Bond yields have seen a relatively sudden spike over the last few months as markets have begun to price in an improving economic environment. Government bonds, particularly those of developed countries such as the US, Canada and the UK have been most affected. For example, at the start of 2021, the yield on a US 10-year government bond was 0.92%; at the time of writing, it is now 1.67%.
What is the yield of a bond?
To answer this, we first need to understand the basics of bonds. Investing $1,000 into a 10-year bond with a fixed coupon of 2% will pay the owner $20 each year until the bond matures. After 10 years the bond will mature, and the owner of the bond will receive back the principal value of $1,000. During the period of ownership, the underlying value of the bond will fluctuate in line with several different factors. These include assumptions regarding the economy, future interest rates and the creditworthiness of the issuer.
Whilst the fixed coupon does not change, the yield does depend on the underlying value of the bond. If the current price of the bond were to fall from $1,000 to $800, the yield would increase from 2.0% to 2.5% ($20/$800). Conversely, the yield will fall when the price of a bond increases.
Why are yields rising now?
The simple answer is expectations. As the world recovers and opens up following the coronavirus pandemic, the expectation is for a more positive economic environment, stronger growth and potentially higher inflation. This type of environment tends to favour higher-risk assets such as equities whose performance is more closely linked to economic activity and which are expected to benefit from higher economic growth in the future. On the other hand, the potential return for bonds is restricted as they have fixed coupons. Therefore, they are deemed less attractive in this environment leading to lower demand, lower prices and in turn higher yields.
Should you still be holding bonds?
In a word, yes. As we have written in the past, even with yields increasing, bonds still play a crucial role within a well-constructed portfolio. Not only do they act as a volatility dampener, they also provide a stable source of income, capital preservation, and portfolio protection in a crisis. These benefits were clearly demonstrated in March last year when equity markets sold off aggressively.
Though higher bond yields are a knock to performance in the short term, those with a long-term view should welcome these higher yields. By reinvesting income from their current bond holdings, as well as proceeds from maturing bonds, into newly-issued, higher-yielding bonds, a long-term investor will generate a higher return in the future.
We must also remember that, if bond yields are increasing across the broad market, it is usually due to a more positive economic environment. So, although our bonds might not be generating the returns we would like, the equity portion will more than likely be making up for this.
Written by Sam Chedzoy and Jonty Brooks.
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General Disclosures: This article is based on current public information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied on as such. The information, opinions, estimates and forecasts contained herein are as of the date hereof and are subject to change without prior notification. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. The price and value of investments referred to in this research and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur.
