How bonds became a serious investment choice again

When the political world shakes, so does the bond market. After French President Emmanuel Macron called a surprise parliamentary election that might have placed the far-right in power, the gap, or spread, between the yield on French and German government bonds reached its highest level since 2012. Some feared a meltdown in the bond market to rival Liz Truss’s “mini” Budget. As it happened, none of the voting blocs were close to a majority and the far-left is in the lead. With the Nouveau Front Populaire’s nascent tax and spend agenda, further wobbles, both political and financial, could occur.

Bond markets like a quiet life. And that is why, in the UK at least, bond markets reacted calmly to its general election. Labour’s tax and spending plans are not a long way from those of the previous government. Furthermore, the inflationary tide seems to have receded, with the headline rate down to the Bank of England’s target of 2 per cent. The BoE may thus be able to reduce rates at least twice, from the current level of 5.25 per cent, during the rest of 2024.

So, with UK retail investors given direct access to newly issued UK gilts for the first time this spring, should they be buying? Or are the returns too meagre — and the outlook too murky — to add them to your portfolio?

Many private investors have been reluctant to own government bonds for much of the past 15 years. From September 2014 to August 2022, the yield on the 10-year UK gilt stayed below 2.5 per cent. Shorter-dated bonds offered even lower returns; earlier this decade, the two-year gilt had a negative yield, meaning that investors who held the bonds to maturity were guaranteed to lose money. As the joke goes, bonds had switched from offering a risk-free return to promising return-free risk.

If government bonds are the safe bet of the fixed-income markets, corporate debt is like a suitor who turns up in a leather jacket riding a motorbike

Sure enough, government bonds had a bad year in 2022 as inflation surged in the wake of Russia’s invasion of Ukraine. Things were particularly bad in the UK, where the disastrous “mini” Budget caused a sharp sell-off. But there was a silver lining to this decline. When bond prices fall, the yield rises. That is because the yield is calculated by dividing the interest income by the price and adding or subtracting any capital gain (or loss) if the bond is held until maturity.

The best time to buy bonds, in retrospect, was in the immediate aftermath of 2022’s sell-off. At the time, however, the headlines were discouraging. Since then, while bond yields have dropped, it is also true that equity markets (the obvious alternative) have risen sharply. 

Now the trade-off between the two asset classes looks better. Bonds offer a reasonable return; in Britain, the 10-year government bond yields 4.2 per cent, while in the US, the equivalent Treasury bond offers 4.4 per cent. If one assumes that central banks manage to keep inflation to 2 per cent a year, bonds offer a real (after inflation) yield of more than 2 percentage points. At last, they seem like a serious option.

Bonds may not be exciting but they do diversify portfolios and reduce risk. Research by Elroy Dimson, of the Judge Business School, and Paul Marsh and Mike Staunton, of the London Business School, shows that, between 1900 and 2023, the correlation between US equity and bond markets was just 0.2 — if two variables move in lockstep, their correlation is one. For much of the 21st century, the correlation has actually been negative: bond markets have tended to go up when share markets go down, and vice versa. 

This helps to reduce losses in bad times. The academics found that, in their worst years, US equities and bonds have each lost 70 per cent in real terms. But a portfolio composed of 60 per cent equities and 40 per cent government bonds has never lost more than 50 per cent in a single year. 

Why not hold cash instead of bonds? The reason is that the returns on bonds tend to be higher because long-term interest rates are higher than short-term rates. Investors need compensation for the risk of tying up their money for long periods. In Britain, the real return on government bonds since 1900 has been around 1 percentage point higher than the return on cash.

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Nevertheless, there are risks involved in owning bonds, just as there are in owning equities. For any UK investor thinking of buying gilts, the main risk is inflation. The value of conventional gilts is fixed in nominal terms; if you buy a bond with a face value of £1,000, you will get £1,000 back when it matures. Those with very long memories will remember the damage done to gilt investors in the inflationary 1970s, when real losses were more than 90 per cent.

For investors worried about inflation, there is the option of index-linked government bonds. Both the annual interest payment and the repayment value (on maturity) of these bonds is linked to an inflation index (currently the retail price index in the UK, but that is set to change).

Oddly, when inflation surged in 2022, index-linked gilts performed terribly. The reason was that pension funds had been huge buyers of these gilts as they were seen as the ideal way of meeting their promise to pay retirees an income that rose in line with inflation. This pushed up the price of the bonds so they offered a real yield that was negative. The “bubble” suddenly burst with the result that prices fell sharply. But the corollary is that index-linked gilts now offer an inflation-beating yield — only modest in the UK, but in the US it is more than 2 per cent.

Another risk for investors is that governments are still issuing a lot of bonds

And the big difference with conventional bonds is that index-linked bonds will deliver a positive real return, if held until maturity, no matter what the inflation rate. If inflation is 5 per cent over the next 10 years, an index-linked bond will deliver positive real returns; at current yields, a conventional bond will not.

Another risk for investors is that governments are still issuing a lot of bonds. In democracies, it is easier to persuade people to vote for lower taxes and higher public spending than for the other way around. Unless the economy is growing rapidly, the result, over time, leads to bigger budget deficits and a high ratio of government debt to GDP. As recently as 2008, UK government debt was less than 40 per cent of GDP. Now it is rapidly approaching 100 per cent. Logic suggests that, if there is suddenly a lot more of an asset class on offer, investors should demand higher returns to own it. So continued high deficits could lead to higher yields; those bought today may look unattractive by comparison. 

And big deficits look likely. The new Labour government, like its Conservative predecessor, has signed up to fiscal rules that promise to reduce debt to GDP within a five-year timeframe. The problem is that both parties interpret that rule to mean they only need to get debt falling in the fifth year, and it is a rolling target. This year they promise to reduce debt by 2029; next year it will be 2030. It is gruel tomorrow, but never gruel today. 

Even this ever-receding target may never be met. The Institute for Fiscal Studies has talked about a “conspiracy of silence” about the parties’ reluctance to admit what their fiscal plans imply for public spending or taxes.

What will make life even more difficult for governments is a policy change being made by central banks. During the 2010s, and the pandemic, central banks were steady buyers of government bonds through quantitative easing, or QE. The aim was to keep bond yields low as a way of supporting the economy. The result was that governments did not have to worry as hard about the cost of financing their deficits. 

But now central banks, having pushed up interest rates, are selling their government bond piles. This policy has been dubbed quantitative tightening, QT. It means that private buyers (pension funds, insurance companies and retail investors) have to buy not just the bonds that governments are issuing to fund their deficits but those that central banks are selling as well.

Given these negatives, why buy bonds at all? First, they are a useful source of income. The FTSE All-Share index currently offers a dividend yield of 3.7 per cent, which is not too bad, when the S&P 500 index only yields 1.3 per cent. If you need income in retirement, bonds are more attractive. Furthermore, capital gains made on gilts held directly (although not in bond funds) are free from tax. 

Second, relying entirely on equities is risky. If retirees put all their pension pots in shares, they may face a nasty shock if stock markets fall 50 per cent. And while we are used to stock markets recovering, it doesn’t always happen. The Japanese stock market, for example, has only just regained its late 1980s high; the FTSE 100 index got very close to 7,000 at the end of 1999 but didn’t actually pass that mark until 2015.

How much should you hold? It used to be a rough rule of thumb that investors should keep a proportion of bonds in their portfolio roughly equal to their age. That would imply a 60-year-old keeping 60 per cent of their portfolio in fixed income securities. These days, such a proportion looks too high. But for a retiree, the old institutional balance of 60 per cent equities and 40 per cent bonds is something to keep in mind. As protection against inflation, some of the bond portfolio should be in index-linked bonds. Those looking for extra income might consider corporate debt (see box). 

If you own a portfolio that consists entirely of equities, this is not an argument for switching 40 per cent into bonds straight away. But you might think about steadily buying bonds over time. Think of it not just as insurance against a stock market crash but the kind of insurance that pays you money.