) has a lot of ammunition in the form of €1 trillion worth of quantitative easing to throw into the pot so we don’t expect yields to rise much further in the short term (ex a Greek exit), but anyone “investing” at these levels needs to be aware of the longer-term risks.

In the UK, 10-year gilt yields bottomed in February and anyone buying at the low yield of 1.32% is now nursing a loss close to 5%. In the US the 10-year treasury yields have gone higher too, from 1.8% to 2.1%; just short of a 3% capital loss.

These moves have prompted some investors to start reallocating their money away from bonds into other assets.

What about corporate bonds?

Investment grade corporate bond funds have given up most of the gains they had made so far this year and are currently up just 0.6% in terms of total returns. High yield bond funds are as yet unscathed, and are typically the least sensitive to interest rate movements. However, as yields here are also very low, this may not be the case for long.

Somewhat paradoxically, however, European corporate bond markets may be OK. Europe has only just begun its quantitative easing and Draghi has most of his €1 trillion left to spend. As the ECB continues to buy government bonds, sellers of this asset will need to buy something else and will be pushed up the credit spectrum.

Why is this happening?

A mixture of reasons. The oil price rally in recent weeks, coupled with stronger economic growth data from the eurozone, has suggested that inflation is not dead.

Inflation is very bad for bonds as it erodes their real value.

Secondly, Janet Yellen, Chairman of the Federal Reserve in the US, pointed out that these longer-dated bonds were expensive – and they duly sold off. The timing is still uncertain, but her statement indicated that interest rates would be rising in the US.

Rising interest rates are bad for bonds as they have to increase yield to attract investors. As we have seen in the examples above, an increase in yield leads to a fall in price.

The trouble is, we've had mixed messages about when interest rates will rise. It has been 'will they or won't they' for a long time now. While there is more certainty that rates will rise in the US sooner rather than later, only yesterday (13th May 2015), Mark Carney, the governor of the Bank of England, has said that interest rates are unlikely to rise for another year in the UK. We can probably expect volatility in the bond markets each time the monetary policy committee meets to discuss interest rates.

Should I be worried?

To put things into perspective, if you hold a bond to maturity, it isn't a problem. You know what interest rate you will be paid and when you will get your money back. The problems start when bonds are sold early at a loss. This situation may occur if bond fund investors, who have enjoyed good returns on bonds for many years now, decide to sell. In this situation you would be crystallising your losses. However, this may be something you are prepared to do, if you think the losses will only get worse.

However, if your investment horizons are long, and you are holding bonds for either diversification or as a source of income, this may not be as much of a concern. And if you trust central banks to take a 'softly-softly approach and 'nudge-up' rather than 'hike' interest rates, you would perhaps believe they will do so without sparking a collapse in bond markets. It is all about sentiment though and, if investors get spooked enough, what could be a small problem could escalate into a larger one.

So what have bond fund managers been doing to deal with this issue?

Liquidity concerns (the ability of a bond fund manager to sell bonds if a lot of investors redeem at once) are not new. Neither is the fact that interest rates have only one direction in which to go. So bond fund managers have had some time to think about this.

They have a number of options to deal with liquidity. These include; buying government bonds (which although not an attractive asset and, as we have seen, could negatively impact performance, they can be sold more easily); increasing their cash weightings; using credit default swaps and introducing redemption fees. Most have used the first two options and the latter is really when they are left with no other choice.

In terms of interest-rate sensitivity, it very much depends on the type of bond funds as to how much action they can take. The most flexible type of fund in this respect are strategic bond funds, as they are able to reduce interest rate sensitivity by the largest amount. In technical terms this is referred to as 'duration' – or the length of time the bond has to maturity. The shorter it is, the less sensitive it is to interest rate moves.

What are my options?

Chelsea Financial Services is an execution-only business and we cannot give individual advice. If you are in any doubt as to what action to take, you should consult a financial adviser. Some general options, however,  are outlined below:

Long-term investors may consider holding tight and ignoring the short-term 'noise' in the market. As we have said, bonds still offer good diversification characteristics and are a source of income. This income, which has been steadily falling, should also see its trend reverse and yields become more attractive. Some may even consider adding to bonds as the income increases.

Those holding bonds for total returns/capital gains might think about switching into another asset class, although this action may already be crystallising losses which have already occurred.

Those invested in bonds for any reason, but who need the money soon, might consider redeeming their holdings.

The important thing, as ever with investments, is not to panic and make knee-jerk reactions. Consider your personal circumstances and re-evaluate why you are invested in bonds and then decide what to do.

Bond funds which may fair better in these circumstances are those with a low duration (low sensitivity to interest rates) like Elite Rated 24 Dynamic Bond and AXA Sterling Credit Short Duration Bond.

If you would like to learn more about bonds and fixed income funds, click here to read our free guide on the subject.