We often talk about bonds, the inverse relationship between yields and prices, and duration. This week, we thought we’d explain some of these concepts and ideas and how it informs our portfolio construction. Apologies in advance if we’re teaching you to suck eggs.
The inverse relationship
Imagine you hold a UK government bond with a 3% coupon (the amount it pays out per annum). Now let’s say interest rates go up from 3% to 5%, so now the government, instead of issuing bonds with a 3% coupon, starts selling them with a 5% coupon. What’s going to happen to the value of your bond with the 3% coupon? It’s going to go down as it’s now less valuable, offering a less competitive yield – who would want 3% when you can get 5% on the same instrument. The opposite is equally true. If rates were cut from 3% to 1%, your 3% bond is now a lot more valuable. So, this is why we say bond prices move in the opposite direction to bond yields.
2022 and 2023 provide a great real-world example of this in action as it was one of the steepest rate hiking cycles in 40 years. In the below chart, the yellow line is the UK interest rate going from near 0% to over 5% and the blue line is the UK Gilt index. You can see that as rates went up, the value of the gilt market fell. The reverse will be true as rates get cut and we’ve already started seeing it play out this year.
Source: Refinitiv Workspace and Bowmore
Duration
In reality, it’s not quite that simple, there are a lot of other factors that influence a bond’s price. Another key driver is duration, which we talk about a lot. In the simplest terms, this is the time (measured in years) before the bond matures (reaches its end date). When we say short duration gilt, we mean it matures in roughly 1 – 5 years and a long duration gilt typically has a maturity of 15+ years. Duration is a good measure for the sensitivity of a bond’s price to interest rate movements – by how much it’s going to move. Short duration is less sensitive whilst long duration is more sensitive.
This is made clear in an extreme example: you hold a gilt with a coupon of 3% but it matures tomorrow. It doesn’t matter if rates go to 5% or 1% because you’re not going to have any time to enjoy that yield before it expires, the value of the bond will stay very close to £100 as that is what it will be worth the next day. Conversely, let’s say your gilt matures in 25 years and has a 3% coupon. If rates go to 5%, that’s 25 years of 2% p.a. missed, that’s an enormous loss so the value of the long duration gilt would plummet whilst the short duration gilt is almost unaffected.
Bowmore Portfolios
We believe that interest rates in the UK are going to come down over the next year, that inflation is coming under control and global economies are starting to feel the pinch of high rates (and therefore need to cut rates). From what we’ve explored in this note, this means we think that the prices of bonds will go up in the medium term and because we have quite a strong conviction on this, we have increased duration (our sensitivity to yields) to fully capture this uplift.
