What to know about bond markets

What’s happened to the bond markets?
In its simplest terms, a bond is a loan to a government or company. In return, investors typically receive regular interest payments, with an agreed amount repaid when the bond matures.

UK government bonds are known as gilts, while those issued by businesses are called corporate bonds.

Most conventional bonds pay a fixed amount of interest, so to date, they have traditionally appealed to investors seeking a steady income and a way to balance the risks associated with shares. However, as we have seen recently, their market value can also fluctuate.

Crucially, bond prices and yields move in opposite directions. When prices fall, yields rise.

For example, a bond paying £40 a year in interest offers a running yield of 4% when trading at £1,000. If its price falls to £800, that same payment represents a yield of 5%.

This relationship helps explain both the recent sell-off and the opportunities it may create.

Why have bonds been selling off?
Several factors have spooked investors but the main two triggers are:

• Inflation and interest rates: Rising energy prices, driven partly by the conflict in the Middle East, have renewed inflation worries. If inflation goes up, although the fixed return remains the same from a bond, the value of that return goes down. Higher inflation simultaneously makes it harder for the Bank of England to cut interest rates.
Both factors can put downward pressure on bond prices as existing bonds offering lower fixed interest payments become less attractive.

• Government borrowing: High levels of public debt are another concern. Investors are demanding higher yields to compensate for the risks associated with lending to heavily indebted governments. The forthcoming Autumn Budget on 28 October will be closely watched for reassurance about the public finances.

The sell-off isn’t confined to the UK. France has been particularly affected by political and fiscal uncertainty, with its borrowing costs rising relative to Germany’s, while German bonds have attracted investors seeking greater security.

This suggests markets are distinguishing between countries according to their financial circumstances, rather than abandoning government bonds indiscriminately.

Is this bad news for my investments?
In the short term, potentially yes.

When yields rise, existing bond prices fall. If your pension or investment portfolio contains bonds or bond funds, you may have experienced losses. Longer-dated bonds are particularly sensitive to changes in yields.

However, there’s an important distinction between individual bonds and bond funds.

If you hold a conventional UK gilt until maturity, you should still receive its agreed repayment amount, assuming the government meets its obligations. A bond fund has no single maturity date, and its value will continue to fluctuate.

For investors approaching retirement or drawing an income, understanding these differences is particularly important.

What is the good news?

The same higher yields that have caused recent bond losses are also improving the outlook for future returns.

Investors buying bonds at today’s lower prices can secure higher yields, while money reinvested as existing bonds mature may also benefit.

As of 19 October, benchmark UK gilt yields were approximately 4.7% over two years, 5% over five years and 5.4% over ten years – considerably more attractive than during the prolonged period of exceptionally low interest rates.

Higher starting yields can also provide a greater income cushion against future price fluctuations, potentially making bonds a more rewarding component of diversified portfolios.

There are already signs of investors responding. Some European government bonds have attracted buyers following the sell-off, helping yields retreat from their recent peaks.

That doesn’t mean the worst is necessarily over. Prices could fall further if inflation persists or concerns about government borrowing intensify. Nevertheless, it demonstrates how market volatility can also create opportunities.

Should investors be doing anything differently?
For most investors, making knee-jerk changes in response to short-term market movements is rarely advisable.

Remember that we’re always on hand to check, reassure and help keep your portfolio aligned with your financial objectives and attitude to risk.

The information contained is for guidance only and does not constitute financial advice. It is based on our understanding of UK legislation, whether proposed or in force, and market practice at the time of writing.

Levels, bases and reliefs from taxation may be subject to change. Accordingly, no responsibility can be assumed by Lycetts, its officers or employees, for any loss in connection with the content hereof and any such action or inaction.