The Bond Opportunity

Written by Chitral Wijesinha.

I have been involved in financial markets for almost 30 years, and one thing that has not changed is that investors are always asking the same question: When is the next correction or bear market coming?

There is nothing wrong with understanding the risks and ensuring portfolios are positioned to withstand periods of market volatility. However, I believe we can sometimes spend too much time preparing for what might go wrong and not enough time identifying what could go right.

The more important question is: What are the great opportunities available today, and what should we be buying when markets become dislocated?

Corrections and bear markets are an inevitable part of investing. They can be uncomfortable, but they also create opportunities to buy quality assets at more attractive prices. The investors who are prepared to take advantage of those opportunities can potentially generate significant returns when markets recover and the tide eventually turns.

This is equally true in both bonds and equities. Higher bond yields today can provide attractive income and the potential for capital gains if yields fall in the future. In equities, market volatility can create opportunities to acquire good businesses when their share prices fall below their underlying value.

Our objective therefore should not simply be to build a portfolio that can survive a bear market. It should be to build a portfolio that is resilient enough to withstand volatility while retaining the flexibility and conviction to take advantage of opportunities when they arise.

After 30 years in financial markets, I believe this is one of the most important lessons: we cannot predict when the tide will turn, but we can make sure we are positioned to benefit when it does.

Bonds and Equities

These are interesting times in financial markets. Interest rates and bond yields have been moving higher, with 10-year government bond yields in the US, UK, New Zealand and Australia trading around or above 5.3%. At the same time, fiscal positions in many developed economies are not improving, which is an important longer-term concern.

However, higher bond yields also create opportunities for investors. We should not look at rising bond yields simply as a reason to move away from fixed interest. At sufficiently attractive yields, bonds can offer both a good income return and the potential for capital gains if interest rates eventually decline.

For example, if a 10-year bond is purchased at a yield of around 5.3% and, over the next three years, market yields fall by 1%, the investor could potentially achieve a capital gain of around 7%, depending on the bond's duration and other factors. In addition, the investor would have received the coupon income during those three years. This illustrates why buying quality bonds at higher yields can provide an attractive risk-adjusted return, particularly when compared with the historically low yields available in recent years.

The key concept is that bond prices and market yields move in opposite directions.

Example: 10-year bond bought at 5.3%

Suppose you buy a 10-year government bond with:

• Face value: $100

• Coupon/yield: approximately 5.3%

• Annual income: about $5.30

• Remaining maturity: 10 years

You are effectively locking in an attractive yield of 5.3%.

Now imagine that three years later, market yields for similar 7-year bonds have fallen from 5.3% to 4.3%.

Your bond is now more valuable because it provides an income stream of roughly 5.3%, while a newly issued comparable bond only provides around 4.3%.

 

Why does the price rise?

The market has to adjust the price of your existing bond upward so that a new investor buying it receives a return comparable with the new 4.3% market yield.

For a bond with a duration of approximately 7 years, a useful rule of thumb is:

Bond price change ≈ Duration × change in yield

So:

7 × 1% = approximately 7% capital gain

If you originally invested $1 million:

	Approximate amount
Original investment	$1,000,000
Capital gain from 1% fall in yield	$70,000
Coupon income over 3 years at 5.3%	$159,000
Total return before tax/costs	$229,000

The actual capital gain will vary because of the bond's duration, coupon, maturity, yield curve and exact movement in yields.

The important point

You do not need to hold the bond to maturity to make the capital gain.

If you buy a 10-year bond today at a 5.3% yield and, three years from now, the market yield falls to 4.3%, you could sell the bond at its higher market price and realise the capital gain.

Alternatively, you can continue holding it and keep receiving the coupon income.

So the investment thesis is:

High starting yield + falling future yields = income + potential capital gain.

The reverse is also true. If yields rise another 1%, the bond price could fall by roughly 7% for a 7-year-duration bond. That is why duration is important and why this is not a risk-free capital gain.

The same principle applies to equities. While markets remain expensive in some areas, there are also opportunities beneath the headline index levels. A significant proportion of companies in the S&P 500 are trading below their estimated fair value, creating opportunities for active managers with strong stock-selection capabilities.

Therefore, our approach is not to move away from markets because of the current uncertainty. Instead, we believe the environment calls for careful asset allocation, disciplined diversification and taking advantage of opportunities where valuations and expected returns are attractive.

The next period may remain volatile, but volatility can create opportunities for long-term investors. Rather than trying to predict exactly when interest rates or markets will turn, we believe it is more productive to position portfolios to benefit from attractive yields today while maintaining exposure to quality companies that can deliver long-term growth.