Given current economic conditions, are bonds a good investment right now? The dilemma was summed up by one Monevator reader like this:
“I’m led to believe that current bond returns are likely very poor, and they could quite conceivably crash too with interest rate rises. So, are they a good idea to have in a 2021 portfolio?”
I believe bonds are a good investment still, and the following thought experiment helps illustrate why.
Imagine you’re 100% in equities with a portfolio of £200,000. The economy takes a dark turn, and the stock market falls 25%.
Your all-stock portfolio is now worth £150,000.
It’s a blow but you can handle it. You’ve seen bear markets before and recovery soon follows.
But the market doesn’t recover; it falls another 35%.
Your portfolio is now worth £97,500.
And the economic news is dreadful. Everyone thinks worse is to come. Your plans have been set back years.
Meanwhile your job is at risk. Your industry is convulsing. Waves of redundancy sweep through your firm. You could be next.
An economic depression looms. Your portfolio is your family’s lifeline.
So you panic. You sell. Now your portfolio really is worth £97,500.
The loss is locked-in. It’s real.
Avoiding that is why you own bonds.
Are bonds a good investment? Depends how you judge them…
Bonds are a good investment mainly because they’re a shock absorber that can stop you hitting the panic button.
We all know that equity declines can inflict savage losses on a portfolio.
The UK stock market fell 72% from 1972 to 1974. Some 57% was wiped off US stocks from 2007 to 2009. And near-90% was erased from the Dow Jones during the Great Depression.
Few of us really know how we’ll react, though. A crisis feels like a crisis because we can’t see the bottom of it.
The overriding point of government bonds is to protect you from the urge to panic.
The reason minimal-risk bonds can do that is encapsulated in the phrase: the flight-to-quality.
When the economy implodes, a money-tsunami flows out of equities and into government bonds.
Investors assume that, when the smoke clears, bond-issuing countries like the UK and the US will still be standing and paying their bills – even if their companies are in dire straits.
That time(s) when bonds saved the day
We can see evidence of the flight-to-quality at the low point of many historical downturns.
When the dotcom bubble burst, gilts gained 14% from 2000 to 2002 as UK equities sank 41%.1
In the following additional case studies, ETF returns data and charts come from the portfolio-building service JustETF. The blue line is UK government bonds and the red line is world equities.
Coronavirus crash 2020
The developed world stock market (represented by iShares MSCI World ETF) fell -26% by 23 March 2020.
UK government bonds (represented by iShares Core UK Gilts ETF) rose 4% by the same date, as investors bailed on equities and took refuge in bonds.
Global Financial Crisis 2008-09
The World ETF crashed -37% by 6 March 2009. Gilts softened the blow by moving 14% in the opposite direction.
European Sovereign Debt Crisis 2010
Equities slumped -15% but UK gilts were up 5% by 2 July 2010 and 9% by 31 August.
Global Stock Market Downturn 2018
World equities delivered a lump of coal on Christmas Eve 2018 as they slid 16%. Christmas cheer came from gilts – up over 1%, and near 5% in March.
August Stock Market Downturn 2011
Equities dropped 19% while gilts countered with a 5% gain by 19 August 2011 and 11% by 29 November.
Guilty pleasures
Time and again we can see the flight-to-quality effect, as investors sell off equities and flee into government bonds.
Gilts have improved portfolio returns – thereby suppressing the panic reflex – in the majority of UK downturns for over a century.
They don’t work every time (and we’ve talked before on what improves your chances) but the fact is high-quality government bonds usually limit the damage when equities plunge.
Other assets don’t come close. Not emerging markets, tech stocks, infrastructure, dividend aristocrats, commodities, property, cash, corporate bonds, gold, bitcoin, or even index-linked bonds.
A diversified equity portfolio does not help in a crisis.
Stock markets buckle like carriages in a train crash in a globally interdependent economy. You can see this using any stock market charting tool.
You’re not diversified if your holdings all behave the same in adversity.
That’s why true diversification means spreading your bets across asset classes, rather than just among the many shades of equity.
One last time: high-quality (developed world) conventional (not index-linked) government bonds are the best asset class to own when recession hits.
For UK investors that means including gilts or a global government bond fund hedged to the pound when choosing your asset allocation.
Expected bond returns
It’s true the outlook for bonds is poor.
The expected return of your bond fund is its current yield-to-maturity (YTM).
To take one example: the YTM of the SPDR UK Gilt ETF is 0.85% as I write.
Subtract 2% for inflation and an intermediate gilt fund is liable to return a small loss in real terms2 for the foreseeable.
The historical real return of UK government bonds is around 1.4% a year, so it may seem unacceptable to lose, say, 1% per year now.
But that nick is much more acceptable set against the risk of locking-in a double-digit loss during a stock market panic.
Call it an insurance payment.
Bond market crash
What are the chances bonds could inflict a more grievous loss?
- When market interest rates fall your bonds make a capital gain.
- But when market interest rates rise, your existing bonds take a capital loss.
The fear of a bond market crash resonates because interest rates are lower than my chances of winning Olympic Gold on an all-chips diet.
Pundits predict the only way is up for rates. That implies capital losses for bonds.
There’s two important things to know, however.
1. Pundits have been predicting a bond market crash for over a decade.
Stopped clocks may strike it lucky but financial markets can defy received wisdom for decades – and indefinitely after a so-called ‘regime change’.
There’s no law that says interest rates must return to the old normal. Indeed there is evidence that rates are in secular decline. And there’s plenty of runway yet for negative yield bonds.
2. Bond market crashes are a mild after-dinner burp in comparison to the Krakatoa-esque implosions of the stock market.
Compare these two charts showing 120 years of UK equities and gilt returns from the Barclays Equity Gilt Study 2020.
Equity returns are dispersed like a shotgun blast: anywhere from over -50% to over 60%. Note the frequency of corrections (-10%) and bear markets (-20%). Major slumps occur regularly.
Gilt returns are overwhelmingly distributed between -6% to 6%. There are only three annual losses greater than 20%.
Point being the outlier bond crashes marked on the agony-to-ecstasy chart above do not match the equity market’s extremes.
Gilt bear markets and corrections happen much less often than more familiar equity woes.
The worst return for gilts was -33% in 1916 amid the bloodbaths of World War One. That’s grim but still, the stock market would sniff “Hold my Beer”.
Note too, the worst three negative results are amplified because the bonds being measured were undated (1916 and 1920) and 20-year long (1974) bonds.
The longer your bond takes to mature, the more vulnerable it is to inflation.
Rampant inflation hammered all bonds during these periods. But the results look especially horrendous if you track the long varieties, or worse, undated bonds that never mature.
In today’s environment, you can lower risk by using intermediate or short duration bonds. They will react much less violently to interest rate rises.
The worst annual loss since Barclays began tracking 15-year gilts is -14% in 1994.
Not all bonds are alike
Outcomes can vary dramatically depending on the average maturity date of your bonds. The farther away the maturity date (that is, the ‘longer’ the bonds), the harder they could fall (all things being equal).
Bond funds use a metric called duration that indicates how they’ll perform if interest rates rise or fall 1%.
For example:
- A bond with a duration of seven years will lose around 7% of its market value for every 1% rise in its interest rate.
- A bond’s price will similarly shoot up by about 7% if its rate falls by 1%.
Whatever your bond’s duration number, that’s how big a gain or loss you can expect for every 1% change in interest rates.
You can control your exposure to downside risk by choosing a bond fund with a lower duration.
For example, SPDR ETFs offer short, intermediate and long gilt funds with very different durations:
| Bond fund type | Bond fund name | Duration |
| Short | SPDR UK 1-5 Year Gilt (GLTS) | 3 |
| Intermediate | SPDR UK Gilt (GLTY) | 13 |
| Long | SPDR UK 15+ Year Gilt (GLTL) | 21 |
Source: SPDR
Imagine interest rates rose by 1%. With these funds, you’d brush off the 3% loss inflicted on the short-dated GLTS much more readily than the -21% gouge out of GLTL’s long bonds.
On the flipside, eagle-eyed readers will pounce on the fact that if interest rates drop 1% during a recession, you’d gain 21% from GLTL versus a limpwristed 3% hoist from GLTS.
That’s the Damoclean choice we make:
- Short bonds are more resistant to rising interest rates but they offer less stock market crash protection.
- Long bonds can inflict equity-like losses if interest rates hike significantly, and equity-like gains if rates drop a percentage point or two.
Thankfully, intermediate bond funds offer a third way. They blend bonds across the maturity spectrum into a single fun-pack.
Remember too that rising interest rates mean higher future yields for bond investors as your fund manager sells off the old and buys the new. If your interest payments are being reinvested then they’ll buy new bonds at cheaper prices than before the rate rise.
The maths shows that a bond fund will eventually recover its initial capital loss and end up ahead due to a rate rise.
The duration metric reveals how many years that will take (approximately).
For example, a duration 7 fund will breakeven around seven years after the rise.
Note: I’ve had to simplify some of the above for sanity’s sake. Use duration as a rule-of-thumb rather than a written guarantee from the Queen.
Interest rates are forever fluctuating, and this doesn’t affect all bonds evenly at the same time.
See our previous deep-dive into how bond prices react to interest rate changes for more (and check out the appendix below this piece).
If you’re especially keen, you can also glean interesting information on how rapidly interest rates can change in the modern era from Monevator reader and professional bond manager ZXSpectrum48K.
Good bond investments
Choose low-cost index trackers that hold gilts, or high-quality global government bonds (developed world) hedged to the pound.
Hedging to the pound negates exposure to currency risk, which would otherwise add volatility to your defensive allocation.
A total bond market fund that includes high-quality corporate bonds is okay. It’s likely to perform worse than straight government bonds in a recession though.
Accumulators
Think intermediate bond funds. Long bonds could mean a world of pain and short bonds barely spike in a recession.
An intermediate bond buffer should leave you with plenty of dry powder to buy cheap equities during the next crash.
A 5% to 10% slug in cash and gold further diversifies your defences in a downturn.
Some people hold no bonds in favour of cash. But cash won’t counter-rise in a crash. Cash yields are also currently negative, after-inflation. Some cash is fine but don’t go crazy.
Similarly, don’t go overboard on gold. It’s performed very well during the last two crises but its long-term track record is patchy. Gold is like a funny drunk – erratic and highly unreliable, but occasionally brilliant.
For good inflation protection you can put about half your bond allocation into index linked bonds. This is the best asset class to defend against runaway inflation. However it doesn’t do much during standard recessions.
The young and new to investing assume they’ll be fine with 100% equities, but that isn’t necessarily true. Some people just can’t stand losing money.
Read this piece on estimating your risk tolerance to know thyself.
Decumulators
There aren’t good alternatives to bonds for those spending down a portfolio. The same forces that previously boosted their portfolios now leave decumulators bereft of defensive assets that can generate a return.
It’s best to suck it up. Think of bonds as an insurance policy and thank your lucky stars for the bull markets that got you this far.
Given elevated stock market valuations, now isn’t the time to ramp up portfolio risk, though it’s a tricky balancing decision.
Personally I’m holding no more than 40% of my portfolio in cash and bonds, in this climate. But at the same time I’m not deluding myself that I’d be safer by going more overboard on shares, either.
Bonds help you manage your cashflow. Short bonds are for near-term bill-paying needs. Intermediate and index-linked bonds help create an all-weather portfolio that should see you through the decades ahead.
What if someone pushes you a product that supposedly has the defensive capabilities of government bonds based on their proprietary back-testing?
Well, they’re probably trying to sell you something, aren’t they?
If you’re tempted to reach for yield then read the wise words of Warren Buffett. (He thinks it’s a bad idea.)
High-yield bonds, low volatility equities, and dividend aristocrats offer the mirage of a circle squared – but they belong in your risky asset bucket.
Are bonds a good investment? The short answer
In a crash situation, bonds can be priceless because they can cushion the losses that turn a crisis into a full-blown panic.
Yes, conventional bonds are vulnerable to an escalation in interest rates, especially if the economy overheats.
That’s ‘if’.
Equities are vulnerable to a massive stock market crash.
That’s a matter of when.
Take it steady,
The Accumulator
P.S. The lived experience of others can help us imagine the unimaginable. The Great Depression: A Diary is a contemporary account of an economic cataclysm that scarred a generation. I had a new respect for bonds after I read this book. Bonds kept people afloat as their equity positions disintegrated.
Bonus appendix: Bond market interest rates
‘Interest rates’ in the context of bonds does not refer to the central bank interest rates we’re used to.
Instead, we’re talking about the interest rates that apply on the bond market.
Each and every bond is subject to its own interest rate that’s a function of its supply and demand.
This ‘market’ interest rate is the return investors require to invest in that bond.
Bond interest rates fluctuate constantly as the market’s view adjusts in line with new economic data including inflation, the bond’s credit rating and maturity date, and – yes, those all pervasive central bank interest rates.
It’s an incredibly deep and liquid market. Are bonds a good investment in 2021? As ever think very hard before deciding you know better than the sum of the world’s investors!
