Cash vs Bonds as reserve

stphnstevey

Long story, I am considering moving my trading to Interactive Brokers

To avoid an inactivity fee, I need to retain a certain equity balance or trade frequently. I dont think I can meet that balance with my trading balance alone and I am considering topping it up with my cash reserve

I realise the inactivity fee is a small cost and not a reason to change an investment strategy (if I even had one to start with!)

I was considering swapping my cash reserve for a bond reserve. The trading fees are minimal, so I think I can sell off bonds as cash is needed

What could be the pros and cons of this approach?

bowlhead99

I think you mean

- they won't charge you for administering the account, holding your assets and making electronic statements available etc, if you aren't actually making them do any transactions for you and you have a high balance;

- you don't currently have a high enough balance of investments with them to qualify for the waiver of inactivity fees, but could create a high balance by using some of your cash to buy bonds to hold on their platform, and you believe that this won't give you any real liquidity issues because you could convert the bonds back into cash quickly if you needed the cash for something else in your life.

If that's what you're suggesting:

The pros:

- Saving of inactivity fees due to appearing like a big customer they don't want to lose so they waive the fee;

- potential gains from "bond interest income plus change in market value of the bonds" exceeding the return available on cash in a bank

The cons:
- Market value of the bonds may fall due to changes in creditworthiness of the bond issuer and other available market interest rates changing the desirability of the bonds;

- transaction fees to buy and sell the bonds.

With bonds as your 'reserve' you are taking investment risk (returns are market-based and unknown: the total return might short of the total return from a product such as cash which is investment-risk-free, and could be negative) and you are taking credit risk (the issuer might default) as well as inflation risk (the nominal value and annual cash payout from the bond declines in value relative to the price of goods and services in our economy).

Whereas with cash you just have the inflation risk really.

stphnstevey

bowlhead99 wrote: »

I think you mean

- they won't charge you for administering the account, holding your assets and making electronic statements available etc, if you aren't actually making them do any transactions for you and you have a high balance;

- you don't currently have a high enough balance of investments with them to qualify for the waiver of inactivity fees, but could create a high balance by using some of your cash to buy bonds to hold on their platform, and you believe that this won't give you any real liquidity issues because you could convert the bonds back into cash quickly if you needed the cash for something else in your life.

If that's what you're suggesting:

The pros:

- Saving of inactivity fees due to appearing like a big customer they don't want to lose so they waive the fee;

- potential gains from "bond interest income plus change in market value of the bonds" exceeding the return available on cash in a bank

The cons:
- Market value of the bonds may fall due to changes in creditworthiness of the bond issuer and other available market interest rates changing the desirability of the bonds;

- transaction fees to buy and sell the bonds.

With bonds as your 'reserve' you are taking investment risk (returns are market-based and unknown: the total return might short of the total return from a product such as cash which is investment-risk-free, and could be negative) and you are taking credit risk (the issuer might default) as well as inflation risk (the nominal value and annual cash payout from the bond declines in value relative to the price of goods and services in our economy).

Whereas with cash you just have the inflation risk really.

As your always very good at, thank you for the concise summary

I am a novice in bonds, maybe I could reduce credit risk with gilts?

I guess I would also swap FSCS compensation cover limits of £85k bank account for £50k on investments (which might already be being used in other investments)

I am also looking into the taxation, but initially I guess it would be swapping IT for CG?

Would bond funds/ETFs make a difference in risk and taxation?

Any benefit to US Bond ETFs as they seem to be available at Interactive Broker? I guess this would add a currency risk to the equation though?

bowlhead99

stphnstevey wrote: »

I am a novice in bonds, maybe I could reduce credit risk with gilts?

As mentioned, there are two main risks, credit risk and market risk. If instead of buying bonds issued by a company you buy a government bond issued by a relatively stable country like the UK or US which can print new money whenever it likes, the whole country is not going to go bust and default on paying you back, so your credit risk is minimal. Accordingly, the interest rates paid will be lower than for the bonds offered by some risky company rated C- instead of AA.

However, you still have the market-based risk where the price changes because of the relative attractiveness or unattractiveness of that particular bond compared to every other fixed interest cash or investment product.

For example take a gilt GB0032452392 maturing in March 2036 which has 17 years left to run. It pays a coupon of £4.25 a year on every £100 of face value. As market interest rates are very low at the moment, nobody is going to sell you their bond for £100 and let you receive 4.25% yield on your investment cost. Actually they will sell it to you on the bond market for £142.78. So the effective yield you get to maturity (getting the £4.25 a year and then getting £100 back at the end, even though you paid £142.78 for it at the beginning) is more like 1.4%.

You might think, OK, if that's the going rate, I guess that's fine, I'll pay over the 142 quid and buy that bond and accept that the £4.25 a year is only about 3% of what I paid and I will lose a known amount of capital when it matures for only £100 at the end. It's still an overall effective yield to maturity of 1.4% which is similar to cash in my bank.

However, what happens in five years time when you want to cash in some of your bond reserve for other opportunities? What you can sell the bond for depends on the state of the market. If interest rates have risen substantially and the going rate for cash is 5%, nobody is going to want to pay as much as £142, or even as much as £100, for a bond that pays £4.25 a year. Maybe they'll give you £80-90 for it.

You could say that's not good enough and rather than taking a monster loss (selling something that cost you £142 for only £80-90) you will just hold it for more than another decade until 2036, receiving your £4.25 a year and getting back the full £100 in line with your original plan. But if you need the money, that's not a very good solution.

See discussions in post 2 of the 'debt bubble' thread https://forums.moneysavingexpert.com/showthread.php?t=5666938 (a thread which had come about after it was mentioned in various other threads that bonds were not particularly safe things to buy at inflated prices)

I guess I would also swap FSCS compensation cover limits of £85k bank account for £50k on investments (which might already be being used in other investments)

The investment cover is changing to £85k soon anyway. But it only really covers a situation where a regulated person screws you over and then goes out of business before they pay you compensation. If a bond issuer defaults, there is no protection payout. You took a risk by deciding to buy an investment which has risks.

I am also looking into the taxation, but initially I guess it would be swapping IT for CG?

When you buy an asset such as a corporate bond or gilt as an investment, subject to some exceptions it is pretty much the same as if you buy an equity.

(1) It will pay an interest coupon (income tax, subject to your annual personal allowances for interest income)

(2) Its value may change between buying it and selling it/cashing it in, producing a capital gain or loss (CGT, being able to be offset with other capital gains/losses and subject to your annual exemption)

Would bond funds/ETFs make a difference in risk and taxation?

Bond funds spread risk over lots of different bond issues and maturity dates (the remaining time to maturity impacts how sensitive the bond price is to interest rate changes). So the risk is different to buying a bunch of bonds yourself where the risk is concentrated in certain specific bonds and you are not very diversified.

However, if you own and control the bonds yourself you can decide to hold them until they mature if you like, whereas the bond fund manager may need to sell them early because its investors want to get their cash back ; or because his strategy is to (e.g.) hold bonds with maturities of at least x years so he is going to sell them as soon as they get down to their last x years, which means selling them on the market at the going rate at that time, rather than waiting until maturity which might have been a better payout if you had waited.

So the risks of using a fund a different, but at their core the basics are similar to holding bonds yourself - it's all about the risk of market value changes and of bond issuer defaults in difficult economic conditions.

The difference with a fund is if there are liquidity problems in a crashing market the funds might run into trouble if the investors want to exit, because they have to sell the bonds quickly at terrible prices, even if you would have preferred to hold on and not sell any. You can keep your stake in the fund but it is a fund that's losing money due to buying high and selling low, and as an owner of the fund you will unfortunately share in those losses. But on the positive side you do get a more diversified portfolio than you could have cheaply built for yourself.

Any benefit to US Bond ETFs as they seem to be available at Interactive Broker? I guess this would add a currency risk to the equation though?

US bonds have a different yield than UK ones although the currency changes over time will mean you can't expect to profit from the higher interest rates because the currency rate changes will cancel them out.

Just like with equities, different economies go through different economic conditions at different times so if you are buying bonds there is no fundamental harm in being globally diversified - government and corporate bonds (including index linked bonds) from all over the world including emerging markets.

However, if you are only buying bonds as a substitute for a pounds sterling cash reserve, it is much less of a direct substitute if within the holding of bonds you are buying overseas assets whose values could drop by 20% in sterling terms over a couple of months due to currency rate changes after a political or economic event.