Mark Dampier: 'Mayhem central - will anyone get out of the bond markets alive?'

Low interest rates mean savers have been fighting for their bonds' income

Bond investors face a conundrum: no one knows whether the rise in bond yields (and fall in prices) will be dramatic or more gradual (Rex Features)

In last week’s column I mentioned, almost in passing, that there had been considerable volatility in the bond markets recently. “Volatility” is a word that tends to be used more often in the context of shares, rather than bonds, which are often used in portfolio planning, partly to reduce volatility. They also pay a regular and relatively secure income.

Yet the period of low interest rates since the 2008 financial crisis means savers have been fighting for their required level of income. As the popularity of bonds has increased, we have seen their yields, particularly the yields of government bonds, fall to all-time lows (and prices rise).

Some bonds now offer a negative yield, meaning investors are in effect paying for the honour of owning them. This is quite extraordinary, as it suggests bond markets are forecasting an almost permanent global recession.

In the early part of this year, bond markets were spurred on by the dramatic fall in the oil price and the introduction of quantitative easing in Europe. For many investors, buying bonds was viewed as a one-way bet, as the popularity of the asset class meant there was always someone else who would buy them from you in the future. I believe this is dangerous territory.

Bonds are traditionally viewed as liquid investments, which means investors should be able to buy and sell their investment at a reasonable price at any time. However, this always assumes there is a buyer or seller on the other side. In recent years, as huge positions in fixed-interest investments have built up, the majority of interested buyers are already in the market. So who are they going to sell their holdings to?

In my view, the recognition of this issue is one of the reasons why we have recently seen increased volatility. It is not out of the question that yields will spike suddenly and quite dramatically. If you want an example of a lack of liquidity, look at what happened to the Swiss franc when the country’s central bank dropped its three-year peg to the euro: its currency soared against the euro.

Prior to this recent weakness, the bond bull market can be traced back to 1981. Back then, Paul Volcker, the chairman of the US Federal Reserve, had been taking drastic action on high levels of inflation. At that time, US treasury (government bond) yields were over 14 per cent. Since then we have seen an almost relentless rise in bond markets, of course with the odd interruption.

Surely we must now be at a turning point. What no one knows is whether the rise in bond yields (and fall in prices) will be dramatic or more gradual.

My bet is that investors’ initial reaction will be more on the dramatic side. A 10-year UK gilt yields around 2 per cent today, but the low at the beginning of the year was 1.3 per cent. It is quite conceivable that this will reach 3 per cent, which would mean a capital loss of around 8 per cent. That said, a spike in bond yields, although unpleasant for investors who bought bonds at a lower yield, could bring more buyers into the market.

Bond investors face a conundrum. With the developed world still contending with huge levels of government and private debt, it is hard to make a case for interest rates rising to a level that most investors would call normal. Arguably, even a peak in interest rates of 2 per cent over the next few years could be deemed too high, given the effect this would have on the average mortgage rate.

For both private and professional investors, this poses a difficult challenge. The best uncorrelated asset class to bonds is cash, yet it is hardly in favour given the low interest rates available. That said, it might be a good place for patient savers to wait until the potential problems have been smoothed out.

For those wishing to maintain bond exposure, strategic bond funds could be another solution. These funds have the flexibility to take advantage of different bond market environments, and some currently focus on sheltering capital in more turbulent times for fixed-interest markets – although their success depends on the fund manager making the right calls.

On the other hand, equities could be considered, although they are also unlikely to escape any bond market turbulence and could increase the risk of a portfolio overall.

Mark Dampier is head of research at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more details about the funds in this column, visit www.hl.co.uk