Benstead on Bonds: best and worst bond sectors since rates began rising

Interest rate changes impact bond prices, but not all bonds are affected equally. Sam Benstead runs the numbers on bond sector performance since December 2021.

When central banks began raising interest rates at the end of 2021, they triggered the beginning of a long collapse in bond prices.

The Bank of England base rate has risen from 0.1% in November 2021 to 4.25% today, while US rates have gone from just above zero to 5%.

Rates had to rise to slow down the economy and therefore, in theory, control inflation – but increasing borrowing costs has big knock-on effects for bond prices.

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When yields on the safest debt rise, this causes a re-pricing of all bonds as investors can now get more from their money elsewhere – but different types of bonds react in different ways to interest rates changes.

The most important variable is how long bonds have until they mature. The longer the bond, the longer the investor is locking up their cash for. Normally, bonds with longer lifespans, such as 30 years, have higher yields than shorter-duration bonds that might be just a few years away from maturity. The higher yields are to compensate investors for lending their money for longer.

Therefore, when there’s a re-pricing of all bonds it is the bonds with longer lifespans that naturally suffer the most. This is because higher yields on newly issued bonds represent a far greater return over the life of a bond compared with older, lower-yielding debt.

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Other bond characteristics matter when rates rise. For example, if rate increases are signalling to investors that there are economic problems ahead, then riskier, higher-yielding bonds will in theory suffer the most, while safer government bonds would be expected to be more resilient as the coupon payments are all but guaranteed. Bonds that are structured so they can adjust their coupon payments with interest rates should also perform better when rates rise.

What actually happened to bond prices?

That’s the theory, but what actually happened to different bond sectors since the Bank of England first increased borrowing costs at the end of 2021?

I looked at the performance of the Investment Association’s bond sector from 1 December 2012 to the end of March 2023 – and the findings were very interesting.

The best-performing sector was local currency emerging market bonds. This was not because the bonds performed remarkably well, but rather because the emerging market currencies strengthened against the pound, boosting the return in sterling.

Most US dollar-denominated bonds also performed well for the same reason, with the pound falling in value versus the dollar substantially over the past 18 months.

For example, dollar government, corporate and high yield bonds lost between 2% and 3% over this period. The pound fell around 6% against the dollar since 1 December 2021.

On the other hand, emerging market bonds issued in dollars, known as hard currency bonds, performed poorly, dropping around 12% when converted back into sterling because of a strong dollar relative to emerging market currencies.

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Comparing the performance of bonds that pay investors in sterling is a more useful exercise in determining which sectors provided most resilient to rising interest rates.

The best-performing sectors were Sterling High Yield (-6.8%) and Specialist Bond (-6.8%). The specialist bond sector was boosted by floating rate bonds where coupons rise with interest rates, such as the iShares $ Floating Rate Bond, as well as asset-backed bond funds, such as TwentyFour Asset Backed Opportunities, where income is often linked to inflation

High-yield bond funds were also relatively resilient. This is because they trade more like equities, where the risk is that the bond will not be paid back, rather than duration (or interest rate) risk.

While not immune to interest rate rises, high-yield bonds tend to have short maturities, typically less than 10 years. So, when interest rates rise this part of the bond market is impacted less. In addition, the average default rates on high-yield bonds are low compared to history, which has been encouraging.

However, a prolonged recession is the key risk for high-yield bonds. If this happens, expect default rates to rise as in a recession it becomes more difficult for companies to refinance.  

The worst-performing sterling bond sectors were UK Index Linked Gilts (-35.3%) and UK Gilts (-23.4%).

Inflation-linked bonds – where the coupon rises with the RPI inflation rate in the UK – were hit particularly hard by rising interest rates. This is because demand from large institutional investors looking to meet pension liabilities means they tend to have very long maturity dates, often of more than 20 years.

They therefore have high “duration”: the sensitivity of a bond, or bond fund, to any change in interest rates. The higher the duration, the more sensitive the bond is to a movement in rates. This means that investors have been dumping inflation-linked gilts, even though inflation is rising. The prospect of rising interest rates has far outweighed the benefits of an inflation-linked income.

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Regular gilt prices are also closely linked to the Bank of England base rate, but have less duration risk than inflation-linked gilts, meaning that prices are less volatile. These funds own bonds of varying maturity dates, with the shortest bonds the least sensitive to rate changes and the longest bonds the most sensitive.

In the middle, the Sterling Corporate Bond sector fell 14.1% and the Strategic Bond sector fell 8.9%. Strategic bond funds take a go-anywhere approach to fixed income and so a fund manager can take steps to mitigate and hedge interest rate risk, such as by buying short-dated bonds. This is one of the reasons that the sector performed relatively well.

Will historic returns determine future returns?

Is this what we would have expected to happen? The answer is yes, but that does not make predicting the future any easier. While many investors forecasted rising inflation, few predicted the reaction from central banks, and many were caught out for owning what they thought were the safest parts of the bond market: gilts and inflation-linked gilts.

What happens next is anyone’s guess, but the same trend is likely to play out if rates keep rising and inflation is not controlled, with the reverse also true if rates begin to fall. Therefore, the best bond sectors to own will be determined by the direction of interest rates.

So, if rates keep rising and inflation is not controlled, then high-yield bonds, floating rate bonds and strategic bonds fund could outperform. If inflation drops suddenly and interest rates fall to stimulate the economy, then gilts, index-linked gilts and corporate bonds could be worth investing in.

Here are some fund ideas from our Super 60 investment ideas: Royal London Sterling Extra Yield (sterling high yield); Rathbone Ethical Bond (sterling corporate bond); Jupiter Strategic Bond; Vanguard UK Government Bond Index (gilts); and M&G Global Macro Bond (strategic bond).

How bond sectors performed

Source: FE FundInfo, 1 December 2021 to 5 April 2023, total return in sterling. Past performance is not a guide to future performance.