Bonds have their mojo back

The Oxford Dictionary definition of a bond (the finance version) is a document issued by a government, local authority, or company promising to repay borrowed money with interest over a long-term period. In a non-finance sense, a bond is a strong feeling of friendship, love, or shared ideas and experiences that unites people.

In recent history, most investors will agree that bonds haven’t delivered a very attractive level of interest. Incidentally, nor do I feel a particularly strong feeling of friendship or love for my recent fixed income investments – I, too, bought the infamous 2061 UK government bond.

However, given the recent sell-off in yields, especially that of the last month or so, have bonds finally got their mojo back?

The importance of yield

I almost feel a sense of discomfort writing something so elementary to a bond-savvy audience, but here goes: the starting yield on a bond largely dictates your future returns.

Now that’s out of the way, let’s put some numbers to it.

2022 was a difficult year for most bond investors, for reasons well documented. The start of the year was around the point that the sell-off in yields started to intensify, so we will start there.

The starting yield of the 10-year US Treasury was 1.51%. Fast forward to 30^th September 2026, yields closed at 5.29%, for a total yield change of 3.78% over a 4 ¾ year period. If you held 10-year Treasuries over that period, you would have experienced a return of -13%, equivalent to -2.9% p.a. For completeness, all analysis assumes a constant 10-year maturity.

Now let’s consider if bond markets experienced a similar sell-off over the next 4 ¾ years. Starting at 5.29%, we follow the same path as the one recently trodden, taking us to a yield of 9.06% on 30^th June 2031. Let’s put aside for one moment the absurdity of yields reaching those levels for the sake of this exercise. Holding 10-year Treasuries over that period would return you 9.3%, equivalent to 1.9% p.a.

The same sell-off in yields over the same period, but a 22.3% difference in returns. Simplistically, 22.3% divided by 4.75 years is a difference of 4.69% p.a. That is the 3.78% difference in starting yield, plus a bit of convexity to bridge the gap: at higher yields, a bond’s duration is lower, so the same rise in yields does less damage to the price.

Back to feeling a sense of discomfort, all of this is to say that: income carries a lot of weight.

Where might we go from here?

Separating the don’t knows from the do knows.

We don’t know if or when a resolution to geopolitical issues will ease supply-side inflation pressures, to what extent the large hyperscaler capex (and broader AI expansion) will impact the economy, or whether a larger degree of fiscal prudence will offer some respite for bond investors.

But, we do (now painfully) know that the range of potential returns over a three-year period on a 10-year government bond at a starting yield of 1.51% on 31^st December 2021 left plenty of room for disappointment – and deliver it did: a three-year yield rise of 3.06% left investors with a return of -14.6% over the period. Looking at a narrower range of yield changes, the potential returns are shown below. 

What we also do know is that the starting yield on bonds is at multi-decade highs.

And the last thing we do know is (apologies, for the final time…) that the starting yield on a bond largely dictates your future returns, and income carries a lot of weight. And that evidence is clear in the potential for attractive returns from this point onwards.

Putting aside one’s view on the world, I think we can all agree that at these levels, bonds have their mojo back.