Bond Yields: The Risk You Can’t See

Fixed income is an important asset class for investors attempting to reduce their portfolio volatility and diversify portfolio returns. Historically, investors with a high allocation to bonds have enjoyed strong returns without having to take on too much risk. 

Bond prices are inversely related to yields, meaning that for the yield on a bond to rise, the price must fall and vice versa. The past 30 years has seen bond yields fall considerably, resulting fixed income allocations being a large contributor to returns of a cautious portfolio.

Figure 1: Historic Yield on the 10 Year UK Gilt

The golden age of fixed income investing is over

For cautious investors, a key consideration in your financial objectives is your portfolio’s ability to keep pace with inflation. Historically this has been relatively straightforward to achieve, as the yield on government bonds has been higher than the rate of inflation in the U.K. We are now in a situation where yields are at all-time lows, and investors can no longer rely on government bonds to produce sufficient income to keep pace with inflation. This means that until yields rise, the purchasing power of money invested in bonds will be reduced over time.

Figure 2: UK 10-year government bond yield vs. inflation (%)

Rising yields pose a different risk to cautious investors, however. In a rising yield environment, the tailwind experienced by bond investors for the last 30 years can turn into a significant headwind.

The negative impact that a rise in yields could have on bonds is not appreciated by many investors. How much a change in interest rates impacts the price of a bond is measured by its duration. In simple terms, duration measures a bonds sensitivity to a 1% change in interest rates. For example, a bond with a duration of 10 will fall 10% if rates rise 1%, a bond with a duration of 7 will fall 7%, and so on.

A useful way to think about the future return prospects of bonds is to imagine an iceberg. The small visible part above the surface represents the historically low yields available today, while below the surface lies a much greater potential fall in bond prices if interest rates rise.
 

What can investors do?

Whether yields rise or remain low, investors who have historically had a significant allocation to fixed income in their portfolios will not be able to achieve similar returns going forward. We recommend revisiting your financial plan, and specifically the trade-off between risk and return, with your Davy UK Wealth Manager. For clients with a very low ability to take risk, we still believe that high quality bonds are the most appropriate asset for your portfolio, although you will need to revise your return expectations. For those who require a higher rate of return, increasing your exposure to risk assets, while uncomfortable in the short-term, may be the only solution to achieving your long-term financial goals.

Figure 3: Potential impact of rate rises on UK Gilt returns

Speak with your Davy UK Wealth Manager to discuss the specifics of your portfolio, and what changes, if any, may be applied.