Bond Watch: are 7.5% bond yields too good to be true?

Welcome to interactive investor’s ‘Bond Watch’ series, covering the latest market and economic news – as well as analysis – that is relevant to bond investors.     

Our goal is to make the notoriously complicated world of bond investing simpler, by analysing the week’s most important news and distilling it into a short, useful and accessible article for DIY investors.          

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Should you consider ‘high yield’ bonds?

Bonds generally serve two main purposes for investors: to protect a portfolio when stock markets fall and to deliver an income.

The safest bonds, like gilts or US Treasuries, as well as investment grade bonds, provide the greatest diversification from equities, but yields are generally lower.

One part of the bond market that may appeal more to income seekers is the “high yield” segment – these are bonds that don’t secure an “investment grade” rating and are therefore considered less secure. They can be referred to as “junk” bonds.

The greater default risk comes with higher yields, currently around 7.5% compared with around 5% for the safest corporate bonds or 4% on gilts.  

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On top of higher yields, another potential advantage of high-yield bonds is that they have shorter maturity dates, meaning their “duration”, or sensitivity to interest rates is lower. This means that an interest rate rising cycle should be less damaging to the value of the bonds, so long as the economy is not going into recession and the expectation is that there will be corporate defaults.

Faisal Islam, manager of Baillie Gifford High Yield Bond fund, says that compared with a couple of years ago, now is a good time to be looking at high-yield bonds.

“Because central bank interest rates are back to normal levels, getting a 7.5% yield from a high-yield bond is a much more normal level compared with low rates seen recently,” he said. 

Islam says that while investors may be concerned about the credit quality of high-yield bonds, the default rate of a global index of high-yield bonds is normally only around 3% a year, rising to 7% or 8% in a recession.

“It’s been much lower recently. Income forms the vast majority of total return on high-yield bonds, and income levels at the moment are historically attractive,” Islam adds.

He says that over five years you are likely to get returns close to the yield-to-maturity of a portfolio, so around 7.5%.

One pushback to investors in the sector is that high-yield bonds are relatively expensive right now. Their “spread”, which is the excess return over safe government bonds, is 3.5 percentage points. Islam says spreads are only this “tight” 15% of the time.

This tight spread is due to a rosy outlook for the economy, and may widen if sentiment goes negative.

UK borrowing costs rise

UK borrowing costs are rising as investors worry about government spending and borrowing plans.

The 10-year gilt now yields 4.2%, up from around 4% a year ago. Two years ago, yields peaked around 4.4%, before falling and then sitting around the 4% level.

• Bond Watch: UK borrowing costs rise ahead of the Budget
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• Benstead on Bonds: what the Budget will mean for gilts

When investors sell bonds, yields rise. Rising yields tell us many things, from a lack of faith in the government, to worries about rising debt levels, as well as concerns about inflation.

In this case, rising yields could suggest that investors are worried about Chancellor Rachel Reeves’ spending plans. Reeves has said there is £22 billion fiscal “black hole” to plug, and there are media reports that she could look to change the fiscal rules to accommodate taking on more debt.

Because the chancellor has said that there would be no changes to income tax, national insurance and VAT, it is likely she will target inheritance tax, capital gains and pension taxes as a means to raise money.