Ask ii: why are my ‘low-risk’ bond funds still losing money?

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Rebecca asks: “I own bonds in my portfolio to protect against stock market drops, but my bond funds fell substantially last year and are not performing well this year either. This is even as the income from them rises, leading to a total return loss that I wouldn’t expect. Are bonds still a good defensive investment and why are they still performing so poorly?”

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Sam Benstead, deputy collectives editor at interactive investor (pictured above), says: You’re probably not the only bond investor, including professionals, who has been scratching their head regarding performance over the past few years. It is very reasonable to assume that in times of market stress and falling stock markets, the role of bonds in a portfolio should be acting as a buffer, helping to reduce overall losses. Moreover, rising bond yields led many big fund groups to declare that ‘bonds were back’ at the start of the year.

However, bonds have continued to perform poorly. Two key bond sectors for retail investors are UK gilts and sterling corporate bonds. Funds in these sectors fell on average 4.5% and 1.5% over the past six months, and are down 29.5% and 13% over three years. This includes the income reinvestment.

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Anyone investing in inflation-linked gilts would have done even worse, as I explain here. To understand why this happened, you need to understand what drives bond prices.

Bond prices move inversely to interest rates. When rates go up, bond prices tend to go down, and vice versa.

This is because when interest rates rise, investors can lock in a better return by buying new bonds. This decreases the appeal of older bonds, and so prices fall, pushing yields into line with market rates.

Therefore, even though bond prices tend to rise when equities fall and markets are worried, the impact of rising interest rates over the past couple of years has been enough to counter this normal pattern.

In 2022, the Bank of England’s base rate rose from 0.25% to 3%. This year, rates have kept rising to 5%, with markets now betting that 6% interest rates could be the peak. Most commentators thought that inflation would drop quickly, but in reality, it has been very sticky and is only just starting to fall. This meant more rate increases than many expected.

Rising rates this year have caused bonds to keep falling in value, but given the end of the hiking cycle could be near, the pain could be nearly over for bond investors.

Inflation figures for June showed that prices rose 7.9%, below the 8.2% expected. Core inflation, which excludes volatile food and energy prices, fell to 6.9%, from 7.1% in May.

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In response, bond prices rose significantly, therefore leading to lower yields. Investors were betting that the central bank would not have to raise interest rates as much as previously thought on the back of the inflation figure.

The reading could show that peak inflation is well and truly behind us now, and prices will fall in the UK like they are doing in America, where the inflation rate is just 3%.

If inflation is near the Bank of England’s 2% target next year, then getting 5% gilt yields and 6.5% corporate bond yields could prove a very savvy trade, especially if there are economic troubles and the Bank of England chooses to cut interest rates to stimulate the economy.

Bonds could therefore become defensive again because central banks are close to winning their fight against inflation, meaning that they have room to cut interest rates if they need to.

So while bond investors have suffered lately, the pain could be nearly over. It all hinges on inflation returning to normal levels and interest rates not rising more than markets expect.

If you want to own bonds that are less sensitive to changing interest rates, stick to bonds set to mature soon. Bonds near their maturity date, say under three years, are less affected by changes in interest rates because investors are not locking up their money for a very long period.