The Future of Bonds

Whilst valuations at the start of 2016 signalled a peak in the value of the bond market, in the nine months to the end of September, four key indexes all continued to rise providing exceptional returns for investors. However, the over-performance of the bond market is only one side of the equation – the UK economy is the other – and it’s not the first time that predicted falls in value have failed to materialise.

In spite of the post-Brexit forecast, confidence has held up, we have a stronger than expected economy and inflation overtook the Bank of England’s official target of 2%. However, following a turbulent nine months on the political front, there has been continued speculation over how these events will eventually affect bond markets and whether investors should plan for a reversal.

One key point to note is that inflation caused by a currency collapse, like that of sterling, is very different to inflation resulting from an overheating economy. Forthcoming UK inflation will likely be driven by imports and, whilst crude oil prices have fallen back to around $52 barrel, rises in domestic energy tariffs and the lagged effect of past currency depreciation all signal upward pressure on costs. Unlikely to be met by an equivalent increase in wages, this could even trigger a contraction of the country’s economy, the opposite of what the Bank of England is trying to achieve. Secondly, central banks are trying to stimulate growth in the economy by simultaneously managing the money supply in the economy and keeping inflation low.

So whilst risk-free bond rates are intrinsically linked to underlying monetary and economic conditions as mentioned above, it would take highly accelerated rates of inflation (hyperinflation) to cause a crash in the risk-free bond market, a scenario which, based on current inflation rates around the world, seems highly unlikely.

Another economic factor contributing towards a continued stability of bond markets is credit conditions. Both credit spreads and default rates are in line with historic averages and, barring a repeat of the 2008 credit crunch, as long as credit conditions remain stable, cash-flows from a bond portfolio should also remain steady.

So at a time when US advisers urge investors to avoid a shift to bonds but Eurozone bonds remain steady as Brexit gets underway, it reminds us why we invest in bonds in the first place – to protect ourselves from uncertainty.

At Finura Partners, we always encourage clients to take a long-term view on their investments as opposed to basing their decisions on what is happening in the market today. If you would like advice on including bonds as part of a diversified investment portfolio, please contact your Finura Partners adviser.

Sources: https://www.ft.com/content/0b279e28-e322-11e6-9645-c9357a75844a
http://www.dailymail.co.uk/wires/reuters/article-4360364/Euro-zone-bonds-steady-Brexit-gets-way.html
https://www.vanguard.co.uk/adviser/adv/articles/research-commentary/topical-insights/will-bond-value-fall.jsp#