What’s Happening with Bonds? And Why You Should Care

Over the past two years, we’ve seen dramatic shifts in the bond markets, haven’t we!? Lots of investors and pension holders in Ireland have often large swathes of Bond Funds within their investment and pension portfolios. But often have never had clarity on what they are or why they move around a bit!

Let’s explore what happened then, and what is happening now.

It’s been a bit of a rollercoaster, to put it mildly. But here’s the kicker: the outlook for bonds is now looking more attractive than it has in decades. And guess what? It’s all down to those rising interest rates.

Interest Rate Movements:

From 2022 through to the summer of 2023, central banks were hiking rates faster than you could say ‘inflation’!

The European Central Bank (ECB) who set the prevailing interest rates for member nations, went bananas with their interest rate increases (in order to tame the inflation that we were experiencing at the time).

ECB rate was 1.25% in September 2022. As inflation took hold, they ramped this all the way to 4.5% by September 2023. That’s a 3% increase in 12 months – it was unheard of and unprecedented…

In the US, the FED rate was 2.5% in September 2022. Again, as inflation took hold, the FED ramped this all the way to 5.3% by September 2023. More than doubled the rate in 12 months. Unprecedented.

In the UK, the Bank Rate shot up from a measly 0.1% in November 2021 to a whopping 5.25% by August 2023, and now it’s settled a tad lower at 5% as of August 2024.

So we can see that central bank rates were going bananas but what does this mean for bond investors I hear you say? Well some hidden ‘good’ and some very visible bad!

The Good, The Bad, and The Bonds

The Good:

Quite simply, new bonds issued during this period of increasing central bank rates offer higher yields than those from the previous years, translating to more income for you. from those newly issued Bonds. That’s a big positive for your long term success, however you can’t actually ‘see’ it!

So, the income from bonds has improved significantly, but if you were watching your portfolio over the last two years you’ve probably noticed that, despite a recent resurgence, the prices/values of bond funds themselves took a hit. Many investors will still be licking their wounds from 2022 when bonds had one of their worst years ever, losing value alongside equities, which is a rare occurrence. So, what’s been driving this price volatility?

The Bad:

It’s mostly down to expectations around future interest rates. When rates were rising, bond prices fell because the market adjusted to the expectation that newer bonds would offer better yields. Which is where we get this inverse correlation between yield (income) rising, and value (value) falling. Yields go up, value comes down! Now, with rates starting to ease off their recent highs in the UK and Europe, and with the US Federal Reserve hinting at cuts, it’s a good time to take a closer look at what drives bond returns.

Why All This Choppiness in Bond Markets?

The volatility we’ve seen since 2022 (falls in 2022 – rising in 2024) is really all about what’s called “duration risk.” In plain English, that’s how sensitive a bond’s price/value which you see on your portfolio, is to changes in interest rates. Longer-duration bonds are more affected by rate changes—when rates go up, the value of future payments from these bonds drops because newer bonds start offering higher yields. Conversely, when rates fall, those same bond prices usually rise.

Think about it this way: if the market thinks rates are going to drop, bond prices can start to rise well in advance. It’s all about expectations, really. And let’s be honest, markets—and the experts in them—don’t usually get it right.

How Did Different Duration Bond Funds Have Performed?

Below shows 3 different funds from Vanguard and Dimensional below.

We have a vanguard diversified duration of 6.6 years

Dimension mixed Duration of 6.6 years

And Dimensional Ultra Short Term where average duration is around 1 month!

Please note, this is just a random small sample here, not a recommendation or any such thing!

2022, as noted, was a shocking year for Bonds, the traditionally defensive asset class!

We can see that the Short Duration Fund still lost value in 2022, but 7/8% better overall than the mixed duration funds. As one would expect.

During the first 9 months of 2023, Bonds were flat. And in October 2023 they started to shift, as rates reductions, and the expectation of rate reductions, became apparent.

From October 2023 to September 2024;

As one would expect, again. The short duration fund has lagged the longer and diversified duration funds, who have recovered 7-9% since the lows of 2023.

I hope this shows the different experiences that one can expect from different duration bond funds. While we can’t expect it to be along those very same lines, the movement of these 3 funds is in line with conventional wisdom. And again, this is a tine sample over a tiny timeframe, merely to show the theory in practice!

Timing The Bond Markets?

If they misjudge the direction or timing of rate changes, active managers and active Bond funds making ‘tactical moves’ to ‘exploit rate shifts’ can lead to some nasty surprises in your portfolio. Hence our strong preference for passive funds here, just as in equities.

When rates were rising, some actively moved from those longer duration Bond and funds, to shorter duration bond funds. This might seem to make sense in hind-sight. However, the challenge then remains of timing their re-entry into the medium-long term funds! Doing so before rates fall, and before the expectation of same being priced is is not something anyone can consistently time. One is trying to play crystal-ball stuff at that stage.

The Importance of Diversification in Bond Holdings

For those of us holding government bonds, the expectations around future rates can and will usually have an even bigger impact on bond prices than the actual changes in rates. If markets expect the central bank rates to move, they adjust. The correlation between actual implemented rate changes and bond yields can be quite low. Sometimes yields fall even when rates are holding steady, all because the market is pricing in future rate cuts prematurely. Expectations! It’s a bit of a dance really, between what’s expected and what actually happens.

So, what’s the takeaway? Well, one thing is clear and predictable from me: it pays to stay diversified! Jumping in and out of bond funds of different durations, or shifting too aggressively from short to long durations can be a risky strategy. In fact, over the long term, a well-diversified bond allocation of different durations and maturities, has tended to outperform sticking with cash or just short-term bonds, even after accounting for the turbulence of 2022………

• Vanguard Global Bond of mixed Duration (6.6yrs) = 44% total return 2009 to 2024
• Dimensional Global Bonds of short duration (c1month) = 16% total return 2009 to 2024
• There has been only one long-term approach to take here dear reader!

The Outlook for Bonds and Interest Rates

Looking ahead, most economists (crystal ballers!) expect interest rates to gradually come down. But don’t hold your breath for a return to zero rates. The so-called “neutral” rate—where rates neither stimulate nor hinder economic growth—is now believed to be higher than it was before the 2008 financial crisis. So, are we likely in a higher rate environment for the foreseeable future. Definitely, Maybe!?

But here’s the silver lining: higher starting rates are generally good news for bond investors, especially for those looking to build lower-risk, diversified portfolios. In fact, our long-term return expectations for bonds have improved significantly since the rate hikes began, even though values have fallen! That means there are solid opportunities for those willing to stay the course and keep a balanced, diversified portfolio. End of.

Bottom Line: Stay the Course, Stay Diversified

At the end of the day, trying to time the markets or guess where rates are headed can be a fool’s game that we don’t play. That’s why a globally diversified approach, both in equities and bonds, makes sense for those of us with some humility!

So, take a step back, keep things in perspective, and remember: a well-diversified portfolio, tailored to your needs, is often the best way to ride out the ups and downs of any market.

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Disclaimer

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