Why Rising Bond Yields Can Rattle Both Bonds and Shares

Bond-market headlines can be confusing. Higher yields sound positive because investors receive more income. Yet a sharp rise in yields is often treated as bad news for bonds, shares and diversified portfolios.

Both ideas can be true.

Rising yields usually reduce the market value of existing fixed-rate bonds. They can also challenge equity valuations and raise borrowing costs. But once yields have risen, new investors receive more income, while existing portfolios have a larger cushion against further price declines.

Understanding that distinction helps explain why the same move can create short-term pain and improve longer-term return prospects.

Why bond prices fall when yields rise

A conventional fixed-rate bond pays a set coupon before returning its principal at maturity.

Suppose an existing bond pays annual interest equal to 2% of its face value. If newly issued bonds of similar quality and maturity begin offering 4%, few investors would pay full price for the older security. Its market price must fall until the return available to a buyer becomes competitive.

The reverse also applies. If newly issued bonds offer less income, an existing bond with a higher coupon becomes more valuable.

This creates the basic bond-market seesaw:

• Yields rise, so existing bond prices generally fall.
• Yields fall, so existing bond prices generally rise.

This applies to government bonds, including UK gilts, as well as many corporate bonds. The size of the price movement depends heavily on a bond's duration.

Duration measures sensitivity, not simply maturity

Duration estimates how sensitive a bond or bond fund is to changes in yields. A portfolio with a duration of six years might lose roughly 6% in price if its yield rises by one percentage point, all else being equal.

That is an approximation rather than a guarantee. Even so, it is a useful way to understand risk.

Long-duration bonds are normally more sensitive to changing yields because more of their cash flows arrive far into the future. Short-duration bonds tend to move less when interest-rate expectations change.

This means two funds both described as bond funds can behave very differently. Their duration, starting yield and underlying holdings matter more than the label alone.

Why the starting yield matters

A bond's total return comes from both income and price movement.

A simplified one-year estimate is:

Approximate return = starting yield - duration × change in yield

Imagine a bond fund starts with a 5% yield and a duration of six years. If yields rise by one percentage point, the approximate price decline would be 6%. The 5% income would offset much of that fall, leaving a smaller overall loss before other effects and costs.

If the same fund started with a yield of only 1.5%, there would be much less income available to absorb the decline.

That helps explain why 2022 was especially painful. According to PIMCO's discussion of why starting yield matters, a major US bond index entered 2022 with a yield of about 1.7%. Rates then rose rapidly, leaving investors with a small income cushion against substantial price falls.

Morningstar reported that its US Core Bond Index lost 12.9% in 2022, illustrating how unusual the period was for an asset class often viewed as defensive.

Higher starting yields do not remove risk. They simply mean that a comparable increase in rates may be less damaging to total returns than it would have been when income was close to zero.

Markets react to expectations before rates change

Bond prices do not wait for a central bank announcement before moving.

Long-term yields reflect expectations about inflation, economic growth and future short-term interest rates. They can also be influenced by the extra return investors demand for lending over longer periods and by the balance between bond supply and demand.

If investors begin expecting inflation to remain persistent, interest rates to stay higher for longer or fewer future rate cuts, long-term yields may rise immediately. Existing bond prices can therefore fall even when the official policy rate has not changed.

This is why comparing the number of expected rate increases with an earlier cycle can be misleading. Markets care about what was already priced in, how quickly expectations are changing and which part of the yield curve is moving.

The surprise relative to expectations often matters more than the headline itself. A similar principle helps explain why the stock market can rise despite bad news. Prices respond to the gap between reality and expectations, not simply whether a development sounds positive or negative.

Why higher bond yields can pressure shares

Government bond yields form an important reference point for other assets. When they rise, equities can face pressure through several channels.

First, investors discount expected future company cash flows at a higher rate. That reduces their present value, with the effect often greatest for highly valued businesses whose expected profits sit further in the future.

Second, bonds become stronger competitors for capital. If investors can earn more from high-quality government debt, they may demand a higher prospective return before accepting the greater uncertainty of owning shares.

Third, higher yields can increase financing costs. Companies refinancing debt may face more expensive borrowing, while consumers and governments can also experience tighter financial conditions.

None of this means shares must fall whenever yields rise. If yields are increasing because economic growth is improving, stronger company earnings may offset some valuation pressure. The reason for the move matters.

Can bonds still diversify an equity portfolio?

Bonds do not always rise when shares fall.

If economic growth weakens and inflation is under control, investors may expect lower interest rates. High-quality bond prices can then rise as equities struggle, providing useful diversification.

If inflation is the main problem, however, stocks and bonds may decline together. Rising yields reduce bond prices while also putting pressure on equity valuations and corporate costs. This was one of the defining portfolio challenges of 2022.

Diversification should therefore be viewed as a way of spreading risks, not as a promise that one asset will always offset another over every month or year.

Questions worth asking about a bond holding

Rather than reacting to a yield headline, investors can examine the source of risk:

1. What is the starting yield? This indicates the income available to cushion price changes.
2. What is the duration? Longer duration usually means greater sensitivity to changing rates.
3. Why are yields moving? Growth, inflation and shifting policy expectations can have different implications.
4. What does the fund own? Government and corporate bonds can carry different combinations of interest-rate and credit risk.
5. What role is the holding expected to play? Income, capital stability and diversification are separate objectives.
6. Is the time horizon appropriate? Short-term price volatility matters differently from the experience of holding an individual bond to maturity, assuming its issuer makes the promised payments.

Higher yields bring both risk and opportunity

A rise in yields creates immediate pressure for existing long-duration bonds. It can also weigh on share valuations and weaken the short-term diversification benefits investors expect from bonds.

But higher yields are not purely negative. They increase portfolio income, provide a larger buffer against further rate rises and can improve the potential return from high-quality bonds over time.

The sensible analytical question is not whether bonds are good or bad. It is whether the income, duration and underlying risks match the job the bonds are expected to perform within a diversified portfolio.