The bond markets tend to feature in newspaper columns these days discussed with a sense of fear, trepidation or possibly wonder. But for contrarian investors, intrigue is the more useful emotion.
Fund management legend Sir John Templeton said that “bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria”, and nowhere is there quite so much pessimism about bonds right now – especially government bonds.
Yields to maturity have been rising, and thus prices falling. Since its summer 2020 peak, the generic UK 10-year government bond, or gilt, index is down by almost a third, which has wiped out any financial benefits of the 0.08pc running yield on offer six years ago.
That capital loss is only crystallised if the bondholder sells, and anyone patient enough to buy a bond at issue and hold on until maturity should, all things being equal, bank their coupons and get their money back.
But the trend in yields and prices looks so resolutely negative, contrarian investors could be forgiven for wondering whether it may be time to take a closer look.
Coupon considerations
Bonds can be a portfolio diversifier, especially for those who fear a bout of equity market turbulence, seeking income or both.
One rule of thumb is that the fixed-income weighting within a portfolio should equal an investor’s age – the older one is, the greater the need to avoid volatility and benefit from income.
Plain, vanilla bonds will redeem at their issue price, or par, but their price will change during their lifetime. Things can and do go wrong.
Bond funds do not mature or close either, so the investor must therefore assess four risks when investing in bonds, via individual issues, or actively or passively managed collectives.
They are: interest rate risk, inflation risk, creditor (or default) risk and liquidity risk.
Any bond must offer a coupon, which, in the eyes of the buyer, offers sufficient compensation for all of those dangers.
The UK has not formally defaulted on its debt since 1672 with King Charles II’s Stop of the Exchequer, and the UK can always print money to pay the interest if it has to do so.
However, rising government borrowing, and thus supply of gilts, is a genuine worry. The Bank of England is no longer a price-insensitive buyer under its quantitative easing (QE) scheme, and is reducing its bond holdings by selling paper or not reinvesting on maturity, in a process called quantitative tightening (QT).
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