Bonds have traditionally been one of the key pillars of a diversified portfolio. Alongside equities, bonds help investors balance risk and return amongst their investments.
That meant using bonds as safe investments, and equities as riskier ones. A balanced portfolio might consist of 60% equities – the riskier, higher-growth assets such as funds, stocks and trusts – with 40% allocated towards bonds, to provide a measure of security in the event that share prices decline.
Like most investing traditions, however, this rule of thumb has come into question. Bond and equity markets are often correlated with one another, particularly during periods of high inflation and volatility (as we’ve experienced over the last two years).
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Also, treating all bonds the same is a bit like treating all stocks the same. While bonds generally deliver smoother, more predictable returns than stocks, there are still high-risk bonds and low-risk bonds.
“Like any other asset class, you want to get a return from your bond investments, but they can be used as a diversifier as well,” Oliver Faizallah, head of fixed income research at Charles Stanley, tells MoneyWeek. “One bond investment might be good for one type of investor, while another might be good for a different type.”
So, what are the key things to know about investing in bonds – and is now the right time to buy?
Investing in bonds: the basics
In effect, a bond is an IOU – it is a unit of debt issued by governments, or large corporations. When someone buys a bond from the issuer, they are effectively loaning money to them.
As with any loan, there are two variables with bonds (besides the important one of who is borrowing money by issuing the bond, which we’ll come to later): the amount of interest to be paid, and the date by which the debt needs to be repaid. When talking about bonds, we refer to these as the coupon rate and the maturity date, respectively.
The coupon rate is expressed as a percentage of the original loan, i.e. the price that the issuer charged for the bond (usually referred to as the bond’s face value or par value).
So a five-year bond that costs $1,000 and a coupon rate of 5% will pay the bondholder $50 per year, for five years. When it reaches maturity, the bondholder will receive $1,000.
Generally, investors will buy bonds for the income they generate. It’s less common to see bonds traded in order to realise gains in their price.
Is now a good time to invest in bonds?
In Faizallah’s view, now is “as good a time as it’s ever been to buy bonds”.
Effectively, this is because the current economic climate combines relatively low, stable inflation with high bond yields – in other words, bonds are cheap, offering decent returns, and these aren’t likely to be decimated by runaway inflation in the near future.
“When you look at the risk-free bonds, like gilts (bonds issued by the UK government), yields have increased quite dramatically over the past two years, as we’ve had inflation run away from us.”
However, despite the Bank of England cutting rates and inflation coming down significantly, yields have remained higher – in fact, in the days leading up to writing this, gilt yields reached levels not seen since the 2008 financial crisis.
“If you buy a five-year bond paying in excess of 4.5%, and you think over the next two years inflation will be around about 2%, if you hold that bond to maturity… you’re growing your wealth in real terms by [at least] two and a bit percent.”
Assuming a high grade bond such as a gilt (the UK government has never before defaulted on its debt), that real (i.e. inflation-adjusted) return is as close to risk-free as investors can get.
However, Faizallah cautions that the long term outlook is uncertain as far as the bond market is concerned.
Should the UK enter a period of stagflation, for example, this would be “potentially worse for bonds”.
Bonds for risk?
There are two forms of risk involved when investing in bonds: credit risk and default risk.
Credit risk essentially refers to the creditworthiness of the borrower. Anyone who has ever taken out a loan or a mortgage is familiar with credit risk, and the concept that more creditworthy borrowers pay less interest on their loans.
The same is true in bond markets. In the same way that some stocks are risker than others – and offer higher returns in exchange – some corporate (or governmental) borrowers are higher-risk than others. Buying bonds from them carries greater default risk, but can also offer higher returns.
At present, says Faizallah, some high yield bonds are offering around 7.5%. “That’s a near equity-like return,” he says. “I might buy high-yield bonds because they’re actually paying a really decent return. There is a risk that there’s going to be a default – you get drawdowns, but probably not as much as equity.”
In other words, it could make sense for investors to add high-yield bonds into the riskier elements of their portfolio, rather than viewing bonds as simply an alternative to equities.
Duration risk and the yield curve
Duration risk relates to the time to maturity of the bond. The longer the duration, the greater the risk that macroeconomic events – higher inflation or interest rates being the prime examples – could diminish its value compared to other comparable investments.
For that reason, longer-duration bonds usually offer a higher yield than shorter-duration bonds, all other things being equal.
“A so-called ‘normal’ shape for the yield curve is where short-term yields are lower than long-term yields, causing it to slope upward,” explains Faizallah. “Bonds that have a longer maturity are more exposed to the uncertainty that interest rates or inflation could rise, and this risk is why investors usually demand a higher yield for longer-dated bonds.”
Exceptions to this rule occur when bond markets anticipate higher interest rates or inflation in the near future than over the longer term. This causes yields on shorter-duration bonds to increase above longer-duration bonds. When this happens, it is called a ‘yield curve inversion’, and it has often preceded a recession.
The yield curve for government bonds in the US, the UK and Europe was inverted through 2023 and much of 2024. However, unusually, central bank rate-cutting caused yield curves to ‘uninvert’ without a recession occurring.
How can you invest in bonds?
Government bonds such as gilts can be bought through investment brokers, on stock exchanges or directly from the government. UK government bonds, for example, can be bought directly from HM Debt Management Office and from authorised agents.
Corporate bonds are all-but inaccessible to most individual investors, given that the minimum purchase amount for any one issuer tends to be $100,000. However, you can gain exposure to corporate bonds through buying funds, such as a bond ETF. For example, the iShares $ High Yield Corp Bond UCITS ETF (LON:SHYU) offers exposure to dollar-denominated high yield corporate bonds, and returned 6.8% during 2024.
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