How bond market upheaval could affect all your investments
Share prices grab the headlines – but bond markets are more powerful. And seismic forces are on the march. By Richard Evans
Stock market investors ignore developments in the bond markets at their peril, especially when, as now, once-in-a-generation shifts are in the offing. Put simply, the return on certain key bonds acts as a benchmark for financial assets: shares, other types of bond, even property and cash in savings accounts. “The single most important driver of all investment prices and returns is the yield on American government bonds,” said James Clunie of Jupiter Asset Management. “The big elephant in the room is what is going to happen to these yields. There has been a 35-year bull market in bonds. If it is ending, it affects everything you do as an investor.”
Several respected authorities do indeed think the bond market has turned a corner. We look at what has happened and explain why it could affect every asset in your portfolio.
Why is the bond market so important?
If you can get a certain return of, say, 2pc a year on a government bond, you will not lend your money to a company via a corporate bond that also pays 2pc – it will need to pay, say, 2.5pc. Should the yield on the first bond rise to 3pc, you will demand 3.5pc from the second, and so on.
Bond yields and prices go in opposite directions. If the yield on government bonds rises, their prices fall; then, when investors insist that corporate bonds continue to yield more than government bonds, their prices fall too.
This is the means by which price movements in one asset are passed on to another.
Although there is more to shares than yield, enough people invest in them for the income for their prices to move if bond yields change significantly. The process is similar to the one just described: many people currently own shares because the FTSE 100 index yields almost 4pc and 10-year British government bonds pay 1.3pc; some will sell and switch to bonds if the latter start to yield 3pc instead, for example.
In essence, movements in the bond market tend to spread to other financial assets.
What has changed recently?
The American government bond market appears to have peaked after the decades-long bull market. Looked at the other way, yields have started to recover: the yield on twoyear bonds recently reached 2pc, a level not seen since late 2008. It has risen by almost three quarters of a percentage point since September. Strikingly, two-year bonds now yield more than the US stock market.
Louise Yamada, a respected Wall Street analyst, said the two-year US yield had been carving out a saucershaped trough for almost a decade.
“This yield is the canary in the coal mine. It is legitimate to say that the bond bull market of the past 36 years is over,” she told The Daily Telegraph last week. Bill Gross, a legendary bond investor, said on Tuesday: “Bond bear market confirmed today.”
Should I sell my bond holdings?
Ms Yamada advised investors to get out of all bonds with a duration of more than two years. Anything longer will see an erosion of capital value.
Bonds with short duration are less risky: two years of slightly poor income relative to that available elsewhere is not a big problem whereas 30 years of the same would be – and that distinction is reflected in the price.
Mr Clunie has structured the bond element of his fund, via complex assets called derivatives, so that it has “negative duration”.
“If bond prices fall, my fund should get a modest lift,” he said.
Should I sell my shares?
The danger of such a drastic approach, as Mr Clunie put it, is that “we never know what will happen next”. Bonds could stabilise, or even recover.
Instead, he is changing the type of stocks in his portfolio. “I’m selling some of the ‘bond proxies’ [those seen as paying reliable but relatively fixed dividends] and buying, for example, British ‘value’ stocks,” he said. “The overall effect is that if the market falls, my fund will gain slightly.
“With stock markets as high as they are and interest rates as low as they are, my mildly ‘short’ positions on both assets feel comfortable.”