Who’s afraid of the big bad financial bond market?
.jpeg){kind=logo}
Bill Clinton’s political strategist James Carville once joked that if he could be reincarnated, he would come back as the bond market because “you can intimidate everyone”.
He was speaking from experience, the Clinton administration having had a go-round with so-called “bond vigilantes”. These are not dinner-jacketed purveyors of violence and catchphrases, but groups of investors who protest monetary policies by selling –or threatening to sell – bonds in bulk.
Well, bonds are back. They’re in the news, making trouble for the government. They’re also in your pension fund or portfolio, hopefully not making trouble.Since this historically low-risk and generally unobtrusive market has been making waves recently, it’s worthwhile to understand how it works, or at least why everyone is afraid of it.
The sale of bonds is one way governments and companies raise money for projects, taking loans from investors on defined terms. Corporate bonds are just what they say on the tin – bonds issued by companies. Government bonds are sometimes referred to as sovereign, with UK Government bonds known as gilts and US Government bonds known as treasuries.
A bond is issued for a sum (the principal, or face value) on the basis that this amount will be repaid in full after a specified period (the term). Bonds are credit-rated by insurers, ranging from AAA, the lowest-risk, down to junk bonds, rated C or below. Anything thing above BBB is investment-grade. Sovereign bonds in developed markets, such as the UK and US, are considered low-risk because it is unlikely that a government will default on its payments.
Repayment in full is why bonds have been investment vehicles of choice in retirement planning for decades.
Terms range from short – one to three years – to ten or 30 years, or for as long as the issuer likes. Buyers receive regular interest payments (coupons) over the course of the term at a fixed rate of the face value, which is why bonds are known as fixed-income or fixed-interest investments.
So far, so good. Especially for long-term, low-risk investments in times of stability. But the picture is complicated when bonds are traded on the secondary market. Here, their price fluctuates, with knock-on effects on yields.Let’s say you purchased a ten-year bond for a face value of £1,000 at a coupon rate of 4 per cent. If you retain it, then the yield – £40per annum from the coupon rate – stays at 4 per cent. But if you sold, and the secondary market would only pay £800 for it, the coupon remains the same (fixed) for the term, but with the lower price the bond’s yield would rise – for example, to 6 per cent.
Yields rise when values fall and vice versa – this is good news for investors but bad news for governments. When prices fall and yields rise, borrowing costs for a government increase. This means that other interest rates tied to gilts also rise, making borrowing more expensive for everyone.
So, the bond market becomes a means of gauging confidence in a country’s economic outlook – especially in terms of debt sustainability, growth prospects and susceptibility to inflation.
When Chancellor Rachel Reeves raised the UK’s fiscal ceiling and announced more borrowing for public spending in the last Budget, gilt yields rose. As the cost of borrowing rises, the headroom she created evaporates into the cost of servicing the debt.
There were two gilt-supply events in the first week of January. Yields climbed once again. While there may be jitters about the UK outlook, there is also considerable geopolitical uncertainty. Trump’s potentially inflationary flagship policies, tariffs and deportations, mean that interest rates are likely to fall more slowly than anticipated, keeping the cost of borrowing high.
This is close to home – quite literally – for those who have to remortgage this year.
But bonds are likely to be doing good for you too. They are an essential part of a balanced portfolio. Andrew Spence, CEO at investment management firm Aspen, highlights that bonds are back as a useful tool, saying: “For many years leading in to 2022, bonds were awkward to hold in client portfolios – yields were low (0 per cent in some cases), and prices were susceptible to a material leg down (which we inevitably saw in 2022, as interest rates rose rapidly to combat inflation). Now, however, we can get between 5 per cent to 7 per cent on our bonds, without taking much interest rate risk (by holding shorter dated bonds), so they are a great asset to have at our disposal again.”
For more visit here