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If you’re unfamiliar with bonds it may be confusing to learn that when bond prices rise, yields fall. And when bonds prices fall, yields rise.
So, what’s the reason behind the inverse relationship between bond prices and yields? And what does it all mean? Keep on reading for all the details or click on a link to head straight to a section…
Issuing bonds is a common way for governments (or companies) to raise funds for new spending. In this article, we’re going to focus on government bonds – known as ‘gilts’ in the UK, or ‘treasuries’ in the US.
If you’re a retail investor and you buy government bonds, you’re essentially buying a slice of the nation’s debt.
In return, you can expect a coupon payment every year until your bond reaches its maturity date. After this date, you can expect to repaid the value of the bond, unless you sell your bond before then, on the ‘secondary market.’
As government bonds are backed by the state, they’re one of the safest assets to invest in. However, this safety comes at a price as returns from bonds are often sluggish in comparison to equities.
However, investors looking to hold a balanced portfolio shouldn’t ignore bonds. You see, bonds can be a lifesaver for investors during times of economic turmoil, including in a stock market crash. That’s because when stocks take a plunge, it’s common for investors to rush to ‘safe haven’ investments. This can push up bond prices as demand grows. This is why bonds typically do well when equities take a hit.
As bonds are perceived as ‘low-risk’, holding gilts can be an excellent way for investors to diversify their portfolio. However, it’s important to note that the inverse relationship between bonds and equities isn’t set in stone. Sometimes both asset classes can take a hit – in 2022 we saw equities AND bonds fall.
There are essentially two ways you can buy, or gain exposure to, government bonds:
Investors with changing risk profiles, such as older investors, may choose to increase the allocation of bonds in their portfolio as time passes. That’s because bonds are typically less volatile than equities and therefore less likely to suffer big, devastating falls.
Obviously big falls can be painful for all investors, regardless of age. However, if you’re an investor in your later years, waiting a decade (or more) for a recovery may be far from ideal – especially if you had plans to sell some of your investments to fund retirement.
For younger investors this is, of course, less likely to be an issue.
There’s an inverse relationship between bond prices and bond yields. This means that when bond prices rise, yields fall. And yes, you guessed it, when bond prices fall, yields rise!
Whenever you hear commentary about ‘a bad day for bonds’ this typically refers to bond prices falling. In other words, when yields rise, this is generally bad news is you’re a holder of existing bonds.
If you’re struggling to get your head around this concept, here’s a quick explanation of the differences between bond prices and yields.
When bond prices rise this means that the demand for bonds has increased. Under the laws of supply and demand, when investors clamour to buy bonds this pushes up prices. Often, bond prices go up during times of economic uncertainly, or following a sharp fall in equity values. This is because ‘safe assets’ become a lot more desirable when other, more-volatile assets start to struggle.
In contrast, when bond prices fall, the opposite happens – yields rise in order to attract new bond buyers. So if you’re holder of bonds when yields rise, this is a bad news.
Usually, bond prices fall when equities rise – especially if the rise in equity values is sharp. This is because a booming stock market is likely to give investors confidence that the market will continue rising. Under such circumstances, it’s easy to see how the safety aspect of government bonds can quickly lose their appeal.
Despite this, holding bonds can be a wise choice for investors seeking a balanced portfolio – even during a bull market. To learn more, see our article that explains how to invest in gilts.
Disclaimer: MoneyMagpie is not a licensed financial advisor and therefore information found here including opinions, commentary, suggestions or strategies are for informational, entertainment or educational purposes only. This should not be considered as financial advice. Anyone thinking of investing should conduct their own due diligence.