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

SnowMan

A_Flock_Of_Sheep wrote: »

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

I was just editing my earlier post to include mention of these. If gilts are in a bubble then corporate bonds are likely to be in a bubble also as the yield on these is just the gilt redemption yield plus an amount for the extra risk. An increase in interest rate expectations reduces the prices of both accordingly.

Quantitative easing and the demands of institutional investors such as pension funds for fixed interest assets to match liabilities will affect both gilts and corporate bonds, bringing down yields artificially.

A_Flock_Of_Sheep

SnowMan wrote: »

I was just editing my earlier post to include mention of these. If gilts are in a bubble then corporate bonds are likely to be in a bubble also as the yield on these is just the gilt redemption yield plus an amount for the extra risk. An increase in interest rate expectations reduces the prices of both accordingly.

Quantitative easing and the demands of institutional investors such as pension funds for fixed interest assets to match liabilities will affect both gilts and corporate bonds, bringing down yields.

So basically bonds are something to avoid at the moment yet the recommendation is to include bonds as part of a balanced portfolio - who would include something that's going to burst?

dunstonh

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

If conventional bonds crash you are looking at a loss of around 10-20% (20% would be extreme). High Yield can be double that. That loss may come but will it come before another 20% gain (including income) or 40% gain or perhaps there will be a 30% stockmarket crash before bonds crash 20%.

So basically bonds are something to avoid at the moment yet the recommendation is to include bonds as part of a balanced portfolio - who would include something that's going to burst?

No. They are not something to avoid at the moment.

SnowMan

A_Flock_Of_Sheep wrote: »

So basically bonds are something to avoid at the moment yet the recommendation is to include bonds as part of a balanced portfolio - who would include something that's going to burst?

In normal times bonds can offer diversification which is why so many of the investment bibles tell you to use them. In these abnormal times in place of bonds I am suggesting substitute savings instead.

What is different at the moment is that the yields are so low that it is hard to see how they can fall any further. As it is falling yields that cause prices of bonds to rise then you can only see bond prices falling.

In normal times prices can increase or fall depending on whether interest rates fall or rise respectively.

A_Flock_Of_Sheep

I am not sure why as I am sure it is simple when I get my mind round it - I seem to find the mechanics of bonds more complex than Equities (shares).

Shares - you buy an interest in the company - equity financing - it is a loan basically but the value of the share increases with the value of the company and profits - the dividend is a share of the profits per share held. If the firm goes bust you lose your money.

Obviously Equity fund prices per unit rise and fall with the value of the shares/assets in the fund.

A bond is an IOU for (x) years in return for the loan you get interest at say 5% at the end of the term you get your original loan value back. It seems similar to an interest only mortgage - the company pays interest and then pays the capital back at the end. How this fits into Bond Funds where you get interest paid and also a capital gain on price per unit is where I am confused. How can the price per unit go up when all you should get is the interest and then your original lump sum back.

SnowMan

A_Flock_Of_Sheep wrote: »

How can the price per unit go up when all you should get is the interest and then your original lump sum back.

Because if interest rates in the economy fall after you purchase the bond the interest payments on your bond which are fixed are worth more.

Think of the analogy of the Newcastle 5 year savings bond that some of us have that pays 5% pa. Say I have £20,000 saved in that. Now for someone to buy me out of that bond today (if that were possible which of course it isn't) I would want more than £20,000 because if I received £20,000 I wouldn't be able to get 5% on saving that money elsewhere up to the end of the fixed term.

The difference between the price I would be willing to accept to buy me out and £20,000 is analagous to an increase in bond price. The increase reflects the increased value of the interest payments in a lower interest rate environment.

grizzly1911

SnowMan wrote: »

Because if interest rates in the economy fall after you purchase the bond the interest payments on your bond which are fixed are worth more.

Think of the analogy of the Newcastle 5 year savings bond that some of us have that pays 5% pa. Say I have £20,000 saved in that. Now for someone to buy me out of that bond today (if that were possible which of course it isn't) I would want more than £20,000 because if I received £20,000 I wouldn't be able to get 5% on saving that money elsewhere up to the end of the fixed term.

The difference between the price I would be willing to accept to buy me out and £20,000 is analagous to an increase in bond price. The increase reflects the increased value of the interest payments in a lower interest rate environment.

In a bond fund that has perhaps 500 bonds say with durations form next year to say 30years. Some of those bonds will be new and some may be half way through their term and a few coming up to redemption. Across those funds there will be a mix of interest rates and yields.

At a given time thre will be the portfolio gross yield and the bond book effective duration.

Will this be so at risk from interest rate changes or is it just as likely to be sentiment as buyers hop on and off the equity roller coaster?

I notice trustnet are "talking up" F &C Macro global Fund on the basis it is heavy on short dated maturities. Is there an easy quick way to compare bond funds?

A_Flock_Of_Sheep

I think it's getting clearer. I am sure bonds should be pretty simple but to me it seems complex possible because of the rumoured bubble hanging around.

I have a mindset that you could buy say a bond fund to balance equities etc then the bubble bursts leaving you with a downside bond fund running like that for donkeys years. A kind of buy high and weep when it tumbles/tanks syndrome.

A_Flock_Of_Sheep

Sorry another question. I often see Bond Funds titled as "Strategic Bond". What does that mean with Strategic?

vectistim

As above any 'bubble' description is presumably due to the current very low interest rates. Perhaps this example might help:

Some government debt is undated - there is no promise to repay it at any future date (much/most of this is old war stock).

One of these bonds (I'll call it War-3.5) may have a face value of £100 against which it promises to pay 3.5% interest per year.
Now, let's say I can only get 1% elsewhere due to the low interest rates.
Now, let's say I want an income of £7 per year.
To earn £7 per year at 1% I need to invest £700.
Alternatively I can achieve the same income of £7 per year by buying £200 face value of War-3.5
Let's say then that it costs me £400, so I'm now getting my income of £7 per year for ever.
Now let's say interest rates shoot up and it becomes possible to get 10% interest elsewhere. In order to get my £7 per year income I only need to invest £70, therefore my War-3.5 will be worth rather less.

OK, that's rather extreme, but hopefully gives the idea. A bond fund will typically invest in a range of maturity dates - those due to mature soon will not have much fluctuation in price, but long dated bonds will vary in price.