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Crash Bang Wallop

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  • Glastoun
    Glastoun Posts: 257 Forumite
    Tenth Anniversary 100 Posts Combo Breaker
    gadgetmind wrote: »
    I'd like to thanks JamesD for giving a very readable 186 word answer when he could have been glib and just said "Convexity".[/url]

    I've read it ten times and I still don't understand how a 0.5% change in interest rates could affect a bond's value so much. :)

    So if I had £1000 in Invescofunds Jupitune Ready Salted Bond Fund, that had been paying me 5% a year yield (is that how it works, like a share fund's dividend payment?), and interest rates rose to 1%, what would happen to my fund?

    I'm half expecting a crash bang wallop upside the head but please indulge me. :)
  • merlingrey
    merlingrey Posts: 398 Forumite
    Glastoun wrote: »
    I've read it ten times and I still don't understand how a 0.5% change in interest rates could affect a bond's value so much. :)

    So if I had £1000 in Invescofunds Jupitune Ready Salted Bond Fund, that had been paying me 5% a year yield (is that how it works, like a share fund's dividend payment?), and interest rates rose to 1%, what would happen to my fund?

    I'm half expecting a crash bang wallop upside the head but please indulge me. :)


    http://www.youtube.com/watch?v=3Ac2-uTrltk
  • bugbyte_2
    bugbyte_2 Posts: 415 Forumite
    Part of the Furniture 100 Posts Name Dropper Photogenic
    Jamesd - I have been playing with excel and you are right. To keep the same yield @5% with a 0.5% increase in interest rates your £100 bond would have to be valued at £90.90. But would this drop really happen to this degree?

    I get the argument of short bonds not having to pay out the reduced amount as long until they mature, so the makeup of the fund will have an effect. But would investors just accept a lower yield of say 4.5% whilst new bonds are brought into the fund? Gilts haven't crashed and they pay diddly squat. It would depend on what everything else is paying out I suppose.

    Interestingly, when I picked my corporate bond fund I narrowed it down to M&G Corporate Bond with a distribution yield of 2.88% or Baillie Gifford Corporate bond @ 5%. Both have excellent track records and both have the same type of funds - BB. I picked the Baillie Gifford because with a higher yield it has more 'value' and would therefore probably fall less than the M&G in the event of a pop.
    Edible geranium
  • bowlhead99
    bowlhead99 Posts: 12,295 Forumite
    Part of the Furniture 10,000 Posts Name Dropper Post of the Month
    Glastoun wrote: »
    I've read it ten times and I still don't understand how a 0.5% change in interest rates could affect a bond's value so much. :)

    So if I had £1000 in Invescofunds Jupitune Ready Salted Bond Fund, that had been paying me 5% a year yield (is that how it works, like a share fund's dividend payment?), and interest rates rose to 1%, what would happen to my fund?
    Simplified version:

    OK, so you have bonds which are yielding 5% and earning you 50 a year. These bonds are basically loans to a company (well, it's a fund, so it will be a whole basket of loans to a whole load of companies, on average paying 5%. But think of it as one company because it's easier).

    Bank base rates are only 0.5%. The reason your companies are paying you 5% to lend them money is because they recognise it is rather more risky to lend money to an individual company than to the bank of england or the government.

    It might be that the companies were originally borrowing money from you (or whoever bought the bond, back in the day) at 10%, and paying you 50 a year interest for the long long term. Perhaps the original loan was only for 500, not 1000, so the 50 a year represented a 10% yield on the outstanding principal (nominal) value of the bond.

    But then base rates fell and fell and suddenly 10% was a monster interest rate compared to base rates or "risk free rates". New loans being requested by comparably risky companies were not at 10% they were at 5%. This was still 4.5% over the new base rate, a fair reward for the risk. So your existing old bond giving you £50 every year forever into the future got a lot more valuable. A fresh loan made this year of £1000 to another company considered equally likely to default (or even the same company) would get you an income stream of £50 p.a.... So pretty much, your existing bond, getting you the income stream of £50 a year, is also worth £1000 right now.

    Of course, the principal of that old bond is only £500, not really as valuable as a bond with a principal of £1000, but if the principal isn't being paid back for20 years when it'll be nothing in real terms, it's the income stream which is the main driver of valuation. So simplistically, let's ignore the principal: you might pay 1000 now for any bond giving you 50 a year. The key point is, that income stream has a high value right now , but won't always be worth that. If base rates were higher, you could get income much more easily and your bond would not be in demand.

    So your problem comes in a few years time when the base rates are 5% again. A risky single company bond only paying 50 a year is not worth 1000. At that point, a 1000 loan to the bank of england, risk free, gets me 50 a year. No way in hell will I pay 1000 to buy the 50-a-year-paying single company loan off you (or your fund), when I can buy someone else's bank of england or government deposit, also paying 50 a year, for 1000. Maybe I'd give you 500 ish for it. This would mean the 50 a year would represent 9.5 or 10%, when base rates are 5%, which might be about right (it's the same premium over the risk free base rate yield as 5% is today).

    Holy cr4p! Your reliable, income paying bond, which has never defaulted, is now only worth half what you would pay for it today! Serves you right for buying, or continuing to hold, the bond now at 1000, when its more normal long term value is 500-600...

    Does that make some sort of sense?

    If so, you can see that if the type of bonds you have in your fund are currently worth a yield of 4.5% over base, because they're riskier than bank of england notes or government bonds, they might still be worth 4.5% over base when base rates rise. If base rates went up from 0.5% to 1%, someone would want a 5.5% yield, not a 5% one, for your dodgy bond. If it pays out a fixed 50 a year, and they need it to yield 5.5% on their investment, they will only pay £909 for your bond. Any more, and the 50 a year income wouldn't achieve the 5.5% yield needed for the risk they're taking.

    £909 is obviously rather lower than 1000. a bit more than 9% lower. So this is the risk people are taking when they seek the "security" of bonds instead of equity. Your 50 a year might be safe, and get paid year in year out, but I'd much rather buy it at 700 or 800 or 909 than 1000.

    The current low worldwide base rates and money printing (driving down yields and driving up bond prices), is why people will pay 1000 today for boring bonds and nice dull dividend-paying stocks. They didn't pay that 4 or 5 years ago. So bond and income funds have been on an unstoppable rise as prices shot up. People look at the charts of these funds and think yeah, reliable steady growth, and my investment book says bonds are safe, so I'll pile into that. Be careful if that's your thought process.

    One final note as this is way too long already... The above assumes the premium above base rate stays constant. In reality, a booming economy makes high yielding corporate bonds a bit lower risk, as the companies behind them are less likely to default, and can raise money on the stock market to help them stay solvent without needing to raise high yielding loans. So, if the rise in base rates to 1% is accompanied by economic improvement, the risk premium might fall from 4.5 to 4%, so the total yield might stay at 5%. Or even go down on expectations of further improvements. If that happens people will still value the bond at 1000 or more. Of course, equity markets are already pretty buoyant so who is to say they will magically get even better when rates rise and QE stops?

    And this "reduction in risk premium when equities do better" might work with high yield riskier corporate bonds, but not with gilts or super safe blue chip investment grade corporate bonds which are already deemed safe and can't get any safer so their risk premiums can't fall.

    Hope that goes some way to explaining it.
  • bugbyte_2
    bugbyte_2 Posts: 415 Forumite
    Part of the Furniture 100 Posts Name Dropper Photogenic
    Thanks for your considered reply. Working out the premium above base rate vs risk is the gray area for me, and in my understanding is the driver to what a bond is worth.
    Edible geranium
  • jamesd
    jamesd Posts: 26,103 Forumite
    Part of the Furniture 10,000 Posts Name Dropper
    There's a market for bonds just like the market for shares. Say interest rates go up. Who's going to pay £100 for an existing bond paying 5% when they can get 9.5% from newly issued bonds? The only way they will be willing to buy is at the lower price that makes them get the same 9.5%.

    This is why the value of bond funds will fall like the value of individual bonds: they do some selling and have to value the bonds at their true market rate at all times.
  • Glastoun
    Glastoun Posts: 257 Forumite
    Tenth Anniversary 100 Posts Combo Breaker
    Yep, all makes sense, thanks very much for this. :)
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