FOR the first time in years, investors’ eyes are focused not on shares but fixed income investments like bonds, money market funds and cash. What’s getting them so excited?
My word is my bond
Bonds are simple. A borrower (usually a company or a government) promises to pay back the amount loaned at a fixed date and to pay interest in the meantime. This fixed structure makes the returns very predictable as long as the bond is held to maturity.
As interest rates change, the price of a bond adjusts to ensure that anyone buying the bond in the secondary market continues to receive a competitive rate of interest. If interest rates rise, as they have over the past 18 months or so, bond prices fall. That’s bad if you own the bond, but it can provide an opportunity for new investors to buy an investment with negligible risk at an attractive price.
Here’s an example. You can buy a UK government bond today that promises to return you £100 in January 2025. Because the interest rate on that bond was just 0.25% when it was issued at a time of rock bottom interest rates, its price has adjusted downwards so that anyone buying today will earn a return in line with prevailing interest rates. Since last week these have risen to 5% here in the UK. The price of this bond is, therefore, a little over £92 today.
Investors are comparing that return with what they can expect to earn from stock market investments and liking what they see. Flows into bond funds have turned sharply positive this year after big outflows last year. Meanwhile, last week was the worst week since March for equity investors.
A share of the action
The reason that shares did so poorly last week is basically the flip side of the bullish case for bonds. Shares fell because central banks made clear that persistently high inflation is likely to lead to higher for longer interest rates. And that’s bad news for equity markets because it raises the cost of borrowing for households and businesses and threatens a recession if rates stay too high for too long.
Growing fears about the economic outlook have raised question marks over the sustainability of recent gains in stock markets. Unlike bonds, which have continued to suffer as expectations for interest rates have pushed ever higher, shares have bounced back since last autumn as investors have started to look through the current phase of tighter monetary policy to easier times ahead. The US stock market recently moved into bull market territory after a 20% rise since October’s market low.
So, while investors are rightly attracted by the positive outlook for bonds, the recent outperformance of shares makes a strong case for holding both assets in a diversified portfolio. No-one has a crystal ball and the timing of the anticipated shift from shares to bonds is uncertain. And no-one should forget that the returns from shares have been much better than for bonds over the long haul.
After years of shares being the only game in town, investors finally have a choice to make. That’s a good problem to have.
