Why have bonds not protected investors during the Middle East crisis?

Bonds have historically provided shelter and ballast to portfolios during times of market uncertainty because of their stable fixed income.

That has not happened over the last month because the shock to stock markets has come from rising energy prices. Something which is likely to lead to higher inflation.  

The worry is that central banks might be forced to hike interest rates to bring inflation back down, in an echo of what happened coming out of the pandemic.

Inflation is the enemy of bond investors because it reduces future spending power. For example, if inflation were to average 5% over the next 20 years it would shrink the value of £1,000 today to around £375.

These concerns have pushed up bond yields (prices move inversely to yields) since the end of February with UK 10-year gilt yields rising from 4.3% in late February to 4.9% in late March.  

Two-year yields which more closely mirror expectations for the direction of Bank of England base rate have increased by almost one full percentage point, reversing prior expectations for interest rates to fall in 2026.

The reason bond prices fall is because new government debt will be issued with higher, prevailing yields which make existing bonds less attractive.

What has been the impact on bond portfolios?

Bonds are sensitive to changes in interest rates and as a rule of thumb, longer-dated bonds are more sensitive than shorter-dated issues.  

For example, 10-year bonds have seen a price fall of around 5% over the last month, while two-year bonds have lost around 2% of their value.  

This means that investors holding a diversified UK gilts fund, could have experienced losses of between 2% and 5% depending on the composition of bonds held.

Remember that no capital losses are incurred when government bonds are held until maturity, because they expire at the same price they were issued.

The corporate bond market has also been impacted by rising yields with UK investment grade (the highest quality part of the market) bond yields rising by around 0.5% to 5.4%.

This is reflected by diversified investment grade bond portfolios dropping by around 3.5% since the end of February. Corporate bonds typically have higher yields than government bonds to reflect the higher risk of default.

It is also worth emphasising that Bank of England policy makers have urged caution and recognise that aggressively hiking interest rates into an energy shock could do serious harm to the economy.

Even so, it could be a close call with market prices implying a 50% chance of a rate hike at the April or May meeting, which is a big change from the 80% chance of a rate cut priced into markets just four weeks ago.

What could happen if current mediation hopes falter?

Recent events indicate US-Iranian talks are finding some traction, implying the conflict is likely to be short lived. This scenario is the base case for most economists although the range of outcomes remains wide.

This view is supported by the state of the oil market which has been in deep contango (meaning oil derivatives are trading at levels that imply prices will be lower in a few months) since the war began.

However, the longer the supply of oil from the Strait of Hormuz remains blocked, the greater the potential damage to the global economy. It is useful here to think of higher energy costs as a tax hike.

It means consumers have less to spend on other things and given consumer expenditures represent two thirds of the economy, this is important.

In other words, at some point a sustained rise in energy costs will start to impact economic growth and potentially lead to interest rate cuts as central banks look to stimulate the economy.