Bonds?

Mark2016

Hi everyone

I have read that people sometimes have a mix of equities and bonds in their portfolios. Can someone help me understand something about bonds. I know they rise and fall, but are they bought like an 'insurance' the way someone might buy gold. Gold usually increases when the stock market falls (though not always). Is such behaviour typical of bonds and so do investors hold them as an insurance? I was considering adding a bond fund when I top up my isa next year..

AlanP_2

Bonds are essentially loans to Govt's, local public service organisations or companies. In exchange for £x over N Years they will pay an "interest" rate of Y% and when you get to point N in the future they will give you your capital back.

It is sensible to assume from this that a UK Gov't Bond is inherently safer than that from some small startup company somewhere, the interest rate will reflect that additional risk.

Many large, well established FTSE 100 / 250 companies issue Bonds with an appropriate interest rate to reflect perceived risk.

The UK Gov't issues Bonds / Gilts to cover the amount it needs to spend over and above tax receipts. It is these that are being referred to when you get an item on the news about the size of public debt and it's growth.

Over long periods of time (up until the turn of the century roughly) Bonds were relatively stable in terms of their capital value (purchase / sale price) compared to Equities. A lot less volatile, and they tended to dampen the effects of large swings in the value of the equities in the portfolio - they have ZIGGED when equities have ZAGGED.

However, QE, low inflation etc. etc. have pushed Bond prices to very high levels compared to historical rates, and as QE unwinds, interest rates rise and inflation starts to come back into the economy the logical answer is that Bond prices will fall.

They are inextricably linked to interest rates / inflation expectations.

For example you may have purchased (or your fund has purchased) £10,000 of 10 year 1.75% UK Gov Bonds a year or so ago.

When you come to sell them, if current new issue Gov Bonds are offering 3.5% who is going to want them at the £10k you paid, instead the new investor will buy £10k of the new issue as he will make a better return on it.

To match that 3.5% "rate" your £10k of Bonds would have to be sold at whatever price gives the buyer a nominal 3.5% to achieve a sale. It's more complicated as the duration of the Bond also comes in to play but that's it in simple terms.

There is a school of thought that Bonds should be avoided as they are likely to fall in value over the next couple / few years but who knows, it has been said many times over the last few years as well and hasn't happened yet.

Even if they do fall it is likley that it will be a shallower, more gradual decline than can befall equities so can still act as a sensible, useful counterbalance to equities.

They are not "insurance" in the sense that "they will pay out to make up for what you have lost on equities" but if you had a 60/40 split portfolio and equitues dropped 30% and Bonds 10% you would be 22% down overall.

aberlyfid_2000

viewed differently, bonds are like bank accounts, in that you have:

* an interest rate
* a time period for the deposit (or bond)

With bonds, you have different issues of different credit qualities, as with banks. You do need to be more careful as bonds are not generally FCSC protected though.

Unlike bank accounts, you also have the choice of currency, i.e. GBP, USD etc.

The prices of bonds will go up or down, but this should only concern you if you are thinking about accessing that money prior to the maturity of the bond. Generally, as interest rates rise, the price of bonds goes down, as any rate of interest you are receiving will be lower than the newly raised interest rate, but you can take steps to mitigate this.

its too expensive to buy bonds individually, but you can buy whole sectors of bonds via a fund or an ETF, and for the latter, there's plenty of literature available on the internet - they are usually screened for credit quality.

kidmugsy

Bonds are traditionally bought as (i) being less risky (i.e. less variable in value) than equity, and (ii) in hopes that they will be negatively correlated with equities i.e. that they might rise when equities fall.

The history of the last decade, with quantitative easing and ultra-low interest rates, makes these assumptions doubtful. My own view/guess is that all financial assets are grossly over-valued. But Merry Xmas to you all the same.

EdGasketTheSecond

With interest rates on the rise, bonds should be avoided as you will suffer a capital loss.

Audaxer

Mark2016 wrote: »

I have read that people sometimes have a mix of equities and bonds in their portfolios. Can someone help me understand something about bonds. I know they rise and fall, but are they bought like an 'insurance' the way someone might buy gold. Gold usually increases when the stock market falls (though not always). Is such behaviour typical of bonds and so do investors hold them as an insurance? I was considering adding a bond fund when I top up my isa next year..

They are a lot less volatile than equities and are usually included in a portfolio to dampen down the portfolio's volatility.

aberlyfid_2000 wrote: »

You do need to be more careful as bonds are not generally FCSC protected though.

I'm fairly sure that bond funds or bonds as part of multi asset funds are covered by the FSCS.

bowlhead99

aberlyfid_2000 wrote: »

viewed differently, bonds are like bank accounts, in that you have:

* an interest rate
* a time period for the deposit (or bond)

With bonds, you have different issues of different credit qualities, as with banks. You do need to be more careful as bonds are not generally FCSC protected though.

Unlike bank accounts, you also have the choice of currency, i.e. GBP, USD etc.

The prices of bonds will go up or down

Hmm, so it sounds pretty simple really, just like a bank account with the removal of the 100% FSCS guarantee and the addition of investment risk ; credit risk, counterparty risk, liquity risk and currency risk to name a few.

but this should only concern you if you are thinking about accessing that money prior to the maturity of the bond.

its too expensive to buy bonds individually, but you can buy whole sectors of bonds via a fund or an ETF

So, it should only bother you if you are thinking of disposing of the bond before it matures...

... but it is too expensive to buy individual bonds and decide to hold them to maturity, instead you have to buy huge collections of bonds and have the fund manager sell holdings within them whenever he is required to sell them as a consequence of investor demand or whenever else he wants to because of thinking it's a good idea. So you will generally not get a chance to hold the bond to maturity through a fund or ETF.

Audaxer wrote: »

aberlyfid_2000 wrote:

You do need to be more careful as bonds are not generally FCSC protected though.

I'm fairly sure that bond funds or bonds as part of multi asset funds are covered by the FSCS.

The distinction is that bonds as an investment are not protected as they are not a deposit - instead, merely a financial instrument; simply a contract between you and the issuer of the bond. If the issuer can't or doesn't pay you back or pay you all the interest promised, he's in default, but that won't recover any money for you - it's just an investment risk you take.

If the operator of a regulated collective investment scheme goes bust and owed you some money for some reason, such as because of a fraud he perpetrated or some other grievance, you can have some FSCS protection for that. But if he invested the fund's money in bonds that couldn't pay it back, you are on your own - back in the same above situation where 'issuer can't or doesn't pay you back or pay you all the interest promised' except with a fund in between you and the issuer.

Having the FSCS in the frame because you're invested through certain types of funds doesn't actually make the bond less of a default risk, the FSCS would only be helping out with some of the incremental risks of interposing a fund structure above the underlying investments (such as the fund manager might be misleading you by mistake or on purpose, may be grossly negligent or bad at admin etc). Effectively the FSCS is just covering a little bit of the extra counterparty risk you introduced in pursuit of diversification and convenience.

Thrugelmir

EdGasketTheSecond wrote: »

With interest rates on the rise, bonds should be avoided as you will suffer a capital loss.

Holding to maturity in many instances is guaranteed to achieve likewise.

The BOE between September 2016 and April 2017 hoovered up £9.9 billion of UK issued Corporate Debt under the Asset Purchase Facility. Aim of the scheme was in part to drive investors towards purchasing riskier assets. Judging by the UK Market Indexes this year appears to be working. Unwinding this position and the £435 billion holding in gilts is going to make for interesting times. With the Fed ahead of the curve taking the first tentative steps to normalise fiscal policies.

Reaper

AlanP wrote: »

There is a school of thought that Bonds should be avoided as they are likely to fall in value over the next couple / few years but who knows, it has been said many times over the last few years as well and hasn't happened yet.

This.

I hold bonds and preference shares (different, but similar idea) directly rather than in a fund. Over the years I've kept thinking they are bound to fall soon and I should be selling, but so far have been glad I didn't.

Now there are early signs of inflation rising I am thinking it again, but with so many false alarms I find myself reluctant.

Flobberchops

A couple of newbie questions. Does anybody buy Gilts direct from the Debt Management Office, and if so what's the process like? Secondly (but perhaps more importantly) is there any point in buying Gilts at the moment?

aberlyfid_2000

its not possible to buy direct from the DMO, unless you are a pre-authorised bank.

you can buy gilts from the London Stock Exchange Order Book for Retail Bonds (ORB) platform http://www.londonstockexchange.com/exchange/prices-and-markets/retail-bonds/retail-bonds-search.html - this would be done via your broker.

I generally don't buy the gilts individually, but via funds that targets short term, mid or long term gilts, its usually cheaper to do it this way.

they are definitely worth having in a portfolio, and certainly once you have exausted all the bank saving account and NS&I bond options (2.2% for 3 years, vs around 0.55% for a 3 year gilt), or they are unavailable to you (i.e. in a SIPP or ISA).