Why bonds, why now?

Bonds are a defensive asset that can provide a portfolio with a measure of protection against volatile markets.

The face value of a bond is returned in full at maturity – the end of a bond’s life. This means capital is somewhat protected if the bond is held to maturity.
Investors who hold bonds also receive interest payments — known as a coupon — that provides regular, predictable income.

Capital preservation and predictable income means government and high grade investment bonds are generally lower risk and less volatile than shares.
In the event of a company going bankrupt, bond holders receive payment before equity holders.

Bonds also trade in what is known as the ‘secondary market’. The price of these bonds rise and fall in line with expectations of interest rates in the future. It means bonds also offer opportunities for capital appreciation (as well as capital loss) because they can be bought and sold before maturity.

The price of a bond moves inversely to the level of interest rates. If rates are rising, the coupon paid on future issuance is likely to be higher than paid on the current bond. Hence the current bonds price falls. So higher rates mean bond prices fall and lower rates mean bond prices rise.

Currently, as interest rates rise, bond prices fall providing a better yield. Given higher interest rates tend to dampen returns in many other asset classes, such as equities, bonds become relatively more attractive.

This feature means slowing economic growth often corresponds with the potential for a lift in the value of bonds, providing positive returns when other investments like shares can be delivering negative returns.

2022 was the worst performing year in recent history for bonds, which sold off in reaction to the fastest pace of interest rate rises ever as central banks fought inflation.
Inflation has been rising for a number of reasons, including:

• COVID restrictions hit supply chains, meaning businesses had to compete for inputs.
• High government spending to cushion economies during COVID meant households had extra money to spend.
• Russia’s invasion of Ukraine disrupted supplies of oil, gas, metals, wheat and corn, forcing prices higher.
• Quantitative easing

Higher interest rates directly reduce bond prices.

Interest rates have been rising since early 2022 as central banks tackle inflation.
When rates rise, bond prices fall — and in 2022, bonds delivered their worst annual price performance as interest rates rose at their fastest pace ever.

But the pace of rate rises is expected to slow.

•  Inflation appears to be slowing
•  Supply chain bottlenecks are easing
• The job market has probably peaked

A slowdown in inflation probably indicates that the end of the global central bank rate rise cycle is nearing.

When central banks start to cut rates, bond prices will rise.

• This is not a linear relationship — depending on the duration of a portfolio, a 1pc fall in yields can deliver returns as high as double digits for a bond fund.

Historically, interest rate cuts quickly follow hiking cycles.

On average, the US Federal Reserve starts cutting rates just 8 months after its last hike. For the Reserve Bank of Australia, this gap is 10 months.

This means the time to add bonds to portfolios is fast approaching.