Bonds and interest rates, is this right?

[willflackster]

So trying to get my finances in order a few years from retirement - with alot of cash now available is it time to buy bonds as interest rates are likely to fall in the next 6-9 months
Can someone explain simply how this works -

I get the principle that a bond paying 5% for example that comes due in one year is worth about £96+/- if interest rates are 5% you get your £100 when it comes due - when interest rates go to 2.% what then happens to the value of that bond - how does it maintain the 5% yield does the bond cost £97.50+/- a year out from repayment. How does it work for say a 5 year 5% bond lifespan is it worth only £78+/-
I read about a bond ladder but not sure how that works and how to construct one for return of capital - any help gratefully received!

Might be worth a sticky tab as a guide!

[SalvorHardin]

Can someone explain simply how this works -

I get the principle that a bond paying 5% for example that comes due in one year is worth about £96+/- if interest rates are 5% you get your £100 when it comes due - when interest rates go to 2.% what then happens to the value of that bond - how does it maintain the 5% yield does the bond cost £97.50+/- a year out from repayment. How does it work for say a 5 year 5% bond lifespan is it worth only £78+/-
I read about a bond ladder but not sure how that works and how to construct one for return of capital - any help gratefully received!

In your example the £100 one year bond issued at 5% interest will initially be sold to investors by the issuer at £100 / 1.05 = £95.24 (I'm assuming that there is no risk of default). You buy £100 at this price. Lets assume that one year interest rates immediately fall to 2.5%. The market will price the bond at £100 / 1.025 = £97.56. You still get your £100 when it matures in one year (so you're getting your 5%) but you can sell the bond now for £97.56 to someone who is happy with 2.5%

Your five year bond sold at 5% interest (all paid on maturity) is priced at £100 / 1.05^5 = £78.35. If five year interest rates immediately move to 2.5% the market price rises to £88.39, new buyers are locking into 2.5% but you are already locked into 5%.

The interest rate paid on gilts/bonds is fixed when they are originally sold to investors. Movements in interest rates cause the market price of the bond to move but the payments remain unchanged. So if you bought a 30 year gilt when it was issued at £100 paying 5% interest then you would get £5 per year for 29 years and £105 in year 30 (£100 plus £5 interest). Regardless of what happens to interest rates in the meantime that is what you would get.

If interest rates rise, the market price of bonds falls. If interest rates fall, the market price of bonds rises. Bonds with longer maturity dates are more volatile than bonds with shorter mturity dates. Bonds which pay higher interest are less volatile than bonds which pay lower interest (both bonds have the same maturity dates)

There are a few bonds where the interest and/or capital are not fixed (e.g. linked to the price of oil). Bear in mind that most of the price action in bonds is in response to interest rate movements and changes in the creditworthiness of the issuer.

A bond ladder consists of buying several bonds, with different interest payment dates and maturity dates, to ensure a reasonably steady flow of cash over the term. As bonds mature you buy another bond with a longer date which fits in with your existing profile. For example, an investor splits their money between five different gilts with maturity dates of three, five, seven, ten and fifteen years. When the three year bond matures the investor buys a ten year gilt so the ladder's maturity dates are now two, four, seven, ten and twelve years (i.e. the original bonds minus three years plus a new ten year bond). By staggering the maturity dates you are less exposed to inflation risk and interest rate rises than if you invested in a single long duration gilt (e.g. put the lot in a fifteen year gilt at the start).

Hope this helps.

[daveh]

If it helps I recently bought a gilt ladder for my cash holdings:

I purchased equal quantities of TN24, TN25, T26 TN28 and TG31. At the time all were showing a redemption yield of 4.5-4.8%. All these gilts have low coupons of between 0.125% and 0.375%, so the majority of the gain comes on redemption when they pay back at par of 100. All were bought at significant discounts to par to get those yields.

I chose low coupon to reduce the income so I avoid tax on the interest as these are held in a GIA. Most of the gain is at maturity and capital gains on gilts are tax free (at the moment). TN24 matured at the end of January when I got a coupon payment and par value. The others have just paid a small coupon payment. All was reinvested in TN25 as that had the highest redemption yield on the day. I'll have another decision to make next year when TN25 redeems.

For the low coupon gilts there isn't much beyond 2031, TG61 is a bit far out for me (I'll be nearly 100!) and at the last price I saw of ~30 the 0.5% coupon would actually pay a significant amount.
At the moment I have a choice of T26A TG29 and TG30 which would fill in a few of the missing years of my ladder. Come April I'll have space in my ISA so the cash will go there first, probably into stocks, but if I want to increase my cash holdings due to worries that their may be a correction I have more choice of what to hold, eg prefs, the full range of gilts, moneymarket funds etc.

[GoSeigen]

That's a really good summary from SalvorHardin. One reservation is that he refers to the effect of interest rates on bonds, in most cases it would be less confusing if the term "yields" was substituted for "interest rates".

Yield is the rate of return calculated for a specific bond or in many cases for a benchmark or notional bond (e,g. the ten-year yield) based on the market price of that bond. OTOH Interest rates generally refer to returns on money, not bonds (and their price of course is fixed).

Of course there is a link between interest rates and yields. This is especially true for short-dated bonds: imagine one could earn 5% on money in the bank. Investors would be equally happy to earn close to 5% on a 3-month gilt, because they know they will receive money in exchange for the gilt in just three months, so it's not much different to putting the money directly in the bank. Therefore such short-dated bonds are usually priced to bring their yields close the the monetary interest rate.

With longer dated bonds the story is very different. The only way to monetise the bond in the short term is to sell the bond in the market; until you do that you are exposed longer term to a number of risks, e.g. inflation changes, default, etc. Investors know this and set the market price of bonds accordingly. Therefore the yield of longer bonds may not reflect interest rates at all. Interest rates could rise but long-dated yields fall and vice versa. There was the famous Greenspan conundrum in the mid 2000s where the Fed repeatedly raised interest rates, yet long-term bond yields failed to rise [they were very likely anticipating the disinflation which followed in the next decade].

That is why in the bond world we usually refer to yield and its effect on the price of a bond, not interest rates.

To summarise, interest rates are a term mainly used about money whereas bond returns are referred to as yield. Short term bond yields tend to follow interest rates but the longer the maturity of the bond the less correlated its yield becomes to interest rate movements. When the yield of a bond rises its price falls and vice versa. A plot of yield of a bond versus the bond's maturity is referred to as the yield curve. Most of the time longer dated bonds yield more than shorter dated bonds because they are exposed to a greater level of risk.


GS

[SalvorHardin]

That's a really good summary from SalvorHardin. One reservation is that he refers to the effect of interest rates on bonds, in most cases it would be less confusing if the term "yields" was substituted for "interest rates".

That's my past life as an Actuary kicking in

Whenever I see fixed interest my reaction is think in terms of a valuation interest rate for the discounted cashflow calculation.

Yes, substituting yields for interest rates throughout my post makes it less confusing for investors.

[formoverfunction]

https://learn.wisealpha.com/

A free course on corporate bonds, although it might cover more complex instruments, it should cover the basics of yield and yields to maturity etc.

https://www.investopedia.com/terms/b/bondladder.asp

Covers bond ladders, and wider things you will need to know about investing in bonds.

https://bondvigilantes.com/podcasts/

Uncle Jim's podcast is always interesting and you might also find M&G's Bond Vigilantes an interesting read.

[JohnW]

'I read about a bond ladder but not sure how that works and how to construct one for return of capital - any help gratefully received!'

A bond ladder consists of buying several bonds, with different interest payment dates and maturity dates, to ensure a reasonably steady flow of cash over the term. As bonds mature you buy another bond with a longer date which fits in with your existing profile.

That describes a rolling bond ladder. If you buy such a ladder but never replace maturing bonds it's called a non-rolling bond ladder; these have a really useful place as an income source for retirees. And they become more useful if you use linkers rather than nominal bonds.
Building a ladder is easy, a spreadsheet helps, but ladders may provide a somewhat 'lumpy' income when coupons are small and most of the income is from maturing bonds especially if the bonds are maturing at 2 or 3 yearly intervals. But, worst case, that exposes you to only 2-3 years of inflation as your lumpy payment sits in a savings account waiting to be spent.
To build, you choose the year in which you wish to receive your last bond ladder income eg age 85. If you want £2000 income from the bond ladder that year, then you buy enough linkers which mature in that year such that their coupons and return of principal will give you £2000.
Next, you plan for income in the year preceding the last (ie last minus 1); it will come from coupons of the linker maturing in the last year plus any linker maturing in last minus 1 and their coupons. And on you go backwards. Explained in detail here: https://retirementresearcher.com/how-do ... nt-income/

[tjh290633]

To build, you choose the year in which you wish to receive your last bond ladder income eg age 85. If you want £2000 income from the bond ladder that year, then you buy enough linkers which mature in that year such that their coupons and return of principal will give you £2000.
Next, you plan for income in the year preceding the last (ie last minus 1); it will come from coupons of the linker maturing in the last year plus any linker maturing in last minus 1 and their coupons. And on you go backwards. Explained in detail here: https://retirementresearcher.com/how-do ... nt-income/

That sounds like recipe for poverty in old age. These days the number of people getting to 100 or more is increasing. What you are proposing is living off your capital as there is very little income from the index linkers. I pity anybody who follows your advice. An index linked annuity would be far better, and a well organised HYP even better.

TJH

[JohnW]

That sounds like recipe for poverty in old age. These days the number of people getting to 100 or more is increasing. What you are proposing is living off your capital as there is very little income from the index linkers. I pity anybody who follows your advice. An index linked annuity would be far better, and a well organised HYP even better.’

It’s certainly not a high yield strategy, but it’s as close to riskless as one can get and the outcome is perfectly predictable. That can suit some folk, or some of some folks’ money.
Outliving the ladder is possible, clearly; have a plan. My post wasn’t advice to construct a bond ladder, but an answer for someone looking at how to do it. An index linked LIFETIME annuity is a good choice, depending on circumstances, but the bond ladder leaves a legacy if you die early and can be sold off if needed.

[88V8]

That sounds like recipe for poverty in old age. These days the number of people getting to 100 or more is increasing. What you are proposing is living off your capital as there is very little income from the index linkers.

It’s certainly not a high yield strategy, but it’s as close to riskless as one can get and the outcome is perfectly predictable.

I suppose that depending on rate movements there might be opportunities to sell some of the bonds at a premium.
Otherwise the attraction of buying low yielders near par escapes me.

V8

[SalvorHardin]

I suppose that depending on rate movements there might be opportunities to sell some of the bonds at a premium.
Otherwise the attraction of buying low yielders near par escapes me.

The benefit is that gilts are exempt from capital gains tax. So low yield gilts which are selling below par value can be quite attractive to taxpayers who have a high marginal tax rate.

A good example is someone who is extremely close to making £100,000 in a year, when crossing that threshold immediately causes their marginal tax rate to jump to 60%. I've seen several stories recently about people refusing pay rises

It might be possible to sell off the income part of the gilt and keep the capital bit, though I haven't looked at how this "gilt stripping" is taxed nowadays (I suspect that HMRC would treat the proceeds from the sale of income gilt strips as income, not capital).

[JohnW]

I suppose that depending on rate movements there might be opportunities to sell some of the bonds at a premium.
Otherwise the attraction of buying low yielders near par escapes me.

I think we can ignore par values and coupon rates because if you buy the ladder now you are buying bonds which yield approx 1% real/year (according to the BoE yield curve as of 5 March). That means, regardless of par value, price or coupon you’ll be getting a nominal return of 4%/year if inflation is 3%/year, etc, guaranteed. You’d have to concede that’s attractive for some people, a set and forget income stream that requires no agonising over someone’s annual report and economic forecasts.

[GoSeigen]

So trying to get my finances in order a few years from retirement - with alot of cash now available is it time to buy bonds as interest rates are likely to fall in the next 6-9 months

[My emphasis]

No question mark in the OP, but this bit was posed as a question, and I don't think anyone addressed it, so some questions of my own:

1. Why does the OP suppose that interest rates are likely to fall? Just because everyone else believes that to be the case?? Because of anchoring -- rates were lower recently so they must return to that level?? Note that last time rates were this level everyone believed "the only way is up" yet they fell for a decade or more.

2. Even if interest rates fall (by how much?) why would that necessarily translate into lower gilt yields. Okay, short-dated yields may fall but if sustained that means falling future income, not rising!

3. If interest rates rise instead of falling what is the plan? Any rise will likely be a result of inflation outlook, so have you considered the effects of inflation on your retirement?

Does anyone have a view on how high rates/gilt yields may go in the next spike; technically yields look bullish with the 200DMA providing support to the 10-year treasury?


GS
Disclosure: Negligible gilts holdings; +/-100% stock/property exposure.

P.S. "with alot of cash now available" -- this is the situation with a lot of people. There's a lot of cash because people wanted cash; not so long ago they were dumping gilts to acquire cash from the central banks. So you might want to get rid of your cash but other people do too. You need to ask who is going to be left holding the cash, the smart investors or the dumb? And if the latter, then is buying gilts at current prices the smart way to offload that cash? And is the amount of cash in the economy going to increase, stay the same or decrease? [Personally I'd say the smart investors acquired the cash, because the gilts they offloaded are now worth a fraction of what they sold them for, but that's just my analysis of the situation...]

[International]

Disclosure: Negligible gilts holdings; +/-100% stock/property exposure.

GS, do you have a post somewhere where you describe your situation? Interested in your thought process for 100% stock/property and if the property is directly-owned or property funds. Context is that I am constructing my own future so interested in others' approaches.

[GoSeigen]

Disclosure: Negligible gilts holdings; +/-100% stock/property exposure.

GS, do you have a post somewhere where you describe your situation? Interested in your thought process for 100% stock/property and if the property is directly-owned or property funds. Context is that I am constructing my own future so interested in others' approaches.

I witter on about my view of markets on these forums, you can find those posts if you are prepared to wade through all the other rubbish I write!

The property is directly purchased, small and overseas, not UK, it won't kill me if it all goes wrong, and with COVID and other things like very poor market it hasn't exactly gone right. However I've bought in a place where the market's been off its peak for 17 years, so at some point I think property will make big returns. It's just not yet...

GS