How quickly things can change. The outline for this article, drafted a few weeks ago, set about to address the prospects for rising rates on the back of strengthening economic growth, central bank tightening of monetary policy (e.g. reduced taper, rate hikes), and more widespread control of COVID-19. Things were looking up, literally, for bond yields.

But at time of writing, while the path to rising rates still exists, markets have turned their attention from higher yields to renewed concerns around the spread of the Delta virus variant and questions on global growth momentum. Australian 10-year government bond yields started 2021 at ~1%, jumped to nearly 2% as markets repriced inflation, robust economic growth, and potentially sooner than expected central bank tightening, and proceeded to nosedive back to 1.2% this week.

So, what now? Here are three things we can focus on: market timing, stay the course with your investment objectives and risk tolerance; bonds as a ballast; and rising rates, when it does occur.

The year-to-date pendulum swing in bond yields, and more rapid drop in the past month, highlights how difficult it is to correctly project and time market moves in the short-term by all market participants. In the span of two weeks in February, yields rose over 70 basis points (59%!) as investors scrambled to position for higher yields on expectations of strong growth due to economic reopening, reflation, and uncertainty around the support governments and central banks would continue to provide.

Investors were surprised, and market prices adjusted to reflect that new information and sentiment. In the other direction, investors were surprised again with concerns over the effect of the Delta virus variant among other things and yields fell over 30bps since fiscal year-end as investors repriced market valuations. What this illustrates is, timing the market is exceptionally difficult, and an investor trying to pick the best entry and exit points on a short-term basis is not setting themselves up for success. Investors are best placed focusing on their long-term investment goals, ensuring that their asset allocation is aligned with those goals, and then, staying the course.

The above leads into the second point in the role bonds serve within an investor's asset allocation. At Vanguard we say this a lot but, for good reason. For most investors, bonds serve a core purpose as a ballast that can help reduce volatility within a diversified portfolio. This dynamic was highlighted from January to March 2020 when global shares fell ~15% and global bonds returned ~1%, similarly played out during the GFC, and consistent on a longer backwards horizon. Looking at the period between January 1988 and November 2020, whenever monthly equity returns were down, monthly bond returns remained positive about 70% of the time. This last statistic reinforces the first point in remaining focused on your long-term objectives as well as the benefit of bonds in a broader portfolio.

But are the two points raised above - staying the course and the role of bonds in an asset allocation - still relevant for when interest rates rise?

The answer comes down to whether interest rates move more than market expectations and an investor's time horizon. An upward sloping yield curve – made up of bond yields at progressively longer maturities – indicates that markets are expecting and pricing higher future short-term interest rates. A very short-term catalyst that causes rates to move above market expectations, as seen in Q1 this year, can produce negative bond returns. However, for an investor with a longer horizon – 3, 5, 10 plus years – rising rates can be a good thing as bond maturities and coupon payments in a bond fund are reinvested at higher interest rates. This helps improve the investor's overall return profile.

While this discussion has been focused on bonds, it is important to remember not to view bonds solely in isolation.

An investor needs to consider how bonds fit into a diversified portfolio that takes into account one's investment goals, risk tolerance, and time horizon, and the role bonds play in a holistic asset allocation.

Vanguard Australia, Smart Investing