Confused about investing in Bonds and gilts

intowhere

Hello,
I am starting to invest in a stock and shares ISA, so I am a beginner. Sorry for asking such basic questions.

Is it worth investing in bonds and gilts? I am slightly risk averse, so would not want to invest more than 65% in equity. I has assumed i would invest the rest in bonds and gilts, however reading online etc it seems that many people think bonds and gilts are over priced, and if there was to be an interest rate increase it would significantly reduce the value of gilts and bond funds.
Looking at trustnet and a few other websites, it appears that gilt funds have been the poorest performers this year, so this trend might continue.

I thought that index linked gilts might be a sensible investment, instead of gilts, but seems index linked gilt funds have also lost value this year. Can anyone explain why, as they are linked I assumed they would increase in value if inflation was high?

What would be a sensible investment for someone with 65% of their portfolio in shares? Should I still look at bonds, because there isn't anything else to invest in? Any suggestions of decent funds; i assume I would need an active fund manager to look after my bond / gilt investments.

Thanks

jimjames

If you're starting out then trying to buy bonds yourself and maintain a percentage allocation seems a bit excessive. If you just buy a fund like Vanguard Lifestrategy 60 then it will automatically contain 40% bonds (or choose whatever allocation you want)

aldershot

be careful with index linked gilts. they are a very specialised instrument with particularly long duration so are very sensitive to changes in the yield curve. They are also expensive (to my mind) yielding a real -1.5%. I'd rather own equities at that price, even though it feels like like all eggs in one basket but I cannot bring myself to guarantee a real loss of that magnitude.

Linton

intowhere wrote: »

Hello,
.......
I thought that index linked gilts might be a sensible investment, instead of gilts, but seems index linked gilt funds have also lost value this year. Can anyone explain why, as they are linked I assumed they would increase in value if inflation was high?

........

Index linked bonds get complicated to explain so lets look at simple interest generating bonds...

If you bought a gilt from the government for £100 it would pay a fixed amount of interest on £100 each year until it matured when you would get £100 back. But you as a small private investor cant buy a gilt from the government. You can only buy it at a market price from someone willing to sell one. At the moment with interest rates elsewhere very low a bond that is paying a higher rate of interest is worth more, possibly significantly more, than £100 until it is very close to maturity. Then, if general interest rates rise your fixed rate bond becomes less attractive than it was and so its value decreases. Either way you as a secondary buyer dont get the stated interest on your investment. Also the capital value of your holding becomes strongly influenced over time by general interest rate changes. The effect is that bonds are less effective as the solid, safe generators of interest as a diversifier to equity that is advocated in classic investment guides.

A further complication is that private investors these days dont buy normally bonds, they buy bond funds. Such funds will hold a set of bonds with a wide range of maturity dates. So the behaviour of a bond fund is very different to a single bond - in particular there is no maturity date at which you are promised to get the value of the bond returned.

So hopefully you can see that the actual return you would get from holding index linked bonds directly or through a fund could bear little relationship to the index.

intowhere

I didn't realise that index linked bonds were so complex. I had assumed they were even safer than convention gilts because they offered protection against inflation.

Just to check my understand, any movement in the yield wanted by an investor would have an greater impact on an index linked bond because of its long duration?

Thrugelmir

intowhere wrote: »

however reading online etc it seems that many people think bonds and gilts are over priced, and if there was to be an interest rate increase it would significantly reduce the value of gilts and bond funds.

A simple explanation.

You could buy Nationwide Building Society (CEBA) 6.875% PIBS for example. Will cost you £111.50 for £100 of nominal stock. If ever redeemed the Nationwide will only ever return you £100. As there's no inflation linking.

The reason investors are willing to pay over the odds is two fold. (1) The income on offer in this low interest rate enviroment (2) As Nationwide are blue chip borrowers, about as secure as you can get.

As interest rates rise. Then the price investors willing be willing to pay to purchase will fall. As a seller you'll incur a capital loss.

While the stock yields 6.875% at par. At current prices your money will earn you 6.16% gross.

Same principle applies to Gilts and Corporate bonds. Central banks have been buying these to boost the money supply. At some point these will be sold back into the market. Depressing prices in the process and raising the cost of borrowing money.

Morphoton

I didn't realise that index linked bonds were so complex. I had assumed they were even safer than convention gilts because they offered protection against inflation.

Indexed linked gilts are safer than conventional gilts and do guard against inflation but this protection is now currently very expensive as stated above and they yield RPI minus 1.5% depending on the timescale. They are only complicated by the fact that the return is linked to inflation but other than that they are the same as conventional gilts.
Whether this is good or poor value only time will tell.
You can check yields on the DMO website:
http://www.dmo.gov.uk/chooseFormat.aspx?rptCode=D3B.2&page=Gilts/Daily_Prices
So looking at 10Y gilts you can get approx. 1.3% for conventional or RPI minus approx. 1.7% for IL.
For 20Y it is approx. 1.9% conventional or approx. RPI minus 1.5% for IL.
So if RPI averages 3.0% (currently 2.7%) over the next 10Y both types of 10Y gilts will give approx. the same return. If RPI is higher, IL will do better, and if lower conventional gilts will do better.
It really depends on what you think RPI will do over the years as to which will give the better return.
Although the IL gilts will protect against unexpected inflation.
The above assumes holding until maturity where the return is always fixed (or fixed to RPI in the case of IL's) If you trade before maturity the price will vary as per how strongly or not the market values the income.
Or you can take the view above that using equities as a hedge against inflation is a perfectly reasonable but will come with the usual expected volatility.
Bond/gilt funds or bond/gilt ETF's behave differently as there is no fixed maturity date. The funds will hold a range of maturities and are likely to trade between different maturities.
Overall you can see how in a low interest rate world it is difficult to get a real yield (i.e. above inflation) as holding either conventional of IL gilts will result in a real decrease in your money by not keeping place with inflation.

Linton

Morphoton wrote: »

Indexed linked gilts are safer than conventional gilts and do guard against inflation but this protection is now currently very expensive as stated above and they yield RPI minus 1.5% depending on the timescale. They are only complicated by the fact that the return is linked to inflation but other than that they are the same as conventional gilts.
......

Where it gets messy is that the maturity value increases with inflation whereas with conventional gilts the maturity value is £100. The extra interest paid is a fixed % of the index linked value. So with index linked bonds it is less obvious how the price compares with maturity value and to see the possible future downside. In explaining how bonds work to a newbie it makes life much easier to start with conventional bonds.

Morphoton

The link below is a good explanation of how IL gilts work.
It is an old article from 2010 when IL gilts probably yielded RPI plus 2%, as opposed to the RPI minus 1.5% now..But the principle is the same. It does explain the difference between the clean price vs dirty price etc. https://www.fixedincomeinvestor.co.uk/x/learnaboutbonds.html?id=206

intowhere

Thanks. I think I have understood but one area still confuses me. Looking at the value of gilt funds, in 2012 there was a massive increase the returns gilt funds were getting, i think gilts were the best performing investment in 2012. However IR hadn't changed, they were as low in 2012 as they were in 2011, 2010. What would have caused this massive increase in the returns funds were getting, because I've understood gilts to be safe investments, sometimes getting a small return above inflation.

thanks

bigadaj

From what I can recall it was quantitative easing, Bank of England printing huge amounts of virtual money, using that to buy government gilts, amongst other assets, so pushing up demand and prices and consequently reducing yield.