How to read the bond market


For the umpteenth year in a row, bonds have confounded the bears in 2019. Once more, its exposure to the fixed-income asset class has proved its worth, for diversification purposes and for sold total returns. Yields may not be huge – far from it with the benchmark UK 10-year Gilt offering 0.71% and the US 10-year Treasury offering 1.76% – but yields are lower than they were a year ago because prices are higher.


Fixed income has provided positive total returns across the board over the past year

Source: Refinitiv data

There are several possible explanations for this:

  • concerns over economic growth and buying of ‘haven’ assets – fears over the ‘Japanification’ of the West meant that long-dated bonds did particularly well as portfolio-builders pondered whether we are in for years, if not decades, of weak growth, low inflation and low interest rates;

  • central banks’ return to cutting rather than raising interest rates;

  • the ongoing reach for yield in a low-interest-rate world among life insurers (as they seek to match future liabilities with income) and savers; and

  • the return to bond-buying via Quantitative Easing (QE) by the European Central Bank, ongoing QE in Japan and the US Federal Reserve’s decision to stop shrinking its balance sheet in an attempt to sterilise its QE scheme.

  • Long-dated Government bonds have been the best sub-asset class over the past year

    Source: Refinitiv data

    “Several factors have created strong demand for bonds – more than enough demand, it seems, to swamp the supply created by rampant Government, corporate and consumer borrowing.”


    All of these factors create demand – more than enough demand, it seems, to swamp the supply created by rampant Government, corporate and consumer borrowing. QE programmes lead some to complain that fixed-income markets are ‘broken’ and distorted, even if the amount of bonds on a global basis that come with a negative yield has dropped from a peak of around $17 trillion to $12–13 trillion.

    If supply is apparently not a problem, at least for now, then investors need to think about what could stoke or choke off demand.

    Know the risks

    “There are three major risks associated with investing in bonds, via individual issues or dedicated bond funds.”


    The three major risks associated with investing in bonds, via individual issues or dedicated funds, are:

  • Interest-rate risk. If interest rates rise, there may be more attractive yields on offer elsewhere, persuading investors to sell their bonds and migrate to either a different asset class (cash) or bonds issued with higher yields.

  • Credit risk. This is the risk that the issuer proves unable to pay the coupons (interest) and ultimately repay the whole loan (principal) upon maturity.

  • Inflation risk. As with cash, inflation reduces the real-terms value of the coupons paid by most bonds (index-linked bonds being an exception).

  • In sum, a sudden burst of economic growth and inflation would probably be bad for bonds, with the exception of high-yield and possibly emerging-market bonds. Growth is good for corporate profits and cash flow and makes it easier for firms (or governments) with weak balance sheets to fund their liabilities. This is why high-yield bonds trade more like equity (shares) than debt (bonds) and in simple terms:

  • the biggest risks for Government bonds are interest-rate risk and inflation risk (as very few countries actually default, Argentina being an unfortunate exception and serial offender);

  • the risks for investment-grade corporate debt are probably equally spread between credit risk, interest rate risk and inflation risk;

  • the biggest risk for high yield debt is credit risk and the danger the issuer goes broke.

  • A view on interest rates and inflation will largely shape advisers’ and clients’ outlook on Government bonds and, to a lesser degree, investment grade corporate bonds. A view on the economy and inflation will shape advisers’ and clients’ outlooks on credit risk and therefore high-yield bonds as well as, to a degree, investment-grade bonds.

    Advisers and clients also need to consider the issue of maturity.

  • Short-term bonds offer less interest-rate risk, less credit risk and less inflation risk

  • Long-term bonds offer more interest-rate risk, more credit risk and more inflation risk, as they have a longer lifespan and there is more scope for things to go wrong.

  • That is why advisers and clients generally demand higher yields on longer-term papers, to compensate themselves for the additional dangers.

    Yield curve conundrum

    “Normally, longer-term bonds offer higher yields but in summer the curve inverted, as benchmarked by the yield gap between 2-year and 10-year Government bonds in the UK and USA.”


    This takes us on to the issue of the yield curve. Normally, longer-term bonds offer higher yields but in summer the curve inverted, as benchmarked by the yield gap between 2-year and 10-year Government bonds in the UK and USA. That is usually taken to be a sign that a downturn or recession is coming, as the market prices in lower interest rates in the future in response to the slowdown.

    The good news is the yield curve has steepened and the curve is no longer inverted (the yield on 10-year Gilts exceeds that of 2-year Gilts).

    Investors must decide whether we are seeing a ‘bull’ or ‘bear’ steepener in the yield curve

    Source: Refinitiv data

    “Advisers and clients must now assess whether this is either a ‘bull’ […] or a ‘bear’ steepener [in the yield curve]. … This has implications not just for fixed income as an asset class but equities too.”


    Advisers and clients must now assess whether this is either:

  • a ‘bull’ steepener, where long-term yields are rising faster than near-term ones (which implies future growth); or

  • a ‘bear’ steepener, where near-term yields fall faster than long-term ones (as that implies an imminent recession and more interest-rate cuts)

  • This has implications not just for fixed income as an asset class but equities too. Note that a sudden steepening of the yield curve was a harbinger of increased volatility (if not outright falls) in UK share prices in 1998, 2000 and 2007, so the yield curve must still be watched, not just for its shape, but how that shape is formed.

    So far, reassuringly, the UK 2-year yield is up by 13 basis points from when the curve first inverted and the 10-year is up by 31 basis points. So far, so bullish, but watch this space.

    AJ Bell Investment Director

    Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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