How far could bonds crash?

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Experts warn the value of bonds could fall up to 50pc. We explain what it means for your pension.

Many investors are concerned that a shakeout in the bond markets could hit their pension and investment funds. But few realise just how stark potential losses could be.

New figures seen by The Telegraph show that some bond funds could almost halve in value if there was a significant market correction.

This could hit the retirement prospects of large numbers of workers whose pension funds are often largely or entirely invested in bonds as they near the end of their working lives. Pension fund managers start to switch their members' assets away from shares and into bonds about a decade before retirement.

The process, which is called "lifestyling", takes place automatically and workers often do not know that it has happened, so they don't realise that their pensions are at risk if the bond markets fall.

Managers switch from shares to bonds in the approach to retirement because bonds are seen as less risky. Bonds are IOUs issued by companies and governments. They are seen as safer than shares because they pay a fixed, regular income and investors get their money back when the bonds mature, typically after five or 10 years.

However, bond investors can still lose money, even if the issuer meets its obligations, because bonds are traded on the stock market, so their price can rise and fall. Anyone who buys above "par" value the amount paid by the original investor risks a capital loss even if he holds until maturity.

Currently, many bond prices have risen well above par value because their perceived safety attracted lots of buyers during the financial crisis. When bond prices rise, the yield falls, so anyone buying bonds now will often get very small returns. For example, the yields on gilts bonds issued by the British government are close to 300-year lows; some yield as little as 2pc, which is well below the rate of inflation.

Bond yields tend to move in line with wider interest rates, so if rates rise as a result of an improvement in the global economy, gilt yields will follow suit meaning that prices will fall.

One bond fund manager calculated that if gilt yields returned to their 20-year average, their price could plunge by 45pc. Chris Bowie of Ignis Asset Management said corporate bond prices could fall by 38pc. Many bond funds invest in a combination of these investments.

So how likely is a collapse in prices of this magnitude? Mr Bowie said the figures were calculated by looking at the "real yield" on fixed-income investments. Over the past 20-odd years, gilts have paid an average of 3pc above inflation (as measured by the retail prices index or RPI). With the RPI standing at 3.1pc and the average 10-year gilt paying a return of 2.03pc, investors are now losing 1.07pc in real terms - well below the long-term average.

In order for yields to return to the average, gilt prices have to tumble. Mr Bowie said: "Even if we don't get back to 'normal' yields, and the gap just halves, this could still mean some significant double-digit price falls.

"What we don't know is when this correction will take place, or how long it could take." He added that a price correction could be a short, sharp shock, or bond investors could be in for years of smaller negative returns.

However, he did not think it was "doom-mongering" to suggest that double-digit losses were a distinct possibility. Higher-than-expected inflation could cause more significant losses, as would a rise in interest rates. And these figures assume that the yield returns to the long-term norm, rather than overshooting the average.

If prices do start to fall, it could trigger a stampede. Bonds aren't as easy to sell as shares and a major sell-off could create problems. This caused price falls in the bond markets in 2008 and 2004; in the worst-case scenario, some large funds could be forced to restrict withdrawals.

Would fears of a bond crisis cause some fund managers to rethink "lifestyling" strategies, where a staggered switch into bonds is seen as the best way to protect investors' assets before retirement?

Most fund managers we contacted were not changing course at present. A spokesman for Legal & General (LSE: LGEN.L - news) , which runs a number of lifestyle funds, said investors were told when this "de-risking" process started - usually 10 years from retirement - and were free to opt out or change their investments as they saw fit. "They aren't locked into this strategy but the decision to opt out must come from the investor," he said.

He added that while there were concerns about bond prices at present, there would equally be concerns about keeping a pension fund wholly invested in equities just months from retirement.

A spokesman for the Association of British Insurers added: "Some fund managers will have the freedom to deviate from set asset allocation strategies, others will follow an automated process based on what has delivered the best retirement outcomes over the longer term."

Gary Potter, a multi-manager with fund manager Thames River, said this kind of issue highlighted the problems of the lifestyling approach, when assets were switched on certain dates without regard to external economic factors or an individual's circumstances. "Investors should look at whether the fund's remit is to deliver an overriding objective, such as preserving capital, or whether its remit is to move a fixed proportion of the fund into bonds on key target dates. Obviously there is far less flexibility with the latter," he said.

What are people's option if they are concerned about bond prices? Mr Bowie said one option was high-yield bonds. These are higher risk, in that the companies offering them are more likely to go bust, but diversification via a fund can reduce this "credit risk". These bonds pay a higher income so the price isn't as vulnerable to a rise in inflation or interest rates. Likewise some advisers favour global bond funds, again because there is less correlation to returns from UK gilts. But in a big bond shakeout, both may still lose money.

Another option is an absolute return bond fund. A number of fund managers now offer these, including Ignis. But while the funds aim to deliver positive returns in all markets - usually by using complex hedging techniques - they don't come with any cast-iron guarantee, and many equity-based absolute return funds have performed dismally in recent years.

Before investors jump ship completely it's worth bearing in mind that not everyone is worried about a bond "bubble". Brian Dennehy of FundExpert.co.uk said: "This isn't the tech boom. People aren't cashing in their life savings or remortgaging their house to buy bonds."

He said that while central banks supported the bond markets, a collapse was highly unlikely. The Bank of England currently owns around a third of all British government bonds. "If they withdrew this support and started selling gilts, it would be mayhem," Mr Dennehy said. "But this seems highly unlikely given the current economic situation." He agreed that the potential upside was limited, and there might be "modest" falls in the year ahead. But he said "strategic" bond funds (which invest in a broad spread of fixed-interest investments), high-yield bond funds and global bond funds remained an important part of a diversified portfolio.