Bond markets are tanking. Why?

Bond markets are sinking, with bond yields climbing rapidly. But equity markets are nervous, too – breaking the inverse correlation usually seen between the two. As a result, the well-known 60-40 diversification rule is broken.

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There’s something of a meltdown going on in the fixed-interest bond markets, currently. And I’m talking globally.
Here in the UK, as I write these words, the yield on ten-year bonds stands at 1.96%: up significantly since the end of last year. Gilts — government fixed-interest bonds — have a similar story to tell.

A chart that I’m looking at on the Financial Times website right now tells me that the UK yield curve for ten-year bonds is up almost 0.5 percentage points in the last month. In the United States, the equivalent figure is closer to one entire percentage point.
That’s quite something.

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Yield up, prices down

Now, because bond market commentators always talk in terms of yield — mirroring how bonds are ‘priced’ — it’s easy for investors who aren’t bond-savvy to misinterpret what rocketing yields are really saying.
What they aren’t saying is that this rising yield is good news for bond investors. Far from it.
Fixed-interest bonds are fixed-interest, remember. So the price at which you buy a bond or gilt locks in the return that you’ll get from the periodic ‘coupon’ (as it’s called) that you’ll be paid.

Think of it like a dividend that never changes, however long you hold the share in question.
So for yields to go up — and this is the crucial point — bond prices have to go down. Which is what’s happening at the moment.
The UK iShares Corporate Bond Index is down 6.5% since the start of the year. Vanguard’s Global Bond Index is down 7.4%.
And in the staid world of bonds and gilts, those are big swings. In both yield, and prices.

Fixed interest is, well, fixed-interest

Now, why is it happening? Simple: as I say, fixed-interest bonds (and gilts) are fixed-interest bonds.

Meaning that when inflation rears its ugly head — as it is doing right now, of course — then the value, or purchasing power, of those fixed-interest coupon payments declines.

Bond markets can live with low-level, predictable inflation: markets just factor that into the price, inside the various sophisticated computer models that bond traders possess.

But what bond markets struggle to deal with is the roaring inflation that we’re seeing at the moment — which, post-Ukraine, could climb much, much higher yet.

And faced with such uncertainty, bond prices are plunging.

So what does it all mean?

Two things.
First, the capital that’s being pulled out of the bond markets has to go somewhere. And it’s going into equity markets, helping to prop up share prices.

So if you’ve been wondering why share prices have been holding up so relatively well, post-Ukraine — and especially in the context of a post-Ukraine energy shock — then that’s your answer: in inflationary environments, shares tend to offer rather more inflation protection.
Second, bond markets and equity markets are normally inversely correlated: when one goes up, the other goes down — which is why the well-known 60-40 asset allocation ‘rule’ (60% shares, 40% bonds) works so well for diversification and capital protection purposes.
Except that this inverse correlation isn’t happening now, though: the link is broken. And in fact, following the 60-40 rule could actually lose you money.

Bond bargains ahead?

It depends what you mean by ‘bargain’.

At some point bonds will be cheap (or rather, their yields will be higher than they are now, in other words). Inflation will be tamed at some point, and bond prices will have sunk to new lows.

But I reckon that it will be a brave private investor who buys in at that point, having seen first-hand just how quickly bond investors can see their capital evaporate as inflation takes hold — which of course, it might very well do.

Certainly, I won’t be buying supposed ‘bargains’ in the bond market.

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Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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