Over the last twelve months, we’ve enjoyed good returns from mainstream shares – over the 12 months to 20th October 2023, the FTSE World Index (an index which includes large and medium size shares around the world) was up by 9.53% (with dividends reinvested), and the FTSE All Share Index was up by 9.27% (also with dividends reinvested). Whilst stockmarket returns were disappointing in the previous twelve months, annual returns from mainstream shares have been pretty good over the last 3, 5 and 10 years.
However, it doesn’t feel like this has been reflected in the returns of many portfolios. The reason for this is that it would have been very risky to invest only in shares, and in just one part of that market, so most investors have diversified their portfolios to include different parts of the stockmarket, and other asset classes. And, on the whole, these other asset classes have produced disappointing returns.
Fixed interest stock is the asset class which has foxed most people. This is an asset class which many find difficult to understand, and it took me many years to get my head around how it works. It is, however, an important asset class – if you add up the value of all the fixed interest stock in the world, it is around 30% greater than the value of all the quoted shares in the world. The first bond is said to have been established in Mesopotamia in 2400 BC (so long ago, that its terms were written on a stone tablet). The first government bond was issued by the Bank of England in 1693 (to raise money for a war against France, of course!); this was the first Gilt (a bond issued by the UK government). So, it’s not as if fixed interest stock is some new-fangled or obscure type of investment!
Each individual bond is fairly straightforward – the bondholder lends money to a government or company at a fixed rate of interest (hence, fixed interest stock) for a fixed period of time. It gets complicated as the bondholder can sell the loan on, and the price of the bond will vary, depending on market conditions. As a result, a market for bonds has built up, and, now, millions of transactions are carried out every day.
Fixed interest stock has been an important part of most investment portfolios, and all but the most risky portfolios have included an allocation to bonds. Since 1997, the FTSE Actuaries UK Conventional Gilts All Stock Index (a good measure of returns from most UK government bonds) has only recorded a negative return in four calendar years (against 22 calendar years of positive returns) – with income reinvested. And bonds have been a reliable way of reducing the extent to which the total return of a portfolio fluctuates, reducing the volatility that comes from shares. The positive long-term return and risk reducing characteristics of bonds is what has made them an important element of most portfolios.
However, fixed interest stock has had a recent transformation – having been the equivalent of the boring friend who you can rely on for a lift home at the end of the evening, it’s become the drunken embarrassment whom you wish nobody had invited! In 2022, the FTSE Actuaries UK Conventional Gilts All Stock Index lost 23.83% of its value (with income reinvested); in 2023 (until 20th October), it has lost another 5.63%.
UK Government Bonds (gilts) aren’t the only type of fixed interest investment, and other types of fixed interest stock have produced similar (but, mostly, not quite as bad) returns.
So, the question which we, and, I’m sure, many other investors are considering, is whether it’s time to give up on bonds completely. After all, it seems like an obvious thing to do, when you can simply take your money out of bonds and put it into a fixed term deposit, earning nearly 6% in interest.
It’s important to recognise that the value of fixed interest stock tends to move in the opposite direction to interest rates. So, when interest rates rise, the value of bonds usually goes down, and vice versa. Rising interest rates were to blame for most of the losses last year.
It’s also important to recognise that the UK isn’t the only bond market in the world – so it isn’t just UK interest rates which impact bond values – for example, US bonds are influenced by US interest rates, and don’t pay much heed to what the Bank of England is doing. Generally, in the context of the fixed interest markets, when we mention interest rates, we are talking about interest rates globally (with a particular focus on US rates).
There are also different types of bond – there is a very large market for “corporate bonds”, which are loans to companies. The value of this type of bond is affected by the creditworthiness of the company which has borrowed the money (as well as by other factors). If a company starts getting itself into trouble, the value of its bonds will fall, as investors think that their loan might not be paid back. The opposite can be true – if you lend money to a riskier company, which subsequently starts doing well (or gets taken over by a safer company), the value of your bond should go up.
Somewhat frustratingly, humans also get involved in bond markets. For example, people try to anticipate what might happen in the markets – so, if people think that interest rates are about to reduce, they might start buying bonds in anticipation. The effect of this can be that bond prices rise, even though there has been no change in interest rates. People try to second guess the other factors in the fixed interest markets, so the movement in prices doesn’t always follow the data.
So, investors in fixed interest stock are well advised to spread their risk, by investing in different types of bond. It is likely that, when one part of the fixed interest market is doing badly, another part will be doing well.
Fixed interest stock has been around for a very long time, and it has been a reliable way of making a positive return and reducing the risk inherent in shares. It would be a huge bet to avoid fixed interest stock altogether. There appears to be a good chance that, after a period of stabilisation, interest rates may reduce, particularly if economies move into a recession and central banks feel act to stimulate economies. There are also signs that, in the gilts market, the UK is beginning to earn back its status as a safe haven. If there is weakness in stockmarkets, some bonds are expected to benefit, as a result of their safe haven status. Some of the “safe havens” may not be considered as safe as they used to be (this may well be the case for gilts now).
It is, however, important to make some active decisions in the fixed interest market, choosing the right type of bonds. The characteristics of some types of bond (e.g. gilts) seem to have changed completely, and, a permanent, large allocation to them is no longer advisable. However, that doesn’t mean that there will never be attractive opportunities to invest in them.
Our conclusion is that most people should continue investing in fixed interest stock, although the allocation to this asset class might be lower than it was in the past. However, we prefer to recommend funds which can invest in all parts of the fixed interest market, rather than limiting themselves to particular parts of that market.
It isn’t just fixed interest stock which has detracted from returns over the last year or so – other asset classes have not produced particularly good returns. We will examine these asset classes in future blog posts.
If you do have any questions about this, or would like to talk about your portfolio, please contact us.
Philip Wise | firstname.lastname@example.org
Managing Director and Chartered Financial Planner