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  • FIRST POST
    • aroominyork
    • By aroominyork 8th Oct 17, 5:07 PM
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    aroominyork
    Bonds - still so confusing...
    • #1
    • 8th Oct 17, 5:07 PM
    Bonds - still so confusing... 8th Oct 17 at 5:07 PM
    A few months into DIYing I still find bonds are the sector I don’t sufficiently understand (despite having read bowlhead et al from dawn til, well, an hour or two after dawn).

    Equities, by comparison, seem relatively straightforward. Either go passive, or choose your geographies, sectors and company sizes then sit back and hope. Why do bonds confuse me so? They are meant to be the main way to balance risk in a portfolio, but much of what’s written is about their downside, eg of the 20-30 year bond run reversing. A few days ago I read in a post a rule of thumb that during an equities crash, bonds go up 0.5% for each % that equities fall, and while I wish it were that simple I fear it’s not.

    I am approaching this with a retirement portfolio with a ten year horizon invested 65% equities, 30% bonds, 5% property/other. The bonds are 10% higher risk (Schroder High Yield Opps and GAM Star Credit Opps), 18% strategic (Royal London Ethical and Morgan Stanley Sterling Corporate) and 2% within VLS.

    I understand (I hope correctly) that as long as interest rates remain low and no sectors of the economy goes wotsits-up, the high yield funds will perform better. So I have two questions. The first is whether, if there is a bond bear market, do investors hang on to their bonds (high yield and cautious/strategic) the way they hang on to equities after a crash, waiting for them to recover, or is the strategy different for bonds?

    My second question is about the role of strategic bonds, whose rises have generally slowed in the last year; is this because the managers see an interest rate rise, the end of the bond bull market and/or an equities correction as more imminent and so are investing more cautiously? And if so, what can I reasonably expect to happen to these funds when one or both of those events happen? If there is not a good chance of the ‘equities down 1%, bonds up 0.5%’ scenario playing out, and given the warnings about the end of the bond run, do bonds have too many more potential downsides than upsides for them to be a worthwhile investment?

    The cause of the next crash will presumably affect bonds as much as equities. Presumably, if it was not caused by the banks (as 2007/8) and was not in sectors where the banks were exposed, then bond funds invested heavily in banks/financials would be safe havens.

    So that’s my conundrum, having a chunk of my portfolio invested for reasons I don’t fully understand (and, I expect, writing a number of things in this post which demonstrate that).
Page 2
    • dunstonh
    • By dunstonh 9th Oct 17, 5:39 PM
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    dunstonh
    (The moderately cautious portfolio of the IFA I recently escaped from had all its bonds in high yield funds.)
    At this point in the cycle, HYBs are generally considered more favourable.
    • aroominyork
    • By aroominyork 9th Oct 17, 5:46 PM
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    aroominyork
    At this point in the cycle, HYBs are generally considered more favourable.
    Originally posted by dunstonh
    Mine are certainly outperforming the cautious strategic funds. So how do I get an understanding of bond – or broader – cycles, and what type of bonds to invest in when? Should I now be moving all my bonds into high yield?
    Last edited by aroominyork; 09-10-2017 at 6:42 PM.
    • dunstonh
    • By dunstonh 9th Oct 17, 6:49 PM
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    dunstonh
    So how do I get an understanding of bond – or broader – cycles, and what type of bonds to invest in when?
    Knowledge and experience. You need to put the research and education in if you want to get to that depth of knowledge.

    Should I now be moving all my bonds in high yield?
    In most cases, no. HYB typically have higher risk. So, HYBs increase the volatility rating of your portfolio. So, whilst in term of bonds, they are the most attractive for upside. They are also pretty heavy on the potential downside. Not far off equities in some cases.

    You have to balance your portfolio to on both the upside potential and the downside potential. If you went all HYB and general equities you could be looking at 45-50% loss potential. The HYBs would not give you much downside protection at all. The other types of bonds are there to give you diversification (as in most cases they are not correlated) and downside protection. They are not there to give you the best return.
    • aroominyork
    • By aroominyork 9th Oct 17, 7:29 PM
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    aroominyork
    Experience comes with time; this forum is my main source of knowledge.

    If I understand correctly, dunstonh, there is nothing too wacky about having 10% of my portfolio in HYBs and 20% in cautious strategic. Is that right?

    Does it seem curious that a moderately cautious portfolio has all its bond allocation in HYBs or (possibly answering my own question) does that depend on how the rest of the portfolio is invested? For example, since it also has 15% in property and some in targeted return could those holdings provide the cautious and the HYBs the intermediate?
    • dunstonh
    • By dunstonh 9th Oct 17, 8:50 PM
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    dunstonh
    If I understand correctly, dunstonh, there is nothing too wacky about having 10% of my portfolio in HYBs and 20% in cautious strategic. Is that right?
    Nothing wacky there.

    Does it seem curious that a moderately cautious portfolio has all its bond allocation in HYBs or (possibly answering my own question) does that depend on how the rest of the portfolio is invested?
    Yes. The volatility rating of a portfolio can be tugged in different directions depending on the underlying assets. If you increase a percent here and means you may have to tweak a percent there and a bit more on another one.

    For example, since it also has 15% in property and some in targeted return could those holdings provide the cautious and the HYBs the intermediate?
    Bricks and mortar property funds can pull that risk level down but property share can push that risk level up. Diversification can pull the risk score down a bit too if the quality of diversification is good.

    By targetted return do you mean absolute return funds? These can range for very low risk to very high risk. Just because a fund is an absolute return fund does not mean it is low risk.
    • chiang mai
    • By chiang mai 9th Oct 17, 9:15 PM
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    chiang mai
    One field of thought is that bonds are a drag on the performance of an equity-based portfolio and that given that the income from bonds is far smaller than that of equities, the only compelling reason to hold them is as an insurance against a drop in the value of equities - the issue here is funds preservation rather than the search for yield.

    But if an investor is unsure of the validity of that insurance, reducing the drag on the equities portfolio by putting the money from bonds into low yielding cash deposits, achieves the same goal and assures the integrity of the funds preservation insurance, albeit the upside is limited.

    I think people sometimes get hung up on asset balancing within a portfolio whereas asset balancing can be done across all assets including cash in bank accounts, the effect is the same, cash is preserved and interest income is earned. Perhaps you should ask yourself why you want to hold bonds in the first place and whether that reason better lends itself instead to cash holdings or investment in equities (profit vs preservation).
    Last edited by chiang mai; 09-10-2017 at 9:35 PM.
    • aroominyork
    • By aroominyork 9th Oct 17, 9:31 PM
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    aroominyork
    Dunston, it was targeted return, I think an Invesco fund aiming for x% above Libor over x years.

    Chiang, I take on board your comment, hence wondering a couple of posts back about moving some of my bond/non-equity allocation into p2p. I recently dipped my toe in through Ratesetter and feel ready for Funding Circle when they open for ISAs later this year.
    • chiang mai
    • By chiang mai 9th Oct 17, 9:44 PM
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    chiang mai
    FWIW I hold bonds in two ways, firstly as a part of Mixed Asset products where I rely on fund managers to manage. In the second way I hold three bond only funds that I have researched and feel comfortable with albeit I track their performance weekly. Those funds contain mid/high credit bonds with short durations, my reasons for holding them are upside gain and downside protection, a sort of cake and eat it scenario which I am comfortable I will at least partially achieve - my asset balancing is done overall and includes low yielding cash in banks. And I also hold an index-linked gilts fund which has surprised in times of stress, in normal markets it is however a drag on overall performance.
    • point5clue
    • By point5clue 10th Oct 17, 7:40 AM
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    point5clue
    I've seen a lot of statements on the prices of bonds changing with interest rates - my question:

    Do the prices change when the interest rate changes, or when there is an expectation of a change ?

    e.g. it is highly anticipated that UK base rates will go up before the end of the year - will the market have already priced that in ?
    • aroominyork
    • By aroominyork 10th Oct 17, 9:14 AM
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    aroominyork
    I've seen a lot of statements on the prices of bonds changing with interest rates - my question:

    Do the prices change when the interest rate changes, or when there is an expectation of a change ?

    e.g. it is highly anticipated that UK base rates will go up before the end of the year - will the market have already priced that in ?
    Originally posted by point5clue
    I think this is a great question, because so often you read that this, that and the other has already been priced in to a share/bond/currency price, to the point where it sounds like the markets barely need open more than once a year because every foreseeable event has already been priced in.
    • chiang mai
    • By chiang mai 10th Oct 17, 11:33 AM
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    chiang mai
    On 17 September the BOE announced interest rates would rise sooner rather than later, the impact on bond fund prices was immediate. Since I track the performance of a new portfolio I've recently constructed I saw the impact of that news on my bond holdings although those funds have now recovered hence the rise is not priced in. It was that event that made me dig more deeply into what makes bonds tick and I've adjusted my holdings accordingly.

    Also to consider: when we talk about interest rate rises and bonds falling, historically we're talking about whole percentage points rather than two small fractions over a year, the size of the rise or fall is therefore critical to the impact outcome.
    • eskbanker
    • By eskbanker 10th Oct 17, 11:54 AM
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    eskbanker
    On 17 September the BOE announced interest rates would rise sooner rather than later
    Originally posted by chiang mai
    Do you have a link for this announcement? I thought it was more like Carney opining that this is likely rather than an official bank announcement that it will happen (which would obviously undermine the role of the MPC).
    • chiang mai
    • By chiang mai 10th Oct 17, 12:08 PM
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    chiang mai
    Apologies for not being grammatically precise, when I wrote "BOE announced", I intended that to mean and I thought it would be sufficently clear that Carney was reported to have said that.......Carney/BOE, anounced/opined, all the same thing really in the context of something happening sooner rather than later.
    • ColdIron
    • By ColdIron 10th Oct 17, 12:27 PM
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    ColdIron
    I seem to remember Mark Carney announcing in his 2013 Forward Guidance that he would not increase rates until unemployment was less than 7%, today it's 4.4%. I think in this context 'sooner rather than later' is near meaningless. I'm not a Carney knocker, I just choose to put little store in his opinings on timing
    • chiang mai
    • By chiang mai 10th Oct 17, 12:48 PM
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    chiang mai
    I do hope you don't think that just because Carney said X in his forward guidance four years ago that that remains cast in stone today!

    Regardless, when Carney (or any other Central Bank Govenor) speaks, markets listen and react to what was said, even if what was said was not an offical anouncement, whatever they are any more!
    • ColdIron
    • By ColdIron 10th Oct 17, 12:59 PM
    • 3,468 Posts
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    ColdIron
    I do hope you don't think that just because Carney said X in his forward guidance four years ago that that remains cast in stone today!
    Originally posted by chiang mai
    Absolutely not, he rewrote his Forward Guidance in 2014 ditching unemployment in favour of the rather nebulous 'spare capacity in the economy'
    • chiang mai
    • By chiang mai 10th Oct 17, 1:18 PM
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    chiang mai
    This red herring has perhaps been stretched far enough, at the risk of sidetracking: the subject is bonds, I've offered guidance that my bond holdings dipped significantly after Carney spoke and also that the degree of rise (or fall) in interest rates is key in understanding the impact on bond performance.
    • lluzers
    • By lluzers 10th Oct 17, 2:08 PM
    • 116 Posts
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    lluzers
    The biggest bond trader in the world is running from bonds.His name is Bill Gross.
    • chiang mai
    • By chiang mai 10th Oct 17, 2:33 PM
    • 75 Posts
    • 14 Thanks
    chiang mai
    "The biggest bond trader in the world is running from bonds.His name is Bill Gross".

    Not quite, especially since he's the portfolio manager of Janus Henderson Global Bond fund!

    And today he wrote: "Investors should brace for higher Treasury bond yields as the Fed begins to unwind its quantitative easing program but yields will edge up "only gradually,".
    https://www.cnbc.com/2017/10/10/bill-gross-of-janus-blames-us-fed-for-fake-markets.html

    So what does all that mean? I think it means that interest rates are going to rise, slowly, and that is indicated by the rising yields of T'bills - the operative word is SLOWLY.

    The impact of those things on existing bonds (that are of poor credit quality and/or of long duration) is that their value will fall, others may not.
    • aroominyork
    • By aroominyork 10th Oct 17, 2:52 PM
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    aroominyork
    The impact of those things on existing bonds (that are of poor credit quality and/or of long duration) is that their value will fall, others may not.
    Originally posted by chiang mai
    Which brings me nicely back to near-ish where I started – how to manage the bond element of a portfolio. At a basic level the relative risks of high yield bonds and cautious/strategic are clear (in the way that another thread is today discussing SMT vs. VLS60) but that leaves the question of how to assess when to invest where on the bond spectrum, since bonds seems to need more active management than equities (especially if taking on board coldiron’s view that index bond funds are buckets of failure).

    I am becoming clearer that my current allocation is too cautious (10% high yield, 18% cautious/strategic, 2% in VLS80), partly because I have a chunk of cash which, for reasons I won’t go into, has to remain in cash right now and so lowers my overall risk. A short term thought is to sell half of each of the two strategic funds, split the proceeds of one between the two HYB funds, and add the proceeds of the other to my VLS80.

    But while that would make me comfortable today, I would soon be thinking whether the environment is changing and I should be moving things around again. Sure, I could try to get the level of knowledge of wiser heads on this forum (and make mistakes along the way when a little bit of knowledge proves a dangerous thing) but I really don’t aspire to that level of understanding. So I come full circle to asking how to most effectively manage a portfolio where I am happy to make decisions about equities but want a more hands off approach to bonds?
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