If not bonds then what?

Jevvers

Hi
I am trying to diversify our investment which is for paying off an interest only mortgage in 12 years' time. We are currently roughly 60% in equities (FTSE all share only) and 40% cash.

I'm reading Monevator and Smarter Investing so I appreciate that bonds are a classic defensive asset. But - and I still don't quite understand why - it doesn't seem to be good to buy bonds right now as they are expensive and you might not get back what you pay for them. So given that cash is vulnerable to inflation, what else would make a reasonable defensive asset at the mo?

Thanks

gadgetmind

That's the problem, there isn't very much.

Corporate bonds yield more, and won't be hit quite so much if/when interest rates go up, but correlate more with equities. If you're really nervous, go for short dated bonds such as IS15.

I personally went for more infrastructure funds (such as HICL, BBGI, JLIF, etc.) in place of some of my bonds, and have done well, but these are all now on nosebleed premiums.

In your position, I'd diversify away from the FTSE, add some commercial property, and hold your nose and buy a mixture of government and corporate bonds.

Chargem

Jevvers wrote: »

[...] But - and I still don't quite understand why - it doesn't seem to be good to buy bonds right now as they are expensive and you might not get back what you pay for them. [...]

This is true of any investment, that you can make a loss. The reason bonds are recommended is because they have a low correlation to equities, so that if the equity markets crashed you would be unlikely to see a corresponding crash in the value of your bonds.

I agree with you that bonds don't seem to be a great asset to hold right now, but I don't think cash is either. If you're not sure which is better why not hold some of both?

Gadget's post contains several other assets which have medium to low correlation to equities, to which I have nothing to add.

Reaper

Jevvers wrote: »

But - and I still don't quite understand why - it doesn't seem to be good to buy bonds right now as they are expensive and you might not get back what you pay for them.

I'll try and explain with an example. Imagine a company offers you a bond. They say if you give them £1000 then they will pay you 5% fixed every year. You think about this and decide with interest rates on savings accounts paying less than that it sounds like a bargain and you buy it.

A few years later inflation has risen and interest rates have risen as well to try to keep it in check. Everybody can now earn 6% in their savings accounts. You try to sell your bond but nobody wants to pay £1000 for it to only get 5% interest. Why would they when they can get 6% in a savings account? So you have to drop the price to sell it.

So in summary fixed rate bonds are great if you think interest rates will fall, not so good if you think they will rise.

gadgetmind

Another aspect is that right now that bond might actually cost £1100 because people are prepared to pay over the odds for the income.

Of course, when calculating what's called "yield to maturity" you need to take into account only getting £1000 back, and what that money will actually be worth when you get it.

The punchline is that people are currently paying more for bonds that they were initially issued at, so the yield is lower, and rising interest rates and inflation will give a double whammy.

Of course, low interest rates, stagflation, and another market crash will make bond holders glad that they hold.

Jevvers

Thanks all, I'm a bit clearer. Yes I was intending to hold bond to maturity so I would hope to avoid the interest rate problem to so extent. But then the only way is up for rates at the mo. I'd only considered gilts so will have a look at those other ones you mention Gadgetmind.

Definitely going to diversify the equities so I guess I can do that anyway with cash as the defensive asset until I can pick the bonds - sound reasonable??

Sobryma

In a similar position I went for short dated but you will probably need to look at active options - Fidelity Global Inflation Linked (mentioned by Hale) or SWIP Defensive Gilt are both short dated, on passives Vanguard have a short term corporate bond fund and Blackrock a 1-10 year corporates.

Sobryma

Jevvers wrote: »

Thanks all, I'm a bit clearer. Yes I was intending to hold bond to maturity so I would hope to avoid the interest rate problem to so extent. But then the only way is up for rates at the mo. I'd only considered gilts so will have a look at those other ones you mention Gadgetmind.

Definitely going to diversify the equities so I guess I can do that anyway with cash as the defensive asset until I can pick the bonds - sound reasonable??

The latest version of Hales book (I can't recall if it was in prior versions) includes an analysis of short dated gilts in market crisis conditions and makes a strong argument to hold them as a defensive.

Thrugelmir

What rate of interest are paying on the mortgage?

Jevvers

0.49 above BOE Base rate for lifetime of the mortgage, Thrugelmir. Lucked out in that respect.

Jevvers

And thanks Sobryma I'll look again at short dated gilts.