Understanding Bonds: How They Work and Why They Matter

So why include bonds in a portfolio?

• They provide predictable income, which can be especially valuable in retirement or during market downturns.
• They help balance out the ups and downs of stock markets, acting as a stabiliser when equities are volatile.
• They can serve as a cushion during economic uncertainty, offering a degree of safety when other assets may be under pressure.
• Bonds are especially useful for investors looking to reduce risk without stepping away from returns entirely.

A key thing to understand is how bond prices respond to interest rates. The relationship is straightforward: when interest rates rise, bond prices tend to fall. When interest rates fall, bond prices usually go up.

Here’s why: a bond is essentially a loan where you lend money and receive a fixed interest payment each year in return. If market interest rates go up, new bonds start offering higher returns. That makes older bonds with lower interest payments less appealing. To sell one of those older bonds, you’d likely need to offer it at a discount. On the flip side, if interest rates drop, your older bond (which is paying a higher interest rate), becomes more attractive, and its price goes up. Understanding this helps investors see how bonds react to changes in the economy and interest rates.

A changing bond market

Government bond markets have undergone a major reset in recent years. After more than a decade of heavy central bank support – through ultra-low interest rates and large-scale bond purchases – both interest rates and bond yields have risen meaningfully.

Bond yields represent how much an investor earns from an investment, usually expressed as a percentage. See chart below.

For many investors, especially those newer to bond investing, this shift can feel unsettling. But in our view, it marks a return to more typical conditions from a longer-term historical perspective. Here’s what’s driving this reset:

Interest rates are normalising

• In the wake of the 2008 financial crisis, central banks slashed interest rates – in some cases even below zero – to stimulate borrowing and spending. This made traditional safe havens like cash and government bonds less appealing, nudging investors toward riskier assets.
• That ultra-low rate environment lingered far longer than expected. But after the COVID pandemic, inflation surged, forcing central banks in developed markets to hike rates to 4–5% to cool demand and restore price stability. We’re now seeing rates settle at levels that neither overstimulate nor stall the economy, and that are more in line with long-term historical norms.

Long-term bonds are offering a higher return again

For much of the past decade, long-term government bonds (10–20 years) offered very little extra return compared with short-term bonds. Normally, these higher returns compensate investors for the uncertainty of future interest rates and inflation – risks that felt low during the deflationary 2010s.

• Today, inflation remains elevated in some regions, and investors are recalibrating their expectations. Governments are issuing more debt, central banks are unwinding their bond holdings, and demand is shifting. The result? Higher yields and a return to more historically typical compensation for long-term lending.

Rising public debt but no cause for panic (yet):

• Government borrowing has increased since COVID, and so have the costs of that borrowing, reflected in higher bond yields. This has sparked renewed debate about the levels of government borrowing and the potential for further yield increases, especially if bond supply outpaces demand.
• While the risk of disorderly moves in yields exists, major economies like the US, UK, EU, and Japan benefit from resilient bond markets. Governments also have ways to manage their budgets, such as changing how much they spend, adjusting taxes, or choosing how long they borrow money for, to avoid paying high interest rates for too long.

Summary

After a decade defined by ultra-low interest rates and subdued bond returns, markets are now transitioning back to more historically typical conditions. Long-term yields are rising, and bonds are once again offering a reward for risk that reflects genuine economic fundamentals. In Europe, concerns around debt sustainability in countries like Portugal, Italy, Greece, and Spain have eased significantly since the eurozone crisis of the early 2010s. Meanwhile, borrowing costs in larger economies such as the US, UK, and Germany have increased, not due to market stress, but as a natural consequence of normalising interest rates and adjusted inflation expectations. Japan, too, is gradually emerging from decades of low growth and inflation, with bond yields adjusting in step.

We view this shift as a healthy reset. Across major economies, bond markets are re-aligning with long-term norms, offering investors renewed opportunities for income and diversification. In this context, we see relative value in UK Gilts, while US Treasuries appear fairly priced. Japan’s bond market remains less compelling, given the Bank of Japan’s cautious pace of policy changes.

Our portfolios are designed to navigate these evolving conditions with resilience. By maintaining a diversified mix of high-quality bonds and higher-yielding alternatives across different regions and maturities (the lengths of time until bonds reach their repayment date) alongside other asset classes such as equities and real estate, we aim to manage short-term volatility while positioning for long-term growth. This balanced approach helps ensure our clients are well-protected during periods of uncertainty and well-placed to benefit as markets stabilise and new opportunities emerge.