Do plunging bond markets offer an opportunity?

The bond market is in free fall. Higher-than-usual yields, and possibly tax-free capital gains, are on offer for those prepared to brave the complexity.

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The headlines are stark.

“Treasury yields hit new high, as bonds extend losses.”

“Bond sell-off intensifies as long-term US yields hit 16-year peak.”

“Hedge funds rush to unwind bets against gilts: short positions in UK government debt fall to lowest level since 2006.”

“UK’s long-term gilt yields highest in 25 years amid bond market rout.”

What’s going on? What does it all mean? And can you — or should you — attempt to profit from it?

Understanding the language

First, a little bit of terminology: even for reasonably seasoned investors, the world of fixed-income debt can be confusing and unfamiliar territory.

What all these news stories are talking about is the bond market — the very same market that brought Liz Truss’s premiership to an end, and crashed pension funds.

Bonds are tradeable fixed-income debt, issued by companies and governments. As the term ‘fixed-income” implies, their nominal interest rate is fixed for life, unless we’re talking about some government-issued inflation-linked bonds. And ‘life’ can literally be forever, or unless redeemed: some (mainly government) bonds are perpetual, with no fixed life.

So as interest rates rise and fall, bonds reflect that through the price at which they change hands. “Bond yields rise” is simply another way of saying “bond prices are falling”.

Gilts? Treasuries? They’re the names for government-issued bonds, in the UK and United States respectively. (UK government-issued bonds were once, quite literally, gilt-edged.)

There’s more — much more. But those are the basics.

Higher for longer

And the bond market rout that the finance pages and websites are talking about?

It’s not difficult to explain. Essentially, bond markets have realised three awkward facts.

First, inflation is stickier than central bankers had hoped — and inflation, of course, devalues the real worth of a fixed-income investment. Whereas equities can increase dividends, a bond’s ‘coupon’ (as it’s termed) is fixed.

Second, the macroeconomic picture for many economies — and, of most interest to us, the UK and United States in particular — is better than many had expected.

And third, as a consequence of these two developments, interest rates are going to stay higher for longer, prompting bond prices to reduce in order to deliver a comparable yield.

Two opportunities

So the opportunity is clear. Or rather, two opportunities.

First, there’s that yield. UK ten-year gilts are offering just over 4.6% at present, I see. 30-year gilts, just over 5%. The income is taxable, but any capital gains aren’t. And you’re lending to the British government, so it’s pretty secure.

Attractive? Up to a point. Buying gilts is complicated: doable, but complicated. Perhaps that’s why the Office for National Statistics estimates that just 0.2% of total UK government debt is held by individual investors.

Buy through a gilt-focused investment fund? Easier, but without any tax advantages, and of course the management fee will sap the returns.

Then there’s those capital gains. What goes down can also subsequently go up — and bond and gilt prices have undeniably gone down. In short, there’s a potential profit to be made, should bond prices go up.

But should you attempt to make that profit? Well, as I’ve said, buying gilts (and bonds) is trickier than buying shares. Let’s hope you know what you’re doing.

Equities still win out

But should you even bother? Granted, retail investors are waking up to these opportunities. But from what I’ve read, it’s wealthier, more sophisticated investors, often with prior bond market experience.

Better by far, I think, is to stick with equities. Plenty of UK blue-chips yield more than bonds and gilts, and also offer capital upside.

Last time I looked, the FTSE 100 was trading on a price-earnings (P/E) ratio of 13, and the FTSE All-Share a P/E of 14. America’s S&P 500? 20. The broader Russell 2000? 25.

I know where I see the greater prospect of an upwards re-rating.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

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