"Bonds in a bubble" - What does that mean?

sabretoothtigger

If houses were in a bubble, you would expect the purchase price to be ridiculous compared to renting.
So if it took 100 years of rental income to pay off a house purchase, the yield does not justify ownership and so its a bubble.

People continued to buy houses they could more cheapily rent, not to use them but to sell them. Ownership was not practical, useful or justified beyond short term speculation.

So swap bond for housing in the example above and you have a bond bubble.


[It is slightly more convoluted in that bonds issue currency and our BOE chief has bought bonds by issuing more currency. ]

So can bonds fall below the original par value

They can fall to zero value if sterling isnt used. War loans must be the worst case example I guess. They cost 95 originally I think and over the last decade you could get:

pqrdef

sabretoothtigger wrote: »

So swap bond for housing in the example above and you have a bond bubble.

The difference is that bonds don't just keep on rising, even during inflation (unless they're index-linked), because they're always reined in by the fixed income and eventually dragged towards redemption at par.

So people don't just keep buying them on the assumption that there's always a profit in it.

pqrdef

quotememiserable wrote: »

As you say, you only lose capital if you sell when the price is below what you paid

You lose capital if you buy at a premium and hold to maturity. But you know how much you'll lose and can set it against the interest. This is done in calculating the maturity yield.

The taxman doesn't see it that way though.

pqrdef

You can think of a bond as simply a promise of some future payments - a small one every 6 months, say, and a big one a the end.

These payments are calculated with respect to a notional par value, but in the real world the only price that matters (except for tax) is the market price - what you pay to buy, and what you have to reinvest if you sell. How you split the payments between capital and interest is arbitrary. For instance, you might see part of each "interest" payment as repayment of premium.

So, if the market price is now £90 and the current yield to maturity is now 4%, and you hold £90 worth at market price (ie one notional £100 block), what you now expect to get back is £90, plus 4% pa on £90. That includes the interest, and also the extra £10 when they redeem at £100. So you can't also count the same £10 as recouping your losses on the market.

So the pull to redemption isn't an extra consideration in addition to the price - it's already in the price.

Ark_Welder

pqrdef wrote: »

So, if the market price is now £90 and the current yield to maturity is now 4%, and you hold £90 worth at market price (ie one notional £100 block), what you now expect to get back is £90, plus 4% pa on £90. That includes the interest, and also the extra £10 when they redeem at £100. So you can't also count the same £10 as recouping your losses on the market.

Just as an example to help to clarify: a bond with 5 years to redemption, priced at 90 and with a 4% Yield To Maturity has a coupon of 1.75% and a running yield of 1.94% (= 1.75% / 90 x 100). The annual interest being received will be £1.75 per £100 block purchased (the same as 1.94% on your £90), and the additional 2.06% of the YTM is the £10 capital return expressed as an annualised basis.

http://www.fixedincomeinvestor.co.uk/x/yieldcalc.html

C_Mababejive

I think we need to differentiate between the direct purchase of corporate bonds and the purchase of funds which invest primarily or wholly in hopefully investment grade bonds.

Surely fund managers are the experts and thats why they are paid to buy and sell the right products at the right time?

gadgetmind

C_Mababejive wrote: »

Surely fund managers are the experts and thats why they are paid to buy and sell the right products at the right time?

True, but they are usually buying from and selling to each other. Who was right and who was wrong?

Note that non-retail bonds ( the bulk of the market) are usually 100k minimum trade size, so they aren't exactly something that your average PI dabbles in.

A_Flock_Of_Sheep

I need bonds to balance a portfolio but its the bonds in a bubble that concern me. Does this apply to bond funds too as I would use a bond fund as a balance rather than owning directly.

I am guessing bonds in a bubble means bond funds are currently over priced and when the bubble bursts its goodnight vienna cheerio money as the price per unit cascades through the hull to the sea bed

SnowMan

A_Flock_Of_Sheep wrote: »

I need bonds to balance a portfolio but its the bonds in a bubble that concern me. Does this apply to bond funds too as I would use a bond fund as a balance rather than owning directly.

I am guessing bonds in a bubble means bond funds are currently over priced and when the bubble bursts its goodnight vienna cheerio money as the price per unit cascades through the hull to the sea bed

Bonds and bond funds behave in a similar way as a bond fund is just a mix of individual bonds.

The real problem with bonds (by which I mean government gilts here) is not that bonds are in a bubble (albeit they might be) but that they are just a promise to pay a certain rate of interest and that rate of interest is not very good.

Currently 5 year gilts are for example priced to give a redemption yield of 0.88% pa.

So if you buy a 5 year outstanding term gilt and hold it for 5 years you are effectively buying something pretty close to a 5 year fixed rate savings account with an interest rate of 0.88% pa.

With especially the longer term gilts there is a danger also that interest rate expectations priced into gilts will rise above the currently very low interest rates. If that happens and you sell the gilt before maturity you will lose money because the ongoing value of the gilt (promise) will have reduced. That is akin to the bubble bursting.

If we are talking bond funds made up of corporate bonds then they pay a slightly higher rate of interest but importantly relative to government gilts involve a risk that the companies offering the corporate bonds go bust and renege on their interest payments. Of course the scenario where lots of companies goes bust is also a scenario where equities fall in price. So there is less diversification than through government gilts.

So if you are balancing your portfolio you might be better to keep the money allocated to gilts or corporate bond funds in best buy savings accounts instead.

A_Flock_Of_Sheep

SnowMan wrote: »

Bonds and bond funds behave in a similar way as a bond fund is just a mix of individual bonds.

The real problem with bonds (by which I mean government gilts here) is not that bonds are in a bubble (albeit they might be) but that they are just a promise to pay a certain rate of interest and that rate of interest is not very good.

Currently 5 year gilts are for example priced to give a redemption yield of 0.88% pa.

So if you buy a 5 year outstanding term gilt and hold it for 5 years you are effectively buying something pretty close to a 5 year fixed rate savings account with an interest rate of 0.88% pa.

With especially the longer term gilts there is a danger also that interest rate expectations priced into gilts will rise above the currently very low interest rates. If that happens and you sell the gilt before maturity you will lose money because the ongoing value of the gilt (promise) will have reduced. That is akin to the bubble bursting.

So if you are balancing your portfolio you might be better to keep the money allocated to gilts in best buy savings accounts instead.

So what about corporate bond funds? Are they not in the bubble too? If the bond fund price per unit is over priced?