Commodities & Bond Funds

xx_Law_Grad_xx

Recently I have been reading alot of articles on asset allocation and the importance of diversifying across the various asset classes.

Having ran my portfolio through Morningstar's X-ray tool it would appear that 18% of the portfolio is in industrial materials and 11% is in energy.

Would it therefore be unnecessary to have a commodities fund in my portfolio as I am exposed to them through the various other funds I have? From what I have gathered there the FTSE100 and S&P500 consist of alot of companies involved in commodities.

---

I am trying to improve my knowledge of bonds and how the various market conditions have an effect on how well they perform.

If interest rates were to rise in the next couple of years what effect would this have on bonds? Am I correct in saying that high yield and corporate bonds would do okay/well whilst government bonds would do poorly? And gilts do well when equities are also performing well?

When are usually the best times to buy into the various types of bonds, i.e. during recessions, high interest rates, inflation, etc?

Thank you.

Loughton_Monkey

xx_Law_Grad_xx wrote: »

If interest rates were to rise in the next couple of years what effect would this have on bonds? Am I correct in saying that high yield and corporate bonds would do okay/well whilst government bonds would do poorly? And gilts do well when equities are also performing well?

When are usually the best times to buy into the various types of bonds, i.e. during recessions, high interest rates, inflation, etc?

Thank you.

Think about it!

You paid £10,000 to buy a corporate bond, government bond, etc. [fixed interest] when the 'going' rate was 4%.

So as long as you keep holding it, you will get 4% - which was what you were 'happy' with presumably.

Can interest rates go down? I think not. Can they go up? I think so. So what happens if interest rates go up? Well the 'going' rate will then move from, say, 4% to 5%. That's what new investors will be 'happy' with.

So you have two choices:

1. Ignore that 5% is the new going rate, and sit there gritting your teeth, pretending to smile, and saying that you are 'happy' with 4%.

2. Sell up. In which case, the value of your £10,000 bond will dramatically dive to (say) £8,500 so that I [the new purchaser] will get the new going rate of 5%. In effect, you got far less than the 4% you wanted, because now you are subsidising me to get more than 4%.

These principles apply whether the bond is high yield or low yield. All the yield does, generally, is reflect the possibility of you getting your money back. The higher the yield, the more risk you are running, in general, of losing the whole shooting match.

Hence, the only 'good' time to buy bonds is when interest rates are high, and you strongly think they will come down. THen you have the 'luxury' of holding them and enjoying the above-market income, or selling them for a premium.

Ark_Welder

I would not buy a separate commodities fund given your current exposure to those sectors, and for the reasons you have discovered and given. If you would like exposure to bonds but are in doubt as to what to go for then you may want to read up on Strategic Bond Funds.


Rising interest rates usually have a negative effect on the prices of investment-grade bonds, such as gilts and high-grade corporate bonds, but corporates may perform better than conventional gilts (as opposed to the index-linked variety) if the rate of increasing rates is low. If it is higher or faster then yields on gilts would go higher and this would push out those on the corporates.

How high-yield bonds might perform will depend on how high interest rates go, and on how well the economy does: the higher interest rates go, the more likely that the yield available from high-grade bonds will approach their high-yield compatriots, and that should push their yields higher. Note that an increasing yield from a bond means that its price is going down (FRN, IL investors et al, please forego any comments there for now!). High-yield bonds tend to perform well when interest rates are not to too high and the economy is doing well: their yield is worth having and the company is less likely to default on them if it is making money).

'Under normal conditions', when equities do well, gilts - and to a degree, high-grade corporate bonds - do badly. The reason is that the rise in equity prices are an expectation of better times ahead so money is taken out of more defensive assets, such as cash and gilts, and put into riskier equities because of the expecation of a better return. That is, under normal circumstances...

So long as things are not expected to deteriorate further, high-yield corporate bonds are what I would go for during a recession: the reason is the expectation that the recession will come to an end and the companies that have issued the riskier high-yielders are more likely to survive and be able to pay the interest and redemption. If thinks do look like they will deteriorate I would probably hold cash in the belief that gilts are already overpriced and the cash that I have is then ready to be invested when things look like they at their worst...:)

When interest rates are high (but I don't expect them to rise much further), then gilts and high-grade corporate bonds: the reason, the expectation that interest rates will decrease, so their prices will rise.

Inflation, if it is high and interest rates are high then conventional gilts and high-grade corporates. Reason: high interest rates should slow down the economy and bring down the rate of inflation.

If inflation is high but rates are low then high-yield and possibly some high-grade corporates. Reason: interest rates are likely to rise to combat inflation.

If inflation is low and I expect it to go to a negative rate for a sustained period, then gilts, and gilts alone. Reason: expecting a deflationary period so quality and security is required.


All of the above, 'under normal conditions', which we haven't got right now. Interest rates have been trending lower for the past 30 years, and bonds have been in a corresponding bull market. If interest rates could go lower, then they would have. Instead, the famed Quantative Easing Show has been on the road in an attempt to head of a deflationary period. The cash that has been made available through this has gone into all asset types, pushing up the prices of equities, bonds, gold, property (in some parts of the world..), other commodities, and especially in Asia and emerging market economies, where inflation is on the increase even more than it is here.

You will see references to index-linked bonds - especially in relation to gilts. These do what they say, their redemption price increases according to the rate of inflation that has occurred since they were issued, and so does their yield. The problem with buying these when inflation is already high is that efveryone else has already done so, so they are 'expensive' - meaning that if you hold them until redemption then your return will actually be less than the rate of inflation from the purchase date to the redemption date. The only reason for buying them in this case would be that you expect inflation to increase further. So, the best time to buy indexed-linked bonds is when inflation is low... (but you expect it to rise!)


**

The FRN mentioned above are bonds known as Floating Rate Notes - which some bond funds may hold). Their rate of interest is dependent upon 'interest rates' (more specifically, something such as LIBOR), so if interest rates are on the increase then the yield on FRN's should also increase, which could make them more attractive.


Well! I will sign off on that one and take shelter somehere...:)

P.S. Sorry if there are any typos, but I'll be b*@@£red if I'm reading that lot again. Did I mention defaulting Eurozone economies and/or credit problems in China? [edit] Or the fact that US Congress and Administration are more interested in preening and posturing than in competent decision making?

Linton

If you want to invest in Commodities I think you should buy a commodity fund.

The sector allocation of shares can be somewhat arbitrary, even perverse. Also, it could be very unbalanced in non specialist funds. For example if you hold a FTSE tracker you will have a number of mining and Asian oil shares. OK they may be commodities/energy but perhaps you want something broader than that.

Jegersmart

I think almost everyone in this thread misunderstands or forgets the crucial difference between investing in commodities and investing in the equities of companies involved in commodities business. There is of course a correlation to a certain degree and if you are happy with that then all is fine.

If you want to invest more directly in commodities prices, there is a fund called Marlborough ETF Commodity that does this - however it does not allow any customisation of your exposure as such (like most funds) - it is a baskets of ETF's and some commodity vehicles based in Luxembourg IIRC.

There are many funds in the C&E sector, most of which have most of their allocations invested in the *equities* of comapnies involved in E&P, mining, fertilisers etc etc.

I hope that helps.

Ark_Welder

Jegersmart wrote: »

I think almost everyone in this thread misunderstands or forgets the crucial difference between investing in commodities and investing in the equities of companies involved in commodities business....

You are correct, I had assumed (crucial failure!) that the OP was talking equities given the context of his post. Unfortunately, large swathers of the financial press do tend to use the term 'commodities fund' when refering to equities in that sector and I, for one, have been dulled into following suit.

The most embarassing thing is that I always get irritated when I see it!

Jegersmart

There is a really difficult balancing act between keeping things simple but at the same time trying to keep track of, research and understand potentially complex issues.

In this particular case there is huge complexity in terms of judging the correlation between a rise in a commodity price and the equities value of the companies in question. I don't remember all the detaisl now, but in the past miners have had quite a mixed bag in terms of correlation because there have been concerns that an increase in the commodity price has not translated to good future investment by the mining company in question - so whilst they have earned more money due to the high commod price, the market at some point also judged that they have not taken advantage operationally and the correlation ends - perhaps not permanently - but it tapers off alomst completely for a period of time. This is just one example of many, many factors that can affect the equity's value - whilst having nothing to do with the commodity in question.

The other thing to consider is the "value" of the commodity and what drives it. If wheat is say 3 times more expensive than 4 years ago, is this down to a fundamental change in the supply/demand structure driving prices to that level? Are there fundamental reasons like ongoing and continual poor weather, poor sowing season and so on that affects the supply side - or has the world population grown sufficiently in that short period to triple prices? Or could it be that thorugh quantative easing and other liquidy measures that a large amount of money has found its way into that market and are causing price inflation through buying action? Is it a combination of these factors? This is just an example of a potentially hugely complex price evolution cycle which we need to look at in as simple as terms in possible to try to judge what our exposure should be and why......is it a bubble? is it non-fundamentally driven?

If we go to bonds it is just as bad. The reasons for this are many, the world and market structure is changing. In the past it has been the case that bonds were an instrument that was used when equities became risky or under pressure. As I see it, whilst this happens still to a considerable degree it is no longer as widespread as before. We have also seen the increased use of gold in thsi respect - but I fear that the global market structure has and continues to be distorted by increasing imbalances in the system on many fronts. Why? Well, there have been huge amounts of money flowing into the majority of markets for many quarters now due to QE in one form or another causing prices to rise out of proportion, there has been an increasing amount of debt of all types accruing for many years and this is accelerating currently due to ongoing bailouts and so on - and inflation or devaluation of taxpayers currency is happening. Thsi is nothing new of course, but it is now a much broader problem than before with other market areas becoming dragged in to this that perhaps 20 years ago were not really involved. In my view, we can no longer be as certain as we once were as to how bonds will react in *some* situations - because I see a possibility that new situations that have perhaps not happened before are more likely to happen as we move forward. We cannot know the future by looking at the past, but we may even lose some of that "crutch" as we head into new "waters". This is specualtive of course, but my point is - we need to try to cut through all this and try to keep it as simple as we can at our end whilst considering as much complexity as we can at the other end.

So with that in mind, with regards to bonds - someone has already described how bonds behave in "normal" situations. Whether this willbe the same in the future we cannot know - but I do still see a usage of bonds in the market when risk-reduction is required - and so one could argue that if you feel that it is time to rotate partly or completely out of equities then bonds could be a tool for that because the market still uses them like that to a degree - i.e. it may not be enough in the new "waters" that we are arguably moving into but because the market still does this then that is the most important thing as it will have the required effect.....if you see what I mean? The market may be irrational, but if it meets your requirement then it can make sense to be irrational too.

For the times when I feel more defensive I do look at how funds performed in the 2008 crash (or longer time periods if relevant/available) - because it gives me some indication of the risk level they had at the time and I can at least see a real-world exmaple of what happened back then - without me assuming it will be exactly the same again. Funds like M&G Optimal Income only lost a single digit percentage in 2008 towards the end - and recovered very quickly. No doubt there are some reasons for its high returns since then - but again it is just an example - there are many funds who have at least performed well in very savage downturns in the equities markets in the past and *may* do so in the future.

So to sum up, whilst the markets and the interation between them and so on are hugely complex I personally try to keep things as simple as possible when I try to navigate these markets and it may be that this will be a good approach for many. As I have said before, I have been working in the financial and energy markets for almost 14 years so far so whilst I have reasonable knoweldge and access to information I stuill feel the need not to overcomplicate things when looking after my own investments.

Hope that helps - and that it makes some sense in rambling way. And of course, IMHO and DYOR.

xx_Law_Grad_xx

Wow.

Some very indepth and informative posts here. A big big thank you as it has made things alot clearer for me. I will be keeping a record of the info so I can make use of it when the markets change.

Ark Welder: As mentioned above. Thanks, your posts have been really useful. A global strategic bond fund looks pretty appealing right now due to their flexibility. As you have mentioned we are suffering from abnormal market conditions so a strategic bond fund would be ideal over say going with a corp bond & high yield funds.

Linton & Jegersmart: In order to diversify my portfolio by including commodities, I am presuming that investing in a fund which invests in equities would provide only a limited amount of diversification. A fund which invests in the actual commodities and not equities would be preferable? Do these funds have the option to short commodities as well as go long on them?

Jergersmart: I will take your advice and look at the performance of various funds over the 2008 crash. You mention how gold has somewhat replaced bonds as a haven during periods of uncertainty with equities. I feel that I have completely missed the boat on gold, especially as I believe it has reached an all time high today. Are over commodities such as silver or platinum a "safe" commodity during times of uncertainty like gold is?

Stochasticity

Loughton_Monkey wrote: »

Think about it!

You paid £10,000 to buy a corporate bond, government bond, etc. [fixed interest] when the 'going' rate was 4%.

So as long as you keep holding it, you will get 4% - which was what you were 'happy' with presumably.

Can interest rates go down? I think not. Can they go up? I think so. So what happens if interest rates go up? Well the 'going' rate will then move from, say, 4% to 5%. That's what new investors will be 'happy' with.

So you have two choices:

1. Ignore that 5% is the new going rate, and sit there gritting your teeth, pretending to smile, and saying that you are 'happy' with 4%.

2. Sell up. In which case, the value of your £10,000 bond will dramatically dive to (say) £8,500 so that I [the new purchaser] will get the new going rate of 5%. In effect, you got far less than the 4% you wanted, because now you are subsidising me to get more than 4%.

These principles apply whether the bond is high yield or low yield. All the yield does, generally, is reflect the possibility of you getting your money back. The higher the yield, the more risk you are running, in general, of losing the whole shooting match.

Hence, the only 'good' time to buy bonds is when interest rates are high, and you strongly think they will come down. THen you have the 'luxury' of holding them and enjoying the above-market income, or selling them for a premium.

This overlooks that the market's expectations of future interest rate changes (as well as many other parameters) are already priced in to the price that you pay for a bond at any given time, or at the very least that's the theory. It is how interest rates rise or fall relative to the market's expectations that define how well a bond will perform.

That means that if interest rates rise more slowly than the market is expecting them to rise, the value of a bond can increase even though interest rates have gone up. And vice versa.

As you say, everyone already knows interest rates aren't going down, and everyone already knows that the only way for interest rates is up. The question is, how quickly or slowly they go up and how high.

Just like with equities or any other asset, the only 'good' time to buy or sell is when you have a reasonable expectation that you have better information than the market, or a better understanding of all of the information that is available in the public domain.

So even if interest rates are high and you strongly think they will come down, yet everyone else also thinks they will come down, and indeed they come down exactly as expected by you and everyone else, then you're not in a position to be able to enjoy 'above-market income'.

Jegersmart

xx_Law_Grad_xx wrote: »

Wow.


Linton & Jegersmart: In order to diversify my portfolio by including commodities, I am presuming that investing in a fund which invests in equities would provide only a limited amount of diversification. A fund which invests in the actual commodities and not equities would be preferable? Do these funds have the option to short commodities as well as go long on them?

Jergersmart: I will take your advice and look at the performance of various funds over the 2008 crash. You mention how gold has somewhat replaced bonds as a haven during periods of uncertainty with equities. I feel that I have completely missed the boat on gold, especially as I believe it has reached an all time high today. Are over commodities such as silver or platinum a "safe" commodity during times of uncertainty like gold is?

Hi

What I was trying to point out was that there is a *marked* difference between investing in funds who are allocated "directly" into Commodities and those that invest in the equity of comapnies involved in Commodities. There will be a correlation but it is important to note the difference. What is preferable is obviously up to you - that depends on what you want to achieve

Gold has for a long time been a safe haven at times of fear, I was just noting that times do change so it is not always the case that the "old trends" still apply - but in general it is still so as far as I can see. Just worth mentioning because I feel it important to keep an eye on these things so we don't get stuck in our ways if indeed the market behaviour is indeed changing. With regards to the price of gold, there are many reasons for the increase over the last 12 months - the weakness of the USD (which has also shown an effect on oil), large amounts of Fed stimulus that needs to find a "home" etc. Personally I am not a buyer at these levels, but I could be 100% wrong. The main reason is that I feel gold is going through a bubble scenario (hugely inflated price through non-fundamental factors) and I think when the downside comes it will probably be fairly savage. I would be a buyer at $750 or so and we will see that level again at some point I am fairly sure. The other problem is that Gold's long term future is a bit shaky in my view - it has less relevance these days in some ways because it does not underpin currencies any longer - it couldn't because there is a finite supply of gold and the monetary system demands infinite growth and that had to be dealt with.

Silver and Palladium are interesting because they have commercial applications - at least currently - and so to me at least the fundamentals are more transparent. As far as I am aware these metals do not have the "safe haven" tradition behind them as gold does - but then again gold's status in that way is not really underpinned by anything these days that I can see apart from market behaviour - i.e. the market goes to gold to a degree because it is a habit - I personally cannot see any tangible reason for this any longer but that is irrelevant for now:)

As a petroleum civilisation (there are almost 7 billion of us, of which at least half (and I really mean *at least*) are only alive today because of oil (and Nat Gas) and the options it gives us. There isn't anything that can replace it comprehensively so in the longer term oil will be increasingly valuable without any doubt - at least until the point where we may bother to find something else to use - but the oil companies will fight that and will succeed imho. The system (a monetary one) will clearly "eat itself" at some point - but that could be a way off of course.

So to sum up, I would be wary of gold at these levels, silver and palladium are worth looking into perhaps for reasons stated and the decision to go into various instruments can only be yours - just note the differences discussed which are in my view very important.

In closing, some may remember a few weeks back when the US and some non-OPECs decided to release around 60 million barrels of crude? This caused an almost 8% drop in futures (it recovered slightly) in a very short period of time - but 60M barrels is only around 18 *hours* of global consumption.......it seems to me that either a) oil prices are not behaving according to fundamentals and b) they way the oil futures markets work allow a lot of manipulation (or perhaps better defined as "exaggerated price movement") because although oil is used locally across the globe - the futures markets are mega-concentrated around the ICE Brent contract or the Nymex WTI - both have a physical settlement point of course but it seems to me that these two contracts have to take the brunt of global speculation and hedging which may explain the very violent price movements when nothing much of significance really happens.....another debate perhaps?:D

If anyone want to discuss these things offline just drop me a line.

IMHO, DYOR

J

Jegersmart

I forgot to mention that there has been some discussions around ETF's and the potential for manipulation. Say if you are looking at a Gold ETF - that fund may be £100 million in size and aims to track the gold physical price. If the fund is relatively small one could argue that a big player could affect the "price" of that fund quite considerably - at least far more easily than the global physical market. This has some risks as a result, but at the end of the day there is also less risk in investing in an ETF rather than say Gold CFD's for example. Manipulation (if it manifests) should not last too long or go too far off track - but I would definitely do research for yourself to see if the vehcile in satisfies your risk requirements.