Yields rose, the spread remained low: a rare equation in the bond market

The bond market may not enjoy the 'glamorous' image of the stock or derivatives market, but in recent months, a dramatic change has been taking place, where the low yields of recent years have given way to a sharp rise. In this edition of 'Data of the Week', Yaron Friedman, Director of Research at Bank Leumi's investment division, explains the reasons for this unusual phenomenon and what you should know before investing in bonds. 'The bond market may sound boring, but it is the anchor of any investment portfolio. Unlike stocks, you know exactly at any given moment what your return will be, even if you don't take any action.'

Consequences of the war in Iran

'After a very long period where the bond market didn't matter because yields were very low, we are seeing a very nice rise in yields,' he explains. 'Suddenly there is meat here. We won't make 20% a year, but we are talking about good bonds that can give 5% and even more — not bad at all in a volatile market.'

The most prominent expression of this is US government bonds, considered the 'safest asset in the world', but as Friedman details, the reason is closer to home. 'This wave comes from the Persian Gulf. Before the war, we saw low oil prices, around 60 dollars a barrel, and central banks lowering interest rates. But as soon as the war started and the Iranians realized they had an effective tool — closing the Strait of Hormuz — the price of oil climbed to 120 dollars a barrel. This fueled a wave of inflationary concerns.'

Change in the global interest rate narrative

This development caused a complete change in perception among central banks. 'We saw a very interesting turnaround,' says Friedman. 'If until February the discourse was focused on interest rate cuts, suddenly the trend shifted to discussions about hikes. In Europe and Japan, they have already started raising rates, and the UK is signaling the same. In the United States, this is not happening yet, perhaps because the Fed chair is new, but the bond market anticipated the central bankers. We saw a rise in yields in the US government bond market, and all bond markets worldwide adapted to the trend.'

Impact on the corporate market

'The rise in yields on underlying government assets directly increases the financing costs of companies,' explains Friedman. 'If we examine a real estate company that needs to finance its operations, when a US government bond yields 4.6%, an investor will ask for a risk spread and demand a yield of 5.25% to 5.5%.'

'When the base yield rises, spreads rise accordingly. Although spreads on high ratings in Israel are still relatively low (0.6%-0.7%), they provide an excellent base; bonds of strong companies currently offer a yield of 4.5% and more,' analyzes Friedman.

Profit mechanism and opportunity

Current conditions create an unusual situation in favor of investors: 'In bonds, there are two main profit engines. The first is the current yield, the "creeping" one. These are the 4.5% per year received if you hold the bond until maturity. The second engine is capital gains resulting from price leverage, in case interest rates drop later. The longer the bond, the more the drop in yields translates into a sharp rise in its price. When the fighting ends, we will see calm, a drop in oil prices, and a moderation in inflation, and central banks will return to talking about rate cuts. When this occurs, it will be accompanied by capital gains — a phenomenon we haven't seen in the bond market for a long time.'

How should a private investor approach this?

'There are two main ways to act,' explains Friedman. 'The first is the direct purchase of a specific company's bond.' However, the private investor is at a disadvantage: you pay tax and commission on every coupon, and active reinvestment is required. This model is suitable for clients with significant amounts.

'For most investors, the simpler way is through mutual funds or ETFs. You can purchase units even in small amounts. The fund achieves broad diversification, and its manager rolls the interest back into the investment. Another added value is the deferral of the tax event until the fund is redeemed.'

If you decide to go for a fund, which parameters are important? 'Management fees are usually low, and it is important to examine them alongside the underlying asset. You can choose between government and corporate bonds, and between high ratings with low risk and lower ratings, which offer a spread of 1.5% and more. The Tel Aviv Stock Exchange offers a wide variety of instruments, and every investor can adapt the right tool for themselves.'

*** Full disclosure: 'Data of the Week' is an editorial project done in collaboration with Bank Leumi experts. The above should not be seen as a recommendation or a substitute for personal investment advice.