How far could bonds crash?
Many investors are concerned that a shakeout in the bond markets could hit their pension and investment funds. But few realise just how stark potential losses could be.
New figures seen by The Telegraph show that some bond funds could almost halve in value if there was a significant market correction.
This could hit the retirement prospects of large numbers of workers whose pension funds are often largely or entirely invested in bonds as they near the end of their working lives.
Pension fund managers start to switch their members' assets away from shares and into bonds about a decade before retirement.
Currently, many bond prices have risen well above par value because their perceived safety attracted lots of buyers during the financial crisis. When bond prices rise, the yield falls, so anyone buying bonds now will often get very small returns. For example, the yields on gilts – bonds issued by the British government – are close to 300-year lows; some yield as little as 2pc, which is well below the rate of inflation.
Bond yields tend to move in line with wider interest rates, so if rates rise as a result of an improvement in the global economy, gilt yields will follow suit – meaning that prices will fall.
One bond fund manager calculated that if gilt yields returned to their 20-year average, their price could plunge by 45pc. Chris Bowie of Ignis Asset Management said corporate bond prices could fall by 38pc. Many bond funds invest in a combination of these investments.
So how likely is a collapse in prices of this magnitude? Mr Bowie said the figures were calculated by looking at the "real yield" on fixed-income investments. Over the past 20-odd years, gilts have paid an average of 3pc above inflation (as measured by the retail prices index or RPI). With the RPI standing at 3.1pc and the average 10-year gilt paying a return of 2.03pc, investors are now losing 1.07pc in real terms - well below the long-term average.
In order for yields to return to the average, gilt prices have to tumble. Mr Bowie said: "Even if we don't get back to 'normal' yields, and the gap just halves, this could still mean some significant double-digit price falls.
"What we don't know is when this correction will take place, or how long it could take." He added that a price correction could be a short, sharp shock, or bond investors could be in for years of smaller negative returns.
However, he did not think it was "doom-mongering" to suggest that double-digit losses were a distinct possibility. Higher-than-expected inflation could cause more significant losses, as would a rise in interest rates. And these figures assume that the yield returns to the long-term norm, rather than overshooting the average.
If prices do start to fall, it could trigger a stampede. Bonds aren't as easy to sell as shares and a major sell-off could create problems. This caused price falls in the bond markets in 2008 and 2004; in the worst-case scenario, some large funds could be forced to restrict withdrawals. Finish reading - Telegraph
12:30PM GMT 25 Jan 2013
Many investors are concerned that a shakeout in the bond markets could hit their pension and investment funds. But few realise just how stark potential losses could be.
New figures seen by The Telegraph show that some bond funds could almost halve in value if there was a significant market correction.
This could hit the retirement prospects of large numbers of workers whose pension funds are often largely or entirely invested in bonds as they near the end of their working lives.
Pension fund managers start to switch their members' assets away from shares and into bonds about a decade before retirement.
The process, which is called "lifestyling", takes place automatically and workers often do not know that it has happened, so they don't realise that their pensions are at risk if the bond markets fall.
Managers switch from shares to bonds in the approach to retirement because bonds are seen as less risky. Bonds are IOUs issued by companies and governments. They are seen as safer than shares because they pay a fixed, regular income and investors get their money back when the bonds mature, typically after five or 10 years.
However, bond investors can still lose money, even if the issuer meets its obligations, because bonds are traded on the stock market, so their price can rise and fall. Anyone who buys above "par" value – the amount paid by the original investor – risks a capital loss even if he holds until maturity.Currently, many bond prices have risen well above par value because their perceived safety attracted lots of buyers during the financial crisis. When bond prices rise, the yield falls, so anyone buying bonds now will often get very small returns. For example, the yields on gilts – bonds issued by the British government – are close to 300-year lows; some yield as little as 2pc, which is well below the rate of inflation.
Bond yields tend to move in line with wider interest rates, so if rates rise as a result of an improvement in the global economy, gilt yields will follow suit – meaning that prices will fall.
One bond fund manager calculated that if gilt yields returned to their 20-year average, their price could plunge by 45pc. Chris Bowie of Ignis Asset Management said corporate bond prices could fall by 38pc. Many bond funds invest in a combination of these investments.
So how likely is a collapse in prices of this magnitude? Mr Bowie said the figures were calculated by looking at the "real yield" on fixed-income investments. Over the past 20-odd years, gilts have paid an average of 3pc above inflation (as measured by the retail prices index or RPI). With the RPI standing at 3.1pc and the average 10-year gilt paying a return of 2.03pc, investors are now losing 1.07pc in real terms - well below the long-term average.
In order for yields to return to the average, gilt prices have to tumble. Mr Bowie said: "Even if we don't get back to 'normal' yields, and the gap just halves, this could still mean some significant double-digit price falls.
"What we don't know is when this correction will take place, or how long it could take." He added that a price correction could be a short, sharp shock, or bond investors could be in for years of smaller negative returns.
However, he did not think it was "doom-mongering" to suggest that double-digit losses were a distinct possibility. Higher-than-expected inflation could cause more significant losses, as would a rise in interest rates. And these figures assume that the yield returns to the long-term norm, rather than overshooting the average.
If prices do start to fall, it could trigger a stampede. Bonds aren't as easy to sell as shares and a major sell-off could create problems. This caused price falls in the bond markets in 2008 and 2004; in the worst-case scenario, some large funds could be forced to restrict withdrawals. Finish reading - Telegraph
