Bonds

[langdale]

I know that bonds should form part of a balanced portfolio but interest rates are so low so bond yields must be too? If interest rates rise in the long-term, presumably bond prices fall. So is now not a good time to invest if you don't aready hold them.

[jonesa1]

Bond funds tend to increase in value as interest rates decline and decrease in value when rates increase. Their primary purpose in a portfolio is as diversification from riskier assets, in recent years they have also provided a good return because of declining interest rates. Given that rates are now very low (with negative real returns on many government bonds), it seems unlikely that the recent capital gains will continue. Instead bonds may become a significant drag, largely dependent on what happens to interest rates. If interest rates stay as they are, then presumably bonds can continue to provide stability to a portfolio, but without much of a return. If rates increase significantly, then you'd probably be better off with cash. Value preservation funds like Capital Gearing Trust and Personal Assets have a large allocation to index linked bonds, this may be the way to go if you feel the need for bonds. Alternative, low risk diversifiers don't seem very easy to spot.

Andrew

[dealtn]

Bond funds tend to increase in value as interest rates decline and decrease in value when rates increase. Their primary purpose in a portfolio is as diversification from riskier assets, in recent years they have also provided a good return because of declining interest rates. Given that rates are now very low (with negative real returns on many government bonds), it seems unlikely that the recent capital gains will continue. Instead bonds may become a significant drag, largely dependent on what happens to interest rates. If interest rates stay as they are, then presumably bonds can continue to provide stability to a portfolio, but without much of a return. If rates increase significantly, then you'd probably be better off with cash. Value preservation funds like Capital Gearing Trust and Personal Assets have a large allocation to index linked bonds, this may be the way to go if you feel the need for bonds. Alternative, low risk diversifiers don't seem very easy to spot.

Andrew

How do index linked bonds priced significantly above (real) par meet the criteria of "Value Preservation" when they are guaranteed to lose money when held to maturity?

[jonesa1]

How do index linked bonds priced significantly above (real) par meet the criteria of "Value Preservation" when they are guaranteed to lose money when held to maturity?

In my view they don't, in isolation. They should mitigate the impact of higher inflation, so possibly a better bet at the moment than non-index linked bonds, if you think we're in for a dose of high inflation. Bonds in general may continue to preserve wealth better than equities when we have down-turns, even if only by losing less. I simply made the point that CGT & PNL held plenty of them as part of their value preservation strategies. I don't hold any bonds in my portfolio, about 70% of my partner's ISA is split between CGT & PNL, on the basis of her stated requirement of preserving value being more important than growing it - hopefully they will continue to demonstrate that they know what they're doing.

[langdale]

Many thanks for the replies. Your explanation is very clear Andrew, thanks. The only bonds I currently have are in Capital Gearing Trust bought a few weeks ago but they're a small part of my portfolio.

[shetland]

This is why I have such a problem with bonds and the lines of CGT and PNL. Bonds are not a safe haven, the capitalist at risk, particularly when interests rates are so low, as they are now.

[hiriskpaul]

A lot of people have been saying bonds are too expensive and will fall when interest rates rise for at least the last 10 years on here and previously on TMF. All the while prices went up while interest rates stayed at 0.5%! I have to concede though I finally agree that prices are too high on investment grade and sold my last tranche of government bonds (US long duration Treasuries) in the spring. But not all bonds are created equal and I still hold a lot of high yield bonds and prefs, buying more when high yield sold off earlier this year. My biggest position is in Co-op Group 11% 2025, which still has a decent yield for a 5 year investment.

[Bubblesofearth]

A lot of people have been saying bonds are too expensive and will fall when interest rates rise for at least the last 10 years on here and previously on TMF. All the while prices went up while interest rates stayed at 0.5%!

It's important to look at expected return rather than historical return.

BoE

[hiriskpaul]

A lot of people have been saying bonds are too expensive and will fall when interest rates rise for at least the last 10 years on here and previously on TMF. All the while prices went up while interest rates stayed at 0.5%!

It's important to look at expected return rather than historical return.

BoE

Agreed. The point i was making was how uncoupled bond prices were (they dropped) from interest rates, which stayed largely the same..

[JohnW]

...but interest rates are so low so bond yields must be too? ... So is now not a good time to invest if you don't aready hold them.

I don't think you need to be uncertain about bond yields as that information is readily available for any that you fancy.
To be certain about your last statement/question, you'd need to be certain about future interest rates, inflation, equity prices and returns. Were you to get a bad mix of those latter four for the next decade you might be thrilled to be holding government bonds. How certain are you?

Instead bonds may become a significant drag, largely dependent on what happens to interest rates.

Qualitatively, but 'do the math' as they say: a 1.5% rise in short term interest rates during the next year would be pretty dramatic, but it would drop the value of a bond fund with a 7 year duration by about 10%, and from then on the fund would start paying more in coupons. Would that sink you?

If interest rates stay as they are, then presumably bonds can continue to provide stability to a portfolio, but without much of a return

As nice as high returns are, they're not always available for the risks one is prepared to take. Perhaps we're in such a time. Does that mean you go chasing the returns you believe you're due, disregarding the risks you used to pay heed to? Bonds, particularly government bonds, provide portfolio stability when the faeces hit the fan for stocks, money pouring out of stocks into something safe - pushing down their yield!

Bonds are not a safe haven, the capitalist at risk, particularly when interests rates are so low, as they are now.

I'll pass on 'the capitalist at risk', but government bonds would still be considered a 'safe haven' unless the UK government is in more trouble than is obvious.

[Wuffle]

If you are young, advice would be to go equity anyway.
If you are old you have made a ton on the asset accumulation as rates have bombed.
Nobody will feel sorry for you if you are just being greedy and want to win at both ends.
There is a natural order to this.

W.

[Bubblesofearth]

Bonds, particularly government bonds, provide portfolio stability when the faeces hit the fan for stocks, money pouring out of stocks into something safe - pushing down their yield!

If the expected return on gilts is no better than cash then why not get stability from cash instead? Unlike gilts, cash has zero volatility. Furthermore, if you look over enough periods, there is little evidence that gilts are negatively correlated with equities.

Institutions invest in gilts/bonds because their size makes it hard for them to hold cash. Private investors do not have this problem and do not need to ape the investment behaviour of institutions.

BoE

[JohnW]

If the expected return on gilts is no better than cash

It is an interesting matter, and I wouldn't dispute the similarity of short term government bonds and cash now (perhaps they're always similar, making the choice difficult).
'Expected' has at least two meanings: 'average' in a statistical sense (based on the past); and 'what's likely to eventuate' in future. I don't know which you intend, but I'm not confident of predicting what bond returns are likely to be; we've been reminded up thread of a decade of rising interest rate predictions that have not eventuated. While in the 'average' sense, I think there's a long history of government bonds of not short duration (that's a big difference from cash) paying more than cash - perhaps not much more, but they should for the risks one takes. And then there are linkers, with no 'cash' equivalents (at least in some countries).

if you look over enough periods, there is little evidence that gilts are negatively correlated with equities.

That indeed is the holy grail, like high returns, but we sometimes have to settle for less. Have a look at a graph of your local stock index compared with a government nominal bond index with a duration of about 7 years, for the period January-December this year. On 21 February the stock index starts falling about 35%, while the bond index flat lines the whole year (it might even show a slight rise). That's not a negative correlation, I think, but it's handy if you're the nervous type.

Institutions invest in gilts/bonds because their size makes it hard for them to hold cash. Private investors do not have this problem and do not need to ape the investment behaviour of institutions.

Indeed, but neither do they need to eschew bonds if they've been a suitable asset during times of higher yield. One hears little of people abandoning high yield stocks because their yield has now fallen. Here's someone who might sell you the idea of long bonds in negative interest rate times. https://portfoliocharts.com/2019/05/27/ ... convexity/

[Bubblesofearth]

It is an interesting matter, and I wouldn't dispute the similarity of short term government bonds and cash now (perhaps they're always similar, making the choice difficult).
'Expected' has at least two meanings: 'average' in a statistical sense (based on the past); and 'what's likely to eventuate' in future. I don't know which you intend, but I'm not confident of predicting what bond returns are likely to be; we've been reminded up thread of a decade of rising interest rate predictions that have not eventuated. While in the 'average' sense, I think there's a long history of government bonds of not short duration (that's a big difference from cash) paying more than cash - perhaps not much more, but they should for the risks one takes. And then there are linkers, with no 'cash' equivalents (at least in some countries).

If you are prepared to shop around then it's possible to get slightly better rates on short-term (1-5 years) cash deposits than gilts of similar duration.

Expected return has a clear definition when referring to financial investments;

https://en.wikipedia.org/wiki/Expected_return

For gilts the expected return is quite easy to calculate as they have a defined duration and maturity value. Cash does as well of course but, unlike gilts, carries zero volatility risk.

That indeed is the holy grail, like high returns, but we sometimes have to settle for less. Have a look at a graph of your local stock index compared with a government nominal bond index with a duration of about 7 years, for the period January-December this year. On 21 February the stock index starts falling about 35%, while the bond index flat lines the whole year (it might even show a slight rise). That's not a negative correlation, I think, but it's handy if you're the nervous type.

There have indeed been periods when gilts have moved in the opposite direction to stocks. But the reverse is also true. Without the power of hindsight it's not possible to know which of those scenarios will play out in the future. If you are the nervous type then surely cash is even more soothing than gilts given the zero volatility?

Indeed, but neither do they need to eschew bonds if they've been a suitable asset during times of higher yield. One hears little of people abandoning high yield stocks because their yield has now fallen. Here's someone who might sell you the idea of long bonds in negative interest rate times. https://portfoliocharts.com/2019/05/27/ ... convexity/

You would need to factor in some probabilities here. What is the probability of rates falling further once they are already zero or negative? Vs probability of a rise in rates? There is no free lunch here and without a clear expectation of a negative correlation with other assets then expected return remains the one investors should be concerned with.

BoE

[JohnW]

Expected return has a clear definition when referring to financial investments;

https://en.wikipedia.org/wiki/Expected_return

Thanks for pointing me to that. I'm guessing it accords with my second notion 'what's likely to eventuate in future', if I understand that integrated equation.

[Bubblesofearth]

Thanks for pointing me to that. I'm guessing it accords with my second notion 'what's likely to eventuate in future', if I understand that integrated equation.

For a bond the expected return at expiration is fixed, i.e. the change in capital value plus any interest along the way. Before expiration the expected capital return can be seen as that point along a straight line drawn between the capital value now and at expiration where time is along the x-axis and capital value the y-axis. The actual return before expiration may, of course, be higher or lower depending primarily on the interest rate environment.

An important point for investors is that expected return should go up with volatility. More volatile assets should have a higher expected return. So equities should have a higher expected return than bonds and bonds a higher expected return than cash. Currently gilts do not have a higher expected return than cash and that makes them a poor investment (relative to cash).

BoE

[JohnW]

For a bond the expected return at expiration is fixed

Thanks again. I was overlooking that for a bond held to maturity the return is always known, if no default.
I'm guessing that that return is wikipedia's 'expected return' which is the centre of the distribution of possible returns, and that the distribution represents the range of returns possible if you redeem early.

Currently gilts do not have a higher expected return than cash and that makes them a poor investment (relative to cash).

I can imagine that is the case if you consider a bond of only one (short) maturity, but longer bonds commonly have a higher return. Perhaps if the bond yield vs maturity curve is flat now, your statement applies to bonds of any duration.

[langdale]

Sorry to be so late replying to this thread I started. Just wanted to say big thanks for all the replies - especially conversation between bubblesofearth and JohnW which helped me a lot to understand bonds in general.

[GoSeigen]

Thanks for pointing me to that. I'm guessing it accords with my second notion 'what's likely to eventuate in future', if I understand that integrated equation.

For a bond the expected return at expiration is fixed, i.e. the change in capital value plus any interest along the way. Before expiration the expected capital return can be seen as that point along a straight line drawn between the capital value now and at expiration where time is along the x-axis and capital value the y-axis. The actual return before expiration may, of course, be higher or lower depending primarily on the interest rate environment.

An important point for investors is that expected return should go up with volatility. More volatile assets should have a higher expected return. So equities should have a higher expected return than bonds and bonds a higher expected return than cash. Currently gilts do not have a higher expected return than cash and that makes them a poor investment (relative to cash).

BoE

I'm glad BoE has picked up at least one clue from my witterings over the years! The other half of the story is that 1. the steepness of the risk curve and 2. the general height of this curve above zero are also crucial. To wit: if the curve is very shallow as in Feb this year it is far more probable than usual that gilts will outperform stocks. This was the subject of a heated debate at the time, when a poster asked whether he should switch to gilts if he felt the price of other assets was too high. I agreed with him but others said things like" gilts are a bad investment because they are trading above par". I sincerely hope that poster went with the courage of his convictions, because within weeks if not days gilts were up 20% while shares were down 30%.

GS

[dealtn]

Thanks for pointing me to that. I'm guessing it accords with my second notion 'what's likely to eventuate in future', if I understand that integrated equation.

For a bond the expected return at expiration is fixed, i.e. the change in capital value plus any interest along the way. Before expiration the expected capital return can be seen as that point along a straight line drawn between the capital value now and at expiration where time is along the x-axis and capital value the y-axis. The actual return before expiration may, of course, be higher or lower depending primarily on the interest rate environment.

An important point for investors is that expected return should go up with volatility. More volatile assets should have a higher expected return. So equities should have a higher expected return than bonds and bonds a higher expected return than cash. Currently gilts do not have a higher expected return than cash and that makes them a poor investment (relative to cash).

BoE

I'm glad BoE has picked up at least one clue from my witterings over the years! The other half of the story is that 1. the steepness of the risk curve and 2. the general height of this curve above zero are also crucial. To wit: if the curve is very shallow as in Feb this year it is far more probable than usual that gilts will outperform stocks. This was the subject of a heated debate at the time, when a poster asked whether he should switch to gilts if he felt the price of other assets was too high. I agreed with him but others said things like" gilts are a bad investment because they are trading above par". I sincerely hope that poster went with the courage of his convictions, because within weeks if not days gilts were up 20% while shares were down 30%.

GS

Sounds like you might be referring to me. Can you find a quote anywhere, in February or otherwise, where I have stated Gilts are a bad investment, or likely to be?

I have consistently pointed out that Gilts trade above par but have only ever said to any (potential) investor they should be aware of the risks in investing in that asset class. One of which might be either a low return to maturity, a fall in real capital, or a fall in price between investing and maturity.

Like any investment, even in a bubble - not that I have described Gilts as such - has the potential for both gains and losses. Investors should be aware of the associated risks to make such judgements for themselves. Lazy clichés such as Gilts are safe, or safer than equities, are what I disagree with.