Bonds / gilts overpriced or worth it

bostonerimus

In the short term (5 years maybe) you will probably lose money on bond/gilt funds as interest rates go up. You'll lose most on long term bonds and less on the short term ones. But that isn't necessarily a reason to avoid them when constructing a portfolio as they act as a volatility dampener. So look at your risk/return needs construct an asset allocation with equities and bonds and get set for the long term. Reinvest dividends and interest, rebalance and hold for at least the average maturity of the bond fund and you'll be ok

RedbullRJ

No one can be certain of the future, but it appears interest rates are more likely to go up rather than down, which would negatively affect the price of bonds. However, as always, a balanced portfolio is normally a good idea and there are a lot of different bond funds out there giving you a wide choice of economies and currencies, so no reason some bonds should not be part of it.

Do review your portfolio a couple of times a year to check it is still right for you and any good or bad changes in value haven’t distorted the balance.

short_butt_sweet

firstly, interest rate increases don't necessarily cause gilt prices to fall. because the price of gilts already incorporates the market's expectations for how interest rates will rise (or fall).


the rate which the bank of england sets directly - bank base rate - is equivalent to a rate for an instant access account.


the price of a 10-year gilt is based on where the market expects bank base rate to go (up or down) over the next 10 years, plus a premium for being locked in to a fixed rate for that long. it's equivalent to the rate on a 10-year fixed-rate savings account (if such accounts exist ...).


so if bank base rate rises by 1%, what happens to the price of a 10-year gilt? that depends what happens to expectations for rates over the next 10 years.


does the market suddenly expect rates to be 1% higher than it expected yesterday, for the whole 10 years? probably not. but if it did, the price of the 10-year gilt would fall by about 10%.


was the base rate rise fully expected? if so, the market price of the 10-year gilt might not change at all.



what's more plausible is that a rate rise was expected some time soon, but not necessarily this month. so there is a small change in expectations for rates over 10 years. perhaps the next year is now projected to have higher rates than before, but there's little change in expectations for the following 9 years. so you might see a small fall in the price of a 10-year gilt.


but it can also go the other way. gilts can rise if bank base rate falls unexpectedly, or even if it rises but by a smaller amount or slower than expected.


it's not a 1-way bet. lots of people think gilts can only fall from here. but many have been saying that for about the last decade, and gilts have gone up a lot since then. the only safe assumption is that we don't know what will happen.


secondly, when people talk about gilts crashing, that might mean up to a 10% fall. compare that to equities crashing, which might mean up to a 50% fall.


thirdly, it's the performance of your whole portfolio that matters. don't focus too much on how 1 part might lose money; that doesn't matter, if other parts are gaining at the same time.


so how does that work when combining equities with gilts? it's very dependent on the relative proportions involved.


if you are mostly in equities, then adding a small percentage of gilts can be very helpful, because gilts often (though not invariably) tend to rise sharply precisely when equities are suffering big falls. thanks to this effect, a portfolio with a mostly equities and a few gilts is likely to give you nearly as high returns as a 100%-equities portfolio, and with significantly less downside. for this purpose, you probably want conventional gilts, not index-linked gilts, and certainly not corporate bonds (the latter are quite likely to fall when equities are falling, though by a smaller amount than equities are falling).



with a small proportion of a portfolio in gilts, it's also easier to shrug off the possibility of gilts crashing, because a 10% fall for a small part of your portfolio comes to just a few percent of the whole portfolio's value.


however, if you're going for a smaller proportion of equities, and a lot more in bonds (or in other alternatives), then shoving all your bonds in conventional gilts is less sensible. in that case, you might also include index-linked gilts, corporate bonds, and other alternatives.

Tom99

[FONT=Verdana, sans-serif]

bostonerimus wrote: »

In the short term (5 years maybe) you will probably lose money on bond/gilt funds as interest rates go up.

[/FONT]
[FONT=Verdana, sans-serif]

RedbullRJ wrote: »

No one can be certain of the future, but it appears interest rates are more likely to go up rather than down, which would negatively affect the price of bonds.

[/FONT]
[FONT=Verdana, sans-serif]So the OP's idea of investing in cash rather then bonds, at least in the short term, seems right.[/FONT]

bostonerimus

Tom99 wrote: »

[FONT=Verdana, sans-serif] [/FONT]
[FONT=Verdana, sans-serif] [/FONT]
[FONT=Verdana, sans-serif]So the OP's idea of investing in cash rather then bonds, at least in the short term, seems right.[/FONT]

Notice I said "probably lose money". Asset allocation should be strategic rather than tactical so the OP should have equity, bonds and cash. Over a number of market cycles a diversified bond fund investment will probably do better than cash.

Computer_Beginner

If you lend a company money in the form of a bond you get you get your interest returned in coupons. But coupon percentage stays the same. So you don't benefit from compounding of that interest.

e.g. You lend HSBC £100 as a bond. Coupon is £5 / year. After 5 years, you have your £100 bond, plus £25 coupon payments. So £125.

You lend HSBC £100 in a fixed rate 5% savings account. After 5 years you have £127.62 (interest has compounded).

A simple example, but it shows that you can't directly compare bond coupon rates to savings account interest rates.

Remember, large companies don't have to issue bonds. They could just borrow the money as a "standard" loan. There must be an advantage to the company issuing the bonds, or they wouldn't do it.

Reaper

Computer_Beginner wrote: »

e.g. You lend HSBC £100 as a bond. Coupon is £5 / year. After 5 years, you have your £100 bond, plus £25 coupon payments. So £125.

You lend HSBC £100 in a fixed rate 5% savings account. After 5 years you have £127.62 (interest has compounded).

True, but you are assuming the investor takes the £5 coupon earned each year and places it in a savings account earning 0% until the end of the term.

Computer_Beginner

Reaper wrote: »

True, but you are assuming the investor takes the £5 coupon earned each year and places it in a savings account earning 0% until the end of the term.

Yes, it was a very simplistic example.

Obviously you also need to factor in FSCS protection and the fact that most companies issuing bonds are not banks who also offer savings accounts. So different default risks etc.