Bond funds - pointless?

Porcupine

What's people's opinions on corporate/government bonds at the moment?

I'm currently wondering whether to pull some cash out of 5% savings (so 4% after tax) so I can claim (some of) this year's S&S ISA allowance sometime before April. I already have cash and some relatively high risk equities, so am wondering about filling the gap.

But it looks like bonds are expensive these days, and pretty volatile. If I'm not going to hold bonds until redemption, the volatility would seem to wipe out a lot of the potential yield.

And is there much point in bond funds at the moment? TER seems about 1-1.5%, which is pretty steep on a fund with yield of 4% or so. Might as well keep it in cash, apart from the ISA thing. If you go for high yield bonds, the price volatility of some funds in the recent past is 50% - you'd have to wait a long time with yields of 8% to get that back given TER of 1.5%. So not much less volatile than equities.
I know there might be cheaper bond ETFs or something, but dealing costs will wipe out any savings.

I'm tempted to stick with my guaranteed 4% and sit out the ISA, but it pains me to let my ISA allowance pass by when I have the money. I think taking the hit (5% taxed savings v 3% ISA) for a cash ISA is worthwhile, given future tax benefits.

Or else I can keep buying ISA equities. Currently my mix is about 17% equity/83% cash, with a likely demand on some portion of the cash in the next 5 years. So I don't think I'm over-risked on equity, though I'd probably go for lower risk to tone the mix down a bit. As the economy picks up, equity will go up - and bond prices go down?

So am I missing something when I think that bonds don't look that attractive right now compared to the rates you can actually get in a savings account (rather than about base rate which is the benchmark)?

dunstonh

If you go for high yield bonds, the price volatility of some funds in the recent past is 50% - you'd have to wait a long time with yields of 8% to get that back given TER of 1.5%. So not much less volatile than equities.

At the height of the financial crisis, they were pricing in 50% failures. Hence the size of the uncharacteristic drop. Once fear was replaced with sensibility they quickly rebounded. Anyone buying at the point when yields were 14% did very nicely. Most saw through the drop and recovery and have done very nicely since. Indeed, HYB are generally on of the few areas still work considering. Yields are still pretty good at around 6-7%.

Thrugelmir

You can hold corporate bonds in ISA's and receive the income gross of tax.

EdGasket

You could go for Greek bonds and lose 50% !
Why rule out ETFs? The annual charge on an ETF is typically 0.25% and dealing costs around £10 depending on who your ISA provider is. So long as you are investing a few thousand, I would say ETFs are better value than traditional funds.
As to bonds generally, they are expensive now because interest rates are low. When interest rates go up, bonds will fall. Rather than conventional bonds, I think Index-Linked would be a better bet. These can be bought in traditional funds like L&G's or ETFs e,g, INXG or why not just buy an IL government stock like T30i then you have no annual fee at all?
Otherwise I'd go for gold or property shares that have some inflation hedging. Best of luck,

Ark_Welder

Depends on which governments, depends on which types of corportate bonds. Can also depend on your age and your timescale. When it comes to gilts I am more of a fan of holding these individually rather than though a fund because doing so can offer a known return on holding until redemption (even with ILs to a certain extent), whereas a fund (either managed or a tracker) will have to buy and sell as befits that particular type of fund (therefore, no maturity date, so no known duration). On that basis, I would stick with cash right now and not hold conventionals!

ILs are also trading above their 'par' value just now, so buying into them will return less than RPI going forward ('par' can be calculated by applying the difference between the 'launch' and 'current' RPI figures (remembering the IL will have either an 8 or 3 month lag) to the launch price, and then looking at the current clean price (i.e. the price without accrued interest). However, linkers (including corporate ones) should give something approaching inflation-linked returns, going forward, if that is a concern.

Outside gilts, the question would be how you expect economic circumstances to develop - and how soon. Investment grade corporates might offer something if we experience more of a mildly recessionary environment (on the grounds that gilts are already highly priced and so offer not-so-much potential, but the economy is not so bad that is causes widespread company failures amongst quality companies, and interest rates won't increase substabtially and soon); but in a low/no growth economy then sub-investment grade, i.e. high yield, could do well (the economy is doing well enough to allow riskier companies to continue trading, and therefore servicing their debt, but no so healthy that equities in these companies might be the better option). It is these latter points that result in high-yield bonds having a greater correlation with equities than do investment-grade.

EM bonds, both corporate and sovereign, could offer more than developed sovereign and high-grade corporates. The potential problems here though is that quite a large proportion of credit made available to those areas has come from european banks. As the banks re-trench, can the reduction in available credit be replaced from elsewhere? It might mean problems rolling over maturing bonds into new issues if there is more competition for investors' cash. A few articles might be of interest here: http://www.bondvigilantes.com/?s=indonesia

But, all of this does all assume a normally operating economic environment....

Anyone that has an interest in credit markets - even if not looking to invest - might like to follow the occasional posts made here: http://www.bondvigilantes.com

Porcupine

Another question... what happens to fees on bond funds? Are they taken out of the capital or the income? For example, if a fund currently lists a yield of 6% and a TER of 1.5% on Trustnet or HL, would I then receive 4.5% or is the quoted yield already reduced? Or if the market never fluctuated would a £1.00 unit this year be a £0.985 unit next year? I'll be reinvesting dividends - taking it off capital works out slightly worse, doesn't it?

Porcupine

dunstonh wrote: »

At the height of the financial crisis, they were pricing in 50% failures. Hence the size of the uncharacteristic drop. Once fear was replaced with sensibility they quickly rebounded. Anyone buying at the point when yields were 14% did very nicely. Most saw through the drop and recovery and have done very nicely since. Indeed, HYB are generally on of the few areas still work considering. Yields are still pretty good at around 6-7%.

But the problem is not the yield it's the volatily, I think? Let's say you have a bond fund with a gross yield of 5% and a TER of 1%, so net yield is 4% (or however it's calculated, doesn't matter for this example). That fund sees a 15% drop in price. The net yield goes up to 4.9%, which is not a huge change. Let's assume the price and yield never changes again. By my calculations it then takes 3.4 years to even get back to par, forgetting about such little things as inflation. So if you happen to buy a bond fund at the wrong time (and the components of the fund are churned, so never reach redemption) you get killed by the volatility, whatever the current yield happens to be?

I think I'm missing something huge here, so would be grateful if someone could point out where I'm being dense...

Thrugelmir

Porcupine wrote: »

I think I'm missing something huge here, so would be grateful if someone could point out where I'm being dense...

Buy individual corporate bonds directly rather though a fund.

Ark_Welder

Fees can be taken from either capital or income (with investment trusts, fees might be apportioned to both, usually depending upon where future returns are expected, i.e. capital growth compared to income generated; I've only seen one or toe other with OEICs, though, but that does not mean that there aren't any that are similar to ITs.).

The only reliable places to determine how charges are deducted are from funds' prospectus and/or annual reports. Some of the fund management factsheets might also provide the information, but not guaranteed. HL do sometimes show this information on the 'at a glance' tag for a fund down in the 'income details' box, but not always. I have also found that the information in that area can occasionally be incorrect, hence the need to use the literature provided by the fund management companies.

If the yield being quoted is 6% then that is an indicator of what you could expect, i.e. it is 'after' charges. When charges are deducted from capital then this has the effect of increasing the yield on the fund, so in this example the yield would be quoted as 7.5% - or something along those lines.

Charges deducted from capital do have the effect of depleting the assets of the fund, the trade-off being the increased yield. A fund's assets has to grow more than one where the charges are deducted from revenue, just to retain its capital value. This is a reason why I sometimes like to look at how the capital return on an asset has performed rather than just relying on the total return (i.e. including re-invested income). I find that it can highlight a fund that might struggle more than others if not much in the way of capital growth is expected, or the fund might be more volatile. But I don't allow this top be the only factor when deciding upon an investment.

If you are re-investing dividends then I think that the overall outcome would be the same regardless of from where the charges are deducted.

Assume the example figures of 6% yield and 1.5% charges, and unit price of 100:

Charges deducted from income:

Gives exDiv price of 94 and distribution of 6, re-invested gives 100

Charges deducted from capital:

Gives exDiv price of 94, less charge gives 92.5 a distribution of 7.5 (because the charges are no longer taken from the distribution, the effect is to bump it up by that amount), which re-invested gives 100

But I am happy for someone with some different thinking to put their penneth worth in.

Ark_Welder

Thrugelmir wrote: »

Buy individual corporate bonds directly rather though a fund.

This does restrict the available number of potential investments, though, unless an investor has large sums to invest. Many corporate bonds have a minimum purchase amount of £50k nominal, and more recent launches require a minimum of £100k. For the majority of retail investors that would like to have direct holdings of corportates, this would tend to restrict them to the retail bonds available on the LSE's ORB platform and a good proportion of those are financials.

Ark_Welder

Porcupine wrote: »

But the problem is not the yield it's the volatily, I think? Let's say you have a bond fund with a gross yield of 5% and a TER of 1%, so net yield is 4% (or however it's calculated, doesn't matter for this example). That fund sees a 15% drop in price. The net yield goes up to 4.9%, which is not a huge change. Let's assume the price and yield never changes again. By my calculations it then takes 3.4 years to even get back to par, forgetting about such little things as inflation. So if you happen to buy a bond fund at the wrong time (and the components of the fund are churned, so never reach redemption) you get killed by the volatility, whatever the current yield happens to be?

I think I'm missing something huge here, so would be grateful if someone could point out where I'm being dense...

The fund itself will not have a par value, that is just the bonds within the fund. The fund will have your particular price fof purchase, though, which is what you want to recover. Even though the bonds withing the fund are bought and sold, there will still be an income generated that will (or should) eventually make up what has been lost: depends upon how long 'eventually' is though.

If we ignore things such as defaults and variable-rate returns (ether coupon, capital or maturity dates) then what is given by ownership of an individual bond is a known return. What you have is a fixed coupon (i.e. interest payment each year, a date when the bond will be repaid, and a known capital return (being the difference between the purchase price and the redemption price, so this return could be positive, negative or zero). Taking the total coupon payments and the difference in repayment of capital at maturity (if any), the total return can be determined at the time of purchase.

But a bond fund is different because it does not have a maturity date and the bonds that it hold over time will vary - and so will the coupons that they pay. So with fund the total return cannot be determnied at the time of purchase - it can merely be wished for! But in that, it is no different to holding equities - either directly of via funds - because the returns on these cannot be determined at the time of purchase either (structured products, anyone...? ). However, the general direction of a fund's returns might be guessed at on an ongoing basis, which might be determined by economic expectations.

So yes, buying a bond fund at the wrong time could have a negative impact - but the 'wrong time' might also be determined by your timescales - but that does also apply to other asset types too, such as equities. Individual gilt/bond holdings are much more suitable for addressing specific timescales because of this ablity for the return to be known. Whereas holding a bond fund does require a more favourable investment environment for a safer return. But the problem here of holding corporates is as mentioned in the previous post, namely the minimum investment amounts.