All eyes on equity markets – but how have bonds fared?

Volatility is back. After more than a year of calm in stock markets, last week was anything but. The FTSE 100 is back where it was in May of last year while the S&P 500 wiped out all its gains since December.

How have bond markets fared?

The global bond 'sell-off' - on the back of higher-than-expected US wage inflation and worries over a new head of the US central bank – was where the market correction started, after all.

Well, despite the initial 'taper tantrum', bonds have fared reasonably well. From 1 February to 9 February 2018, the worst performing bond sector, IA Sterling High Yield, is down 0.89%*. The average strategic bond fund is down 0.77%* and the average corporate bond fund is down 0.73%*. Further afield, the IA Global Emerging Market Bond sector average made a loss of just 0.12%* while both UK government bond funds and global bonds are still in positive territory returning 0.01%* and 0.38%* respectively.

So despite the possibility that we are entering a bond bear market, fixed income funds generally are holding up okay for the time being.

What does 2018 hold in store for the asset class?

Bond markets are finally starting to price in the fact that central banks around the developed world could raise interest rates more quickly than previously expected - particularly if inflation is stronger than anticipated. Rising interest rates and inflation are traditionally bad for bonds.

The Bank of England monetary committee, which decides on the level of our interest rates, has been more upbeat recently and their focus has shifted back to tackling above-target inflation. The possibility of a rate rise sooner rather than later is growing and some investors think rates could even rise twice this year.

Across the pond, it is expected that the Federal Reserve (US central bank) – even under the new Chair – will follow through on its plans to raise interest rates three times this year. The European Central Bank is also forecast to end its stimulus programme and the Bank of Japan has hinted that it could scale back some of its stimulus later in the year too.

Options for investors

The bond market is very complex and different types of bonds behave differently to others. So there are ways to mitigate these risks and bonds still warrant a place in your portfolio, in our opinion. As we saw this week, bonds tend to fall less than equities at times of market stress.

Government bonds tend to be more sensitive to interest rates than high yield bonds, as do bonds with maturity dates further into the future. So one option is avoid or reduce your weighting to government bonds and another is to have a bias towards 'short duration' bonds – these are bonds that are due to mature soon. The manager can also then reinvest the maturing bond money into another bond with a slightly higher yield.

Corporate bonds – those issued by companies - tend to be more sensitive to the economic outlook and the underlying company’s financial situation. As the global economic back-drop is actually looking quite healthy, this suggests this part of the bond market should be relatively resilient.

Another option is to choose a fund that has a higher yield, which could compensate for falling prices and potentially result in positive total returns.

Over the years, the tools available to bond fund managers and the types of fixed income securities have increased in number, helping them to navigate all market conditions. Strategic bond funds in particular, which can invest across the whole fixed income spectrum, benefit from this flexibility.

So one final option is to choose a strategic bond fund and let the manager – who has the full range of tools in his kit – choose where to invest and shift the portfolio as the market conditions change.

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius's views are his own and do not constitute financial advice.

*Source: FE Analytics, total returns in sterling, 1 February to 9 February 2018, using the IA bond sector averages.