Who’s afraid of the big bad bond sell-off?

Life has grown “interesting” for bond investors yet again.

Government bonds, the debt instruments that act like IOUs for nations borrowing money, have been tumbling in value this year.

Prices have fallen especially hard in recent weeks and yields (which move inversely to prices) have surged.

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To quantify this, note that the yields on some government bonds have hit multi-decade highs in recent weeks. 

The yield on a 10-year UK government stands at around 5.4%, slightly above that of its US equivalent. 

Even a 10-year bond from the German government, often viewed as especially safe, has moved on to a 3.6% yield, much higher than a year earlier.

To put this in context, in early October the yield on the 10-year US Treasury hits its highest level since 2002. The German 10-year yield reached a level not seen since 2009.

What’s happening?

Investors tend to reach for a simple narrative when explaining any sell-off, and in this case one factor cited is a rise in energy prices, the possibility of inflation surging, and the interest rate rises that could accompany it.

Certain idiosyncratic developments are also having an effect in places: French government bonds have sold off ahead of elections there, for example. 

There are also some jitters about the artificial intelligence (AI) “hyperscalers” turning to the bond markets for funding.

Rate rises are often regarded as the enemy of government (and higher-quality corporate) bonds, because the increased cost of money erodes the value of the fixed-interest payments such bonds deliver.

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And bonds are still nursing wounds from 2022, a year that was marked by rate rises and a big sell-off for the asset class.

The average UK gilt fund is down by around 20% over a five-year period, although some of this pain can also be attributed to the disastrous “Mini-Budget” unveiled by Prime Minister Liz Truss in the autumn of 2022.

What it means for you as an investor

This has a few effects for investors.

It could mean another rough period for bond funds, as well as for individual bonds. 

Although with the latter, volatility is irrelevant if an investor decides to hold to maturity.

Here, they can lock in the return promised by yield, by receiving interest payments over the period and then a repayment of their capital.

DIY investors have certainly made the most of higher bond yields in recent years, as well as the fact that they don’t have to pay capital gains tax on such holdings outside of a tax wrapper. 

Investors have often backed bonds with shorter maturities and made good gains.

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Our own data suggests that investors turned to the same tactic in September. 

If we look at “real-time” buys from ii customers (and exclude regular investing), they heavily favoured the UNITED KINGDOM 0.125 31/01/2028 (LSE:TN28) UK government bond in September, with customers also snapping up UNITED KINGDOM 0.5 31/01/2029 (LSE:TG29) and UNITED KINGDOM 0.25 31/07/2031 (LSE:TG31).

Some did take advantage of the yields offered by longer-maturity bonds, which are more vulnerable to rate changes, with the UNITED KINGDOM 5.375 31/01/2056 (LSE:T56) also proving fairly popular.

Bonds do remain a niche area, and something of an unknown, for many investors. 

But the sell-off does have important implications for many other areas of your portfolio.

Beyond bonds

Performance figures from 2022 might offer a sense of how a prolonged bond sell-off would affect other corners of the investment universe.

The pain for bond funds themselves was apparent enough in that period. 

The average UK index-linked gilt fund, which is particularly sensitive to rate rises because of the long maturity of the bonds it tends to hold, lost 35.3% in that year alone.

The average gilt fund fell by around 24%, with the average fund from the Investment Association’s (IA) Sterling Corporate Bond sector, exposed to higher-quality corporate bonds, losing around 16%.

2022 also made it painfully obvious that infrastructure and property assets are highly correlated to government bonds. 

The yield from a gilt is seen as the base, “risk-free” level available, and when that rises so do yields from riskier assets such as infrastructure. 

The fact that both infrastructure and property investors take on lots of debt means a higher cost of debt can eat into returns, with this also proving painful for private equity funds.

It’s therefore worth keeping a close eye on those infrastructure funds popular with ii customers, from Greencoat UK Wind (LSE:UKW) to Renewables Infrastructure Grp (LSE:TRIG). 

Property funds that have proved popular, such as Schroder Real Estate Invest Ord (LSE:SREI) and Tritax Big Box Ord (LSE:BBOX), could also feel the pain.

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Investors will want to keep an eye on a few things. 

There are the so-called discount rates, or the value such funds attribute to their future cash flows. 

The value of such flows falls as rates rise, meaning discount rates can fall and net asset values (NAV) can also come down, eating into returns.

It can also be harder to sell assets at decent valuations in such an environment, meaning it’s worth watching how well investment trusts in these sectors manage to sell assets. 

Renewable energy infrastructure trusts in particular are on a mission to sell down assets and in turn reduce their already high levels of debt.

On the bright side, we could make the argument that these sectors are better prepared for an era of high rates than they were back in 2022. 

Back then, infrastructure trust shares had tended to trade on big premiums to NAV before rate rises kicked in, leaving valuations a long way to fall.

Meanwhile, keep another eye on those funds that use bonds as a source of ballast. 

The so-called wealth preservation trusts, Ruffer Investment Company (LSE:RICA), Capital Gearing Ord (LSE:CGT) and Personal Assets Ord (LSE:PNL), make use of bonds to varied extents, and differ by their exposure to bonds of different maturities.

A popular multi-asset franchise would also feel the brunt of the bond sell-off. 

The more bond-heavy names from Vanguard’s LifeStrategy franchise could feel the pain – and actually performed worse than their equity-heavy counterparts in 2022.

There’s a chance that a bond sell-off could eventually feed into an equity sell-off, too. 

That could hurt highly valued shares such as those in the AI space, and growth shares are more generally pretty vulnerable to higher rates. 

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But there is an argument, again, that some classic growth companies have grown more resilient since 2022, with stronger balance sheets.

Bargain hunters may well want to establish a watch list and buy in if we see big falls, provided they can be patient and stomach some volatility. 

Punchy growth funds such as Scottish Mortgage Ord (LSE:SMT) suffered horrific losses in 2022 but mounted a stronger recovery in later years.

If 2022 is a reliable guide, there may not be many places to hide from a broad sell-off. 

But it’s worth noting that commodities and value funds did have a better year.