Bond investors should beware the panic as inflation approaches
With yields at record lows and fear of inflation rising, bondholders have rarely looked this vulnerable

Global bond markets have been in a bull market since the early 1980s. That marked the end of the last major inflationary period seen in developed markets. Most bonds pay a fixed income (“coupon”). So while rising inflation is bad (because it makes any fixed payment less attractive), falling inflation is very appealing (the “real” value of the fixed payment increases as inflation falls). This has been reflected in declining bond yields (and thus rising bond prices) for the past 40 years or so. However, the end of the pandemic might also mark an end to the bull market, as governments pump money into their economies to try to prop up the post-Covid-19 recovery and central banks resolve to ignore inflation in favour of full employment. Last week we looked at what sort of assets thrive in a more inflationary world. But what might happen to bondholders?
We’ve already had a taster. Yields rose sharply last week, hitting pre-pandemic levels. What makes today’s bond investors particularly vulnerable is that, as Cullen Roche notes on his Pragmatic Capitalism blog, record-low interest rates mean that bonds offer virtually no income cushion to protect against capital losses. In the late 1970s, when US government bond yields were at double-digit levels, the pain caused by any rise in rates hitting the price of the bond was partly offset by the income.
Today, most government bonds and other “low-risk” bonds pay barely any yield (or none at all in many cases); or, as James Ferguson of MacroStrategy Partnership puts it, “bond yields have less of an inflationary margin of safety than at any time in the last 60 years”. Also, the fact that the last bond bull market began about 40 years ago means that “no one now working in the bond market has ever experienced worsening inflation, nor navigated a proper bond bear market”, adds Ferguson. This surely increases the risk of panic as inflation starts to rise.
MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Central banks are likely to try to avoid any overly disruptive surges in yields. For example, the Reserve Bank of Australia has already printed more money to buy more bonds and thus keep rates down, and “yield curve control” (see below) is likely to be adopted by many more monetary authorities. But while this strategy of “financial repression” might stop bond prices from crashing, it won’t prevent their overall returns from falling in real terms if inflation keeps rising. None of this is to say that you should sell all your bonds. No one has a crystal ball. But it’s worth reviewing your asset allocation and considering how to boost your inflation protection and also perhaps your cash levels. As Roche notes, even discounting a return to 10%-plus inflation levels, “the remainder of 2021 is unlikely to be a fun one for bond investors”.
I wish I knew what yield curve control was, but I’m too embarrassed to ask
In the wake of the 2008 financial crisis, interest rates across the developed world were cut to near 0%. As a result, the world’s central banks have been forced to experiment with ever more radical monetary policies, from negative interest rates to quantitative easing (QE – printing money to buy government bonds and other assets). One such monetary policy tool is “yield curve control”. So what is it?
A “yield curve” compares the yield on bonds with the same credit quality, but different maturities (the maturity is the length of time before the bond repays its face value). So the Treasury yield curve (the most important one) shows how interest rates vary across different maturities of US government debt. A healthy yield curve slopes upwards from left to right – in other words, a ten-year bond will yield more than a five-year one, for example. That makes sense, because in a growing economy with plenty of opportunity, you’d expect to get paid more to wait for your cash.
Yield curve control is when a central bank, rather than just setting short-term interest rates, aims to fix rates on longer-term debt too, by pledging to buy (or sell) as many long-term bonds as necessary to hold interest rates at or below a certain level. The Fed conducted yield curve control both during and after World War II, in order to keep US government borrowing costs down.
The Bank of Japan (BoJ) has had a similar policy in place since 2016, keeping the yield on the ten-year Japanese government bond (JGB) at 0%, although in the case of the BoJ, the main aim was to keep long-term rates from turning negative and hurting the banking sector. The Reserve Bank of Australia adopted limited yield curve control in March last year as Covid-19 spread around the world, saying it would pin the three-year bond rate at 0.25%, and then reducing that target to 0.1% in November last year.
Get the latest financial news, insights and expert analysis from our award-winning MoneyWeek team, to help you understand what really matters when it comes to your finances.
John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.
He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.
His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.
-
Is it time to ride the recovery in emerging markets?
Interview What's the outlook for emerging markets? Gustavo Medeiros, head of research at Ashmore Group, gives his analysis and reviews progress in developing economies
-
Could the Enterprise Investment Scheme cut your tax bill?
The Enterprise Investment Scheme is tax-efficient and potentially lucrative. Taking a chance on the scheme could trim your family’s IHT bill, says David Prosser
-
'Ride the recovery in emerging markets': Gustavo Medeiros of Ashmore Group tells MoneyWeek
Interview What's the outlook for emerging markets? Gustavo Medeiros, head of research at Ashmore Group, gives his analysis and reviews progress in developing economies
-
What is the Enterprise Investment Scheme and should you have one?
The Enterprise Investment Scheme is tax-efficient and potentially lucrative. Taking a chance on the scheme could trim your family’s IHT bill, says David Prosser
-
The alcohol industry is suffering as consumers sober up – is it still worth investing in the sector?
Changing consumer tastes are rocking the alcohol industry, but the best players are adapting their strategies. Buy them while their shares are still cheap
-
A strange calm in credit
Corporate bond markets remain remarkably relaxed, with yields that offer little compensation for risks
-
The City's big bet on green finance fails to pay out
Opinion Insurers and banks are backing away from “green finance”, and there is not much sign of the green boom we were promised. That’s a problem for the City
-
Why is English football thriving – and can it last?
What has gone so right for English football? The national team has found its feet; the Premier League is swimming in money and profits are soaring
-
Six top investment trusts for smaller stocks
Liquidity constraints mean investment trusts are best placed to seize the juiciest opportunities
-
Could colour diamonds add a sparkle to your portfolio?
Diamonds of various shades never go out of fashion, says Chris Carter