Are bonds back on the agenda after last year’s woes?
- Identify some of the fundamentals of the bond market
- Explain the impact of inflation and interest rates
- Describe the issue of duration
- Identify some of the fundamentals of the bond market
- Explain the impact of inflation and interest rates
- Describe the issue of duration
Last year was the worst year in a generation for bond investors. As it became increasingly clear that central banks — and most investors and forecasters — had incorrectly labelled the spike in inflation “transitory”, bondholders were reminded of the pain inflation can inflict on a bond portfolio.
Persistent inflation forced central bankers to raise interest rates at a pace not seen in decades, and to levels that were last witnessed before the global financial crisis. This in turn pushed bond yields sharply higher, and therefore bond prices sharply lower.
The sensitivity of a bond to rising yields is measured through its duration — the higher the duration of a bond, the larger the fall in price for a given rise in yields. Multiple factors impact the duration of a bond, but generally, bonds with longer maturities and lower coupons have higher duration.
Many companies took advantage of rock-bottom rates in 2021 by issuing bonds with longer maturities, and investors who bought those bonds suffered large losses in 2022.
Given the sheer size of the increase in yields last year, duration was the dominant factor in the varying returns from different segments of bond markets. For instance, high-yield bonds outperformed investment-grade bonds in 2022, despite credit spreads widening significantly during the year as investors increasingly priced the risk of a recession.
Because investors are less willing to lend to riskier companies for a longer period of time, high-yield bonds usually have shorter maturities. Also, these businesses must pay more in coupons to compensate for their higher risk of defaulting, further reducing their duration. These features mean high-yield indices tend to have far lower duration than investment-grade indices.
Why linkers got carried out
Investors holding inflation-linked bonds might have thought they could escape 2022 somewhat unscathed — after all, their coupons and principal are linked to inflation, which was the main cause of losses.
However, a significant rise in real yields (that is, after inflation) meant these bonds also suffered. In fact, the UK index-linked gilt index was one of the worst performers worldwide, driven by its extremely long duration since it is stuffed full of very long-dated bonds.
Linkers maturing in five years or less would have made mid-single digits because the coupon inflation uplift offset the effect of higher real rates on the maturity payment, but anything beyond that was dealt double-digit losses.
Many companies took advantage of rock-bottom rates in 2021 by issuing bonds with longer maturities, and investors who bought those bonds suffered large losses in 2022