Bond funds - very basic question

[International]

Hello All,

I have been lurking on this excellent site for a while and am forming up a few fundamental questions. I'll post them separately to keep focus.

I started my ISA portfolio back in 2010 with a fairly vanilla 80/20 equities/bonds asset allocation. Within the bonds are some gilts. I have topped up each year.

As we all know, when interest rates started to rise recently then existing bond prices fell. My question is whether the price of bond funds will recover over time.

1) I understand that if I bought an actual bond with a coupon of, say, 1%, then when interest rates rose to, say, 5%, then no-one would want to buy my bond. They would just buy their own bond at 5%. So my bond resale price would drop a lot. But if I kept the bond to maturity I would have still got my 1% every year and my principal back. I wouldn't have lost money apart from the opportunity cost.

2) I think I understand that a bond fund contains a number of different bonds of different maturities and that the fund manager is generally free to buy and sell bonds rather than keep them to maturity. So there will regularly be bonds coming in an out of the fund as the fund manager, erm, manages

I'm not clear on whether the money in a bond fund that has lost value will ever come back. On one hand, if the manager keeps the bonds then the principal will be repaid so the money "comes back". Hopefully they will also have bought some new bonds too and so are getting the now-higher coupon. On the other hand, if the manager sold the bond when the price dropped then the money went with it. The new bond-holder gets the principal. But then that would have been reflected in the price. I'm finding I don't understand what is happening in this respect within a bond fund and so I don't know if the fund value will eventually recover as I believe it would if I just owned the underlying bonds.

Any thoughts on this? If it helps the fund in question is "Legal & General All Stocks Gilt Index Trust" with a buy date of March 2020, down 33% as of now. It is not a very large percentage of the overall, but I want to firm up my understanding as I want to continue to buy bonds and gilts as traditional ballast as I get older.

Thank you in advance.

[clissold345]

I might use the wrong terminology if I talk about bond funds so I'll talk briefly about bond etfs (which presumably are similar to bond funds). I think the short answer is Yes, the share price will recover after rates go up and then come back down. The simplest case would be where the etf holds long-duration bonds only and bonds are held to maturity, so it could be that the bonds held before rates go up are exactly the same as the bonds held after rates come back down.

I'm sure other posters know more about bond funds/etfs than me.

[Alaric]

I'm finding I don't understand what is happening in this re.

Depending on the mandate of the manager, a bond fund will usually shuffle the bonds as time goes by to maintain a fairly stable average time to bond maturity. By contrast if you held personally a portfolio of bonds, the average outstanding duration would reduce as time went by and maturity approached. That applies to ETFs as well as funds, more so with ETFs as the indexes they track aren't designed to be time sensitive.

In terms of capital value then, a price recovery is likely to require a reduction in the general level of interest rates back to where they had been when the holder first bought into the fund. It's not all bad as the income will increase as newer bonds are purchased with higher coupons.

[GoSeigen]

There is no practical difference between a bond fund and buying the bonds/gilts directly: if you buy either when yields are low, then when yields rise you have suffered a loss. There really is no getting away from it I'm afraid. The only way you'll "get your money back" is if yields magically return to prior levels, but good luck with that!


GS

[International]

It's not all bad as the income will increase as newer bonds are purchased with higher coupons.

This is this kind of thing I am trying to work out. If I hold for long enough then does the total come back? GS suggests not. I am happy to wait indefinitely but if there is no chance of recovery I would be better to move the 66% remaining into something more useful.

I'm also trying to work out if I ever buy any more. Clearly someone does as all UK Govt debt is in such issues.

For some reason I have a mental block on bonds!

[GeoffF100]

If you buy a bond index tracker, the fund buys every bond that is issued in its market weight and holds it to maturity. When bonds are issued, they are bought at the market price, which can be greater of less than the maturity value.

In normal circumstances, if you buy units in the fund, you will effectively be buying a basket of bonds at close to their market price. If interest rates rise, the market value of your holding will fall, but that does not affect what the fund will get back when the individual bonds mature.

[Lootman]

It's not all bad as the income will increase as newer bonds are purchased with higher coupons.

This is this kind of thing I am trying to work out. If I hold for long enough then does the total come back? GS suggests not. I am happy to wait indefinitely but if there is no chance of recovery I would be better to move the 66% remaining into something more useful.

I'm also trying to work out if I ever buy any more. Clearly someone does as all UK Govt debt is in such issues.

For some reason I have a mental block on bonds!

The good news is that you can absolutely get away with never holding bonds. For the average private investor they are superfluous. That is not to say that you cannot make money from them. But that demands a lot of knowledge and luck.

You cannot invest without shares or cash. You can ignore bonds if you choose, not least because they really only make money when rates are declining, and in that environment shares and commodities are probably going up too. And when rates and/or inflation are going up, your bonds will die.

[GeoffF100]

You can ignore bonds if you choose, not least because they really only make money when rates are declining, and in that environment shares and commodities are probably going up too. And when rates and/or inflation are going up, your bonds will die.

You also make money from bonds when interest rates remain broadly the same. If equities crash, there is usually a "flight to safety" and bond prices rise as a result. That is the main reason why many people hold bonds in addition to equities. More often that not, the bonds rise when equities take a serious fall. Even if that does not happen, bonds dilute you losses when equities take a serious fall.

[International]

When bonds are issued, they are bought at the market price, which can be greater of less than the maturity value.

Ah! I had assumed that bonds were bought at a face value when they were first issued, rather than a market price. Thank you Geoff.

[Alaric]

Ah! I had assumed that bonds were bought at a face value when they were first issued, rather than a market price..

Usually the first day of trading would see the bonds at or about the issue price, which usually would be par. It's buyers on the secondary market such as private investors who pay a market price.

Indexed bonds have been known to be issued at prices which gave a negative real return. For that matter with conventional bonds, if the coupon was well below the normal rate of return, say 1% when 4% was normal, those would be at a discount.

[GeoffF100]

The government sells gilts at auction. These can be new gilts or new issues of existing gilts.

Companies can, of course, raise borrowing however they wish, provided there are buyers for their debt. If they issue a bond with a fixed price and fixed terms, they risk either not raising enough money, or raising too expensively (unless there are already agreements with big institutions in place).

[JohnW]

I understand that if I bought an actual bond with a coupon of, say, 1%, then when interest rates rose to, say, 5%, then no-one would want to buy my bond. … So my bond resale price would drop a lot. But if I kept the bond to maturity I would have still got my 1% every year and my principal back. I wouldn't have lost money apart from the opportunity cost.’

‘The only way you'll "get your money back" is if yields magically return to prior levels, but good luck with that!’

Apparently opposite views. If they are opposing views, the first is the way I see it, and the second is misleading.
Any individual bond you hold, regardless of interest rate gyrations between now and maturity, is on a course to reach £100 (face value for a nominal bond) on the day it matures. The course might be wobbly but you know what you’ll get and when you’ll get it, every coupon and return of face value principal. Whether you call that a loss or not, please yourself since you know how much you paid for the bond, how much you’ll get in coupons, and how much principal will be returned, but the daily market price gyrations are irrelevant for individual bonds. Bond funds are a horse of a different colour despite the confusing...

There is no practical difference between a bond fund and buying the bonds/gilts directly:

because a bond fund never matures, so it's always as prone as it always was to gyrations in interest rates. The fund is not on an inexorable course to £known on a certain date.

[JohnW]

A bond fund keeps on buying new bonds as older ones mature, and the new ones come with higher interest payments because of the rate rise you mentioned. So picture the graph of the value of a bond fund which drops initially (as rates increase) and after some or several years it starts to turn up again crossing the zero line (value before rates increased) and keeps going up. The ‘duration’ of the fund gives you some rough idea of the time needed to recover to zero after rates rise. Here it is illustrated: https://www.bogleheads.org/forum/viewtopic.php?t=360575
Truth is, all the bonds in your fund probably fell in value recently, but it is also true that a bond is a promise to repay what was borrowed; so if your fund bought bonds for around £100 which have since fallen to £80, then the fund will get its £100 back when the bond matures. The fund, and you, only lose out if you choose to sell now at £80.
Try this for enlightenment also: https://www.bogleheads.org/forum/viewto ... 2#p5846789

[GeoffF100]

The fund is not on an inexorable course to £known on a certain date.

An index tracker bond fund is on an inexorable course to return £known on various future dates (barring default), but the fund itself never matures, because new bonds are added as they are issued to replace the bonds that mature. The duration of a bond index can change over time, but, barring that, it constantly renews itself to give a more or less constant duration, whereas the duration of a single bond diminishes over time.

[JohnW]

Yes, I don't think we're disagreeing. I said the fund is not heading towards a specific value (on a certain date), while you referred to a specific return; value (price) and return are different beasts.
An active fund could I suppose deliberately hold its duration constant, but it would seem to be a bit of a constraint if 'constant=very constant'. But an index fund would be buying the bonds in the index, and so the duration would indirectly depend on what sort of bonds the bond issuers issue. And then, duration shortens as interest rates rise, because more of you total return comes to you earlier with higher coupons, so there's that too.

[Howard]

Any thoughts on this? If it helps the fund in question is "Legal & General All Stocks Gilt Index Trust" with a buy date of March 2020, down 33% as of now. It is not a very large percentage of the overall, but I want to firm up my understanding as I want to continue to buy bonds and gilts as traditional ballast as I get older.

Thank you in advance.

Can I offer a view as an amateur investor which may help answer your question.

You have lost money holding your L and G fund and whilst you will get some income from the fund you won’t get the capital loss back unless interest rates drop to what they were around the time you bought the fund.

If you fancy building up a proportion of bonds in your portfolio because you believe interest rates will fall in your lifetime you could buy more of your L and G fund. You might believe that now is the time to buy.

If your prediction proves true and rates fall, you should make a gain on your subsequent investment which may make you feel better about the loss on the original investment (which will have increased in value because of the drop in interest rates which you predicted).

Declaring an interest, I agree with Lootman’s view above. To keep things simple I invested in a wide range of equities because of a belief I understood them slightly better than bonds. Like you I do have a very small part of the portfolio invested in bond funds and their poor performance over many years has confirmed this approach.

Hope this helps.

Good luck with your decisions.

Howard

[88V8]

It's not all bad as the income will increase as newer bonds are purchased with higher coupons.

This is this kind of thing I am trying to work out. If I hold for long enough then does the total come back?

You bought at a time when interest rates were lower so the value of bonds was higher. Unfortunately you bought near the top of the market.

Last summer when rates peaked and SPs were low was a recent opportunity to top up on Fixed Interest, and I did. Since then there have been gains in individual bonds and in bond funds.
In particular I'm invested in BIPS and NCYF and with the latter you can see that - disregarding the 2020 blip - the SP has not regained the heights of four years ago.

I can't find the ticker for your fund, but I expect it shows much the same overall trajectory. The SP up from lows, but not back to where you purchased. I expect further price rises as rates fall, but not back to where we were four years ago.
At some point we will have to decide that SPs have risen to a peak, and sell our funds and our individual holdings, but for me, not yet.

V8

[GeoffF100]

There seem to be people wearing blinkers here:

"Stocks for the Long Run? Sometimes Yes, Sometimes No", Edward F. McQuarrie:

https://www.tandfonline.com/doi/full/10 ... 23.2268556

"The expanded historical record shows that stocks can perform poorly in absolute terms and underperform bonds, whether the holding period is 20, 30, 50, or 100 years."

Bonds sometimes beat equities for long periods, Sometimes they lose. With the exception of one relatively short time period, bonds have been pretty much on a par with equities. The future may not be like the immediate past. Spread your risk.

[PrefInvestor]

You need to buy bonds and fixed interest investments generally when prices are low and yields are high, that’s typically when interest rates are high. That way as interest rates fall then your investment prices will rise, but you will still receive the high level of jncome resulting from the price that you bought at.

You definitely do not want to buy when interest rates are ultra low and so prices are high, which sounds like what you did if you bought 4 years ago. From there you were inevitably going to see falling capital values for your investments I’m afraid.
Will fixed interest investment prices ever go back to where they were ?. As others have already said, only if interest rates go back to being ultra low – which personally I think isn’t going to happen in the foreseeable future. But I am expecting to see some recovery in prices as interest rates fall – which I think we will see this year.

I’m a fan of bonds, prefs, debt and property type investments but I’ve never been able to see the point of gilts. The yield on gilts is pretty poor compared with what you can get elsewhere on what I consider reasonably safe investments. Yes gilts are supposedly risk free as they are backed by HMG, but I think the fact is that you need to take a bit of risk to get better capital performance and better yields. Well unless you managed to buy during the truss gilt volatility period of course…

ATB

Pref

[Alaric]

I’m a fan of bonds, prefs, debt and property type investments but I’ve never been able to see the point of gilts.

In recent years, there were a few issues of ultra low coupon conventional Gilts with short maturity dates. That's where coupons could be as low as one quarter of 1%. I don't think any corporate issues would have gone that low. Now that interest rates have risen and the market prices stand at a discount to maturity value, these can be of interest to tax paying individuals by being nearly tax free. Gilts aren't subject to Capital Gains tax and the interest is next to nothing.