Are bonds the safe bet they seem?

Investment is all about trading off risk and reward. A common view is that shares are risky. They tend to be a lot more volatile they'll deliver more ups and down, and give you more sleepless nights. But over the long haul, in exchange for putting up with this volatility, history suggests that you will make more money from them than from most other asset classes.

The trouble is, most investors don't like risk. The wild ups and downs of the stockmarket over the last decade or so have understandably put many people off investing in shares. Instead, they have been ploughing their money into bonds in the belief that their savings are safer.

For a long time that's been true. As long as the company or government that issued the bond doesn't go bust, then investors in conventional bonds (which pay a fixed coupon' or interest payment each year) get an annual income and then get their money back when the bond matures (in other words, when the loan period ends).

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However, investing in bonds is more complicated than this. Yes, if you buy an individual bond and hold it for all its life then you know what your return will be, in nominal terms at least (ie, excluding the impact of inflation). But that doesn't mean that the price of the bond won't bounce around a lot in the meantime. Also, lots of people invest in bond funds where the bonds are not always held to maturity. As a result, these funds can be a lot more risky in some ways than holding individual bonds.

How interest rates move bonds

As we have seen recently, bonds and bond funds can lose a lot of value if interest rates rise. That's because bond prices move in the opposite direction to rates. One way to think about this is to see bonds as a seesaw. When one end goes up (interest rates), the other end (the bond price) goes down, and vice versa.

This happens because the yield on a bond (the value of the annual coupon divided by the price of the bond) has to rise to compete with higher interest rates on offer elsewhere. For example, say you buy a bond paying a coupon of £5 for £100. The yield is 5% (£5/£100). If interest rates rise suddenly, so that you can get 6% from a bank account, why would anyone accept a bond paying 5% instead? The price of the bond has to fall so that the yield will rise to a point where investors are interested in buying again. On the other hand, if interest rates were cut, so that a bank account paid just 4%, a bond paying 5% would be desirable. So the price would be pushed higher and the yield would fall.

Calculating duration'

How can you work out the impact that a change in interest rates will have on any given bond? There is a formula that you can use: it's called duration' or modified duration'. You don't need to know how to calculate duration (it's quite technical), but it can be very helpful to know what it means and how to use it. The debt management office gives the modified duration figure for all the gilts (UK government debt) in issue. A bond-fund manager will also usually tell you what the duration of the fund is.

Duration is expressed in years. Two things affect duration: the size of the coupon and the length of time until the bond matures (repays the original loan). Short-dated bonds with high coupons have short durations, whereas long-dated, low-coupon bonds have long durations.

For example, the 8% 2013 US Treasury, which matures on 27 September 2013, has a modified duration of 0.2 years. The 0.375% index-linked gilt due in 2062 has a modified duration of 45 years. So what does this mean? Knowing a bond or bond fund's duration can help you make money in the bond market and also help you to limit your risks. Duration tells you how sensitive a bond's price will be to changes in interest rates. The higher the duration, the more sensitive the bond.

So for the 2062 bond above, a 1% rise in interest rates would see the bond price fall by 45% (0.01 x 45). Conversely, a 1% fall in interest rates would see the bond price rise by 45%. Buying long-duration bonds over the last 30 years and maintaining that duration (in other words, selling bonds as their duration declines and replacing them with ones with longer durations) has been a very effective way of making money providing you had the time to see it through.

A simple rule of thumb

But owning long-duration bonds when rates are rising and you are close to retirement is a bad strategy. You haven't got time to recover any losses. If you own short-duration bonds say, less than two years you don't have to wait too long to reinvest your money and take advantage of higher interest rates. The simple rule of thumb is: if you expect rates to go up, stay in short-duration bonds. If you expect them to fall, then invest in long duration ones. You can read our view in the box below.

What you should do

How should you invest in today's bond market? Ten-year gilts currently yield 2.49% to maturity, with a duration of 8.98. The September 2014 gilt yields 0.31% with a duration of 1.11. With inflation (as measured by the Retail Prices Index) at 3.1%, the after-inflation yield on a ten-year gilt is still negative.If yields were to rise to 5%, the price of a ten-year gilt would fall by 22.5% (0.0251 x 8.98). A rise in yields for a one-year bond would see the price fall by just 2.8% (0.0251 x 1.11).

That said, some bond funds have target durations and rebalance their portfolios regularly. So even if they take a short-term battering, they will be buying bonds at higher yields, which will soften the blow. But if you think UK bond yields can go a lot higher from here (as we do), you should stick to short-duration bonds.