As interest rates peak, is now the time to invest in bonds?

Investors are wondering if they should be taking a risk on stock markets now that bonds are offering higher returns

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After the latest round of central bank meetings, it's beginning to look like interest rates may have peaked, opening up a massive opportunity for the bond market to shine again.

Yields on US government bonds, known as Treasuries, have just hit their highest level since before the global financial crisis in 2007.

Ten-year Treasuries are now yielding 4.5 per cent and shorter-dated, two-year bonds are offering a return of more than 5 per cent.

Bond yields are unlikely to climb much higher, with the US Federal Reserve and Bank of England both holding interest rates in September, and the European Central Bank suggesting its increase would be the last in the cycle.

While markets suspect the Fed will deliver one more increase before the end of the year, we’re almost there.

Watch: US Federal Reserve chief warns of 'pain' in reducing inflation

Many investors are now asking themselves whether they need to take a risk on the stock market – and finally get a decent return from bonds.

Bonds are issued by governments and companies to fund their spending. They pay a fixed rate of interest (known as the coupon) over a set term, with a pledge to return your capital in full at maturity.

Government bonds offer more capital protection because the risk of default is virtually nil. With corporate bonds, there is a danger that the issuing company could run into financial difficulties and default.

After years of low yields, bonds now offer an interesting income opportunity, says Charu Chanana, market strategist at Saxo Bank in Singapore.

Their safe-haven nature may also help. “Uncertainty and volatility are likely to be key themes as we navigate the end of the interest rate cycle and bonds can help to hedge portfolio risk,” Ms Chanana adds.

There’s another reason why bonds are looking tempting right now.

Once issued, bonds are traded on the bond market, which means their prices can rise or fall, depending on demand.

As they pay a fixed rate of interest, they are much less attractive when interest rates are climbing, but tempting when they fall.

Accordingly, when interest rates rocketed last year, bond prices crashed.

That was a huge blow for investors, who had sought them out as a safe haven.

But here’s the exciting thing: When interest rates start to fall, presumably at some point next year, bond prices should shoot off in the opposite direction.

This means investors who buy today could be in line for some pretty meaty capital growth, on top of today’s generous yields.

While there are never any guarantees when it comes to investing, this looks like a pretty good bet.

It partly explains why the S&P 500 is now falling. Investors are wondering whether to rotate back into bonds instead.

Bonds can be advantageous when interest rates approach their peak, which is the case today, says Vijay Valecha, chief investment officer at Century Financial.

“After an era of historically low interest rates, bonds now offer much more appealing yields, with high-quality ‘investment grade’ corporate bonds offering yields of 6 per cent or 7 per cent.”

While we might see the odd hike, the era of rising interest rates looks to be coming to a close, Mr Valecha says.

“Should the economy stumble into recession, as many now suspect, interest rates will fall, increasing the value of the bonds in your possession.”

While the interest rate on an individual bond remains fixed through to maturity, its price depends on what others are willing to pay for it.

“If you buy a bond yielding, say, 6 per cent, and interest rates decline in the following year, a comparable newly issued bond might yield only 5 per cent. Since your bond still pays 6 per cent it becomes more desirable and its price will rise,” Mr Valecha says.

Investors or bond fund managers can then either hold the bond to maturity, or sell it at a higher price for a profit.

“Today's bond yields may become even more attractive if interest rates decrease in the coming years,” Mr Valecha adds.

Investors may have to be patient for a bit longer, as markets now expect interest rates to stay “higher for longer” as the Fed continues its battle against inflation.

While we wait, we can enjoy those yields, says Yves Bonzon, group chief investment officer at Swiss private bank Julius Baer. “Given higher future inflation uncertainty, bond investors seem to be demanding a higher term premium.”

Given higher future inflation uncertainty, bond investors seem to be demanding a higher term premium

Yves Bonzon,
group chief investment officer at Julius Baer.

Government bonds such as US Treasuries or UK gilts are generally considered safer, as nobody expects the Fed or Bank of England to go bust.

Emerging markets bonds are a bit riskier, but typically pay higher interest rates in return. Corporate bonds are also riskier because of the default risk, although “investment grade” bonds are lower risk, but yield less as a result.

Ms Chanana at Saxo Bank favours shorter-dated government bond exchange-traded funds with a duration of one to three years, either from the US, Europe, Germany or the UK.

“Treasury Inflation-Protected Securities, or TIPS, also remain interesting if stagflation risks rise,” she adds.

Mr Valecha recommends investing in a spread of bond funds to cover different sectors, maturities and risk levels.

Here are four funds worth considering:

SPDR Bloomberg 1-3 Month T-Bill ETF: This invests in short-term US Treasuries, renowned for their low-risk profile. The fund aims to offer a dependable income stream and safeguard your capital. Current yield: 4.09 per cent.

iShares J.P. Morgan USD Emerging Markets Bond ETF: Invests in emerging market debt but denominated in US dollars to avoid exchange rate fluctuations. Current yield: 5.09 per cent.

ProShares Investment Grade-Interest Rate Hedged: Provides exposure to investment-grade corporate bonds while seeking to mitigate interest rate risk by shorting Treasury bonds. Current yield: 4.66 per cent.

Franklin International Aggregate Bond ETF: An actively managed fund that focuses on government and corporate bonds in Europe, Asia and Latin America. Current yield: 2.93 per cent.