Ask ii: ‘are bonds really low risk? My portfolio keeps dropping!’

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A reader asks if fixed income is really the defensive investment it is made out to be: “Are bonds really low risk? My portfolio keeps dropping!

“I have about £300,000, which I am in the process of moving to interactive investor, to invest cautiously. Bonds would have formed a significant part of the strategy in the past, but I am worried about how risky they are as I’ve read that inflation is still sticky, interest rate cuts have slowed, and the UK government is having trouble finding buyers for its gilts.”

Sam Benstead, fixed income lead at interactive investor (pictured above), says: “While bonds are often marketed as ‘safe’ investments, and correspondingly typically tend to make up a large proportion of a portfolio for investors who have retired, they are definitely not risk-free. In fact, they can be equally as risky as shares, as many investors would have noticed over the past couple of years as interest rates rose. How bonds perform depends on what’s happening in the economy and markets.

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“Let’s go back to basics and explain what a bond is and why its price moves. So, broadly speaking, bonds are issued by a company or government to raise money. In return they pay a fixed coupon (an amount of income), which is determined by the market conditions of the day, as well as the quality of the issuer, for the life of the bond. They then return an investor’s money when they mature.

“If you own bonds directly, such as a UK government bond, known as gilts, and sell before the bond matures you will make a loss or a profit, depending on market prices when you sell.

“This is because bonds are traded on secondary markets, and the value of the fixed coupon to other investors will change. The big thing that causes the value of the coupon to change is interest rates. If rates rise, the fixed coupon becomes less valuable – this means the bond will fall in value, while its yield rises. If rates fall, the relatively higher fixed coupon becomes more valuable, causing the bond’s price to rise and its yield to fall. Remember, price and yield are inversely correlated.

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“The degree of interest-rate sensitivity is called ‘duration’. Generally speaking, the longer until a bond matures, the longer the duration, but coupons are also part of the calculation.

“Therefore, bonds generally fell in value during the period between late 2021 and early 2023 when investors began pricing in higher interest rates.

“That was a big shock to bond markets, but these haven’t really got that much better since then. Yields have continued to rise as investors have questioned whether inflation is really defeated, as well as if the new government will be fiscally responsible.

“So, where does that leave us now? Are bonds still risky? There are two reasons bonds are a much safer investment now than a few years ago. The first is that yields give investors protection from capital losses. Paying around 4.5%, gilts now offer a respectable income which could cushion the impact of further yield rises.

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“The other reason to be more confident owning bonds is that because interest rates have risen so much, central banks have the capacity to cut rates (and boost bond prices), if the economy goes into recession. In this environment, equities could perform poorly, but bonds could be rising in value – giving a portfolio a boost when it needs it most.

“That’s not to say yields won’t rise further, but we are very unlikely to see the jump in yields (and therefore significant bond losses), that we saw when interest rates went from 0.1% to 5.25% in the UK.

“If you’re really worried about bonds falling in value, some parts of the asset class are less risky, such as bonds maturing soon. Direct gilts are an option here, with lots of shorter-maturity bonds proving popular right now. Or a fund of short-duration bonds could do the trick.”