Reasons to invest in Bonds / Gilts

kidmugsy

EdGasketTheSecond wrote: »

Cash will always lose to inflation unless you can get an inflation-beating return on it

EdGasketTheSecond wrote: »

Who could disagree?

EdGasketTheSecond wrote: »

Therefore it is not 'loony' at all to hold cash in a S&S ISA or SIPP if ...

It's often reckoned rather dishonest to argue by misquoting your opponent. Shame on you!

Thrugelmir

EdGasketTheSecond wrote: »

That leaves gilts/bonds or gold as an alternative to equities all of which carry risks.

15 year gilt yields offer lower rates than inflation.

Blue chip corporate bonds likewise.

Gold offers no protection against inflation at all.

EdGasketTheSecond

kidmugsy wrote: »

EdGasketTheSecond wrote: »

It's often reckoned rather dishonest to argue by misquoting your opponent. Shame on you!

I'm afraid you've lost me there?

short_butt_sweet

EdGasketTheSecond wrote: »

So if you are in a S&S ISA or SIPP and want some 'risk off', where do you suggest investing other than cash? Cash will always lose to inflation unless you can get an inflation-beating return on it and you can't in a S&S ISA or SIPP. That leaves gilts/bonds or gold as an alternative to equities all of which carry risks.

gilts or investment-grade bonds, but not ones with excessively long duration.

e.g. consider vanguard global short-term corporate bond index fund.

this fund holds bonds with an average YTM (yield to maturity) of 2.5%; allowing for the fund's OCF of 0.25%, the expected return is therefore very roughly 2.25%.

it holds bonds with an average duration of 2.8 years. so holding this fund is a bit like being locked into a 2.25% interest rate for 2.8 years.

that doesn't look too bad to me.

or if you don't mind a longer duration, look at vanguard global corporate bond index fund. using the same method of calculation, that fund is a bit like being locked into a 2.85% interest rate for 6.4 years.

is that too long a lock-in? your call

those example funds hold investment-grade bonds. if you go for gilt funds instead, you will get lower interest rates.

however, gilts have a good chance of rising when equities crash. investment-grade bonds are perhaps more likely to fall when equities crash (but by a much smaller amount than equities are falling).

so gilts give you better diversification (assuming you're also holding plenty of equities), but investment-grade bonds give you more interest. so take your pick, or hold a bit of both.

EdGasketTheSecond

Yes I think short-term corp bonds are the only sensible, non-equity investment within a SIPP/ISA. Even so there is a risk to capital if one or more of the companies dont have the money to redeem the bonds. The short-dated gilt funds return less than inflation but better than nothing.

londoninvestor

short_butt_sweet wrote: »

this fund holds bonds with an average YTM (yield to maturity) of 2.5%; allowing for the fund's OCF of 0.25%, the expected return is therefore very roughly 2.25%.

You need to be a bit careful about currencies when looking at this.

If a dollar-denominated bond has a YTM of 2.5% from a dollar-based investor's perspective, the yield from a pound-based investor's perspective will be lower. That's because of the interest rate differential and the forward curve.

Let's say I buy a USD-based bond that matures in a year's time, and hedge the cashflow on maturity into GBP. If you look at the forward curve, you'll see that for a 1y forward, a dollar buys fewer pounds than it does for a spot transaction today. So, if $1000 of bond bought today will give $1250 in a year's time to a dollar investor, £1000 of the same bond bought today will give a bit less than £1250 a year from now.

The USD/GBP forward curve has that shape because of the interest rate difference (interest rate parity model.) USD interest rates are higher than GBP and so the further forward in time you go, the higher the USDGBP rate (i.e. the more dollars per pound).

Conversely, the euro and yen are lower-interest currencies than the pound. So if you buy a EUR or JPY bond, the yield from your perspective as a GBP investor is higher than it would be for domestic buyers of that same bond.

This is a useful paper from Vanguard, particularly Figure 4: "Hedging has tended to equalize long-term returns between an investor’s domestic and international market".

Does this mean buying foreign bonds is useless? I'd say not, but the advantage is the diversification rather than getting a free lunch from higher interest rates in other currencies.

seacaitch

Here's a nice chart:

Thrugelmir

short_butt_sweet wrote: »

however, gilts have a good chance of rising when equities crash.

If the correction is due to rising interest rates then both classes are closely correlated. The elastic needs to be broken.

short_butt_sweet

londoninvestor wrote: »

You need to be a bit careful about currencies when looking at this.

If a dollar-denominated bond has a YTM of 2.5% from a dollar-based investor's perspective, the yield from a pound-based investor's perspective will be lower. That's because of the interest rate differential and the forward curve.

Let's say I buy a USD-based bond that matures in a year's time, and hedge the cashflow on maturity into GBP. If you look at the forward curve, you'll see that for a 1y forward, a dollar buys fewer pounds than it does for a spot transaction today. So, if $1000 of bond bought today will give $1250 in a year's time to a dollar investor, £1000 of the same bond bought today will give a bit less than £1250 a year from now.

The USD/GBP forward curve has that shape because of the interest rate difference (interest rate parity model.) USD interest rates are higher than GBP and so the further forward in time you go, the higher the USDGBP rate (i.e. the more dollars per pound).

Conversely, the euro and yen are lower-interest currencies than the pound. So if you buy a EUR or JPY bond, the yield from your perspective as a GBP investor is higher than it would be for domestic buyers of that same bond.

yes, very good point.

the funds i mentioned both hold bonds in multiple currencies, and hedge the currency to sterling. it's perhaps worth comparing those global bond funds with sterling-only bond funds ...

e.g. vanguard UK short-term investment grade bond index fund, which has the same duration (2.8 years) as vanguard global short-term corporate bond index fund. the UK-only fund has a YTM of only 1.8%, compared to 2.5% for the global fund.

a lot of that 0.7% difference in yield is probably down to differences in yields in GBP compared to other currencies. and therefore is likely to be lost after currency hedging is taken into account.

though some of the difference may be down to the UK fund having a higher average credit rating (A+) than the global fund (A-).

but we should probably look at the global fund as being locked in (for 2.8 years) to a fixed rate of less than the 2.25% previously calculated.

the UK fund is perhaps like being locked in to 1.65% for 2.8 years (... calculated by subtracting the OCF (0.15%) from the YTM (1.8%)).

the global fund may not be much higher.

londoninvestor

short_butt_sweet wrote: »

the UK fund is perhaps like being locked in to 1.65% for 2.8 years (... calculated by subtracting the OCF (0.15%) from the YTM (1.8%)).

the global fund may not be much higher.

Agree, that was my instinct too. My inclination is to use funds like these in my SIPP, but to give them a miss in my unwrapped portfolio and use fixed-term savings instead.