VLS results over last year shows still worthwhile holding bonds

MarkCarnage

Have read this thread with some interest.....I'm probably more in Linton's camp than the others.....

Government bonds have historically been a decent diversifier in most situations. 1987 and 2008 spring to mind. However, the starting point for bond valuations was somewhat different in these cases. I am also only talking about goverment bonds, as corporate credit was certainly not in 2008, behaving more like equities.

However, as Linton points out, buying government debt now more or less 'bakes in' a guaranteed negative return in real terms and in some cases nominal terms too. US TIPS perhaps being an exception.

The QE policy followed by central banks has clearly been a visible and very major contributor to where bond valuations currently are. However, institutional investors are also major drivers of it. Large DB pension funds, as they mature, are natural buyers of high quality bonds, and this has been 'hard wired' over time by statutory measures which mean that they are in many cases holding more than they might otherwise wish to in gilts etc.

IL gilts are the only natural full hedge asset for UK DB pension funds. However, the total value of DB liabilities is around 3x the size of the entire ILG market......as DB funds have matured, and are managed with a very tight focus on liability matching, the supply/demand equation has pushed prices of gilts upwards to the point where real yields have been negative for some years now. Same applies to conventional gilt market.

The same type of regulatory pressures apply to pension funds and insurance companies globally, hence where annuity rates have been for some time. Also, there are limits on how much they will want to hold cash with commercial banks given the potential for default risk. No FSCS for them....

Therefore, it's a demographic thing to some extent, similar to Japan, and indeed there is some evidence that demographics are likely to be a major driver of future market returns. One main difference between UK and Japan is that there hasn't been a major correction in property prices in the UK.....yet.

Turning back to bonds, it's possible to see a scenario where high quality bonds (essentially government/supranational) bonds continue to perform relatively well, with yields falling even further. However, that can really only be squared with a persistently deflationary environment, which most central banks will give their eye teeth to avoid. Deflation of itself needn't be a bad thing, but when debt levels remain at historically elevated levels, it would be a suffocating grind, and continual pressure on bank balance sheets. There are only so many ways that the current secularly high level of debt can be resolved, none of them pretty.

Bonds may well be a diversifier, in a portfolio, but there are times when they won't be, when discount rates rise again, and most assets come under valuation pressure - 1994 was a relatively mild example of this, 1974 in the UK was a much more extreme one.

It strikes me that there is a great opportunity here for governments to issue debt at generationally low rates to fund spending which has a clear positive payback - infrastructure, some health and education spending. By that I mean areas which will be cost effective and improve productivity. Not just to fulfil election promises to raise pay, pensions etc.

Anyway, I think that there is enough evidence to challenge the received wisdom that individual savers should hold more bonds as they grow older, particularly if they already have a DB/State pension which is basically their bond portfolio already. Right now, I hold next to nothing directly in bonds for the reasons outlined above. I have some investment trust holdings with significant government bond holdings, which are either inflation linked or very short dated quasi cash. I would also suggest that for individual investors, holding cash is a quite decent alternative to bonds right now, provided an eye is kept on the FSCS compensation limits. Certainly there is little incentive to hold long duration for private investors I think.

If there is a inflationary resolution to debt levels, then holding nominal bonds will turn the 'low risk' mantra on its head, as the FCA definitions don't really take any account of anything but short term volatility in defining risk.

Ultimately, I suspect that we will see some pretty messy outcomes in financial markets as the economics and populist politics collide.....a lot of parallels with mid 1930s right now..

dharm999

There was a really interesting link to an article on Monevator, that looked at long term performance of a diversified portfolio, that looked at bonds, equities, cash, etc.. not just equities and bonds. Long term, a maximum 40% allocation to equities, worked out best.

I'll try and find a link

dharm999

Found that article

https://portfoliocharts.com/2019/08/20/the-top-4-portfolios-to-recession-proof-your-investments/

It's not quite what I originally thought, but still shows 40% being a maximum allocation to equities. I'm not so sure about the allocation to gold. Personally I have an amount in cash and P2P instead of gold

itwasntme001

MarkCarnage wrote: »

Have read this thread with some interest.....I'm probably more in Linton's camp than the others.....

Government bonds have historically been a decent diversifier in most situations. 1987 and 2008 spring to mind. However, the starting point for bond valuations was somewhat different in these cases. I am also only talking about goverment bonds, as corporate credit was certainly not in 2008, behaving more like equities.

However, as Linton points out, buying government debt now more or less 'bakes in' a guaranteed negative return in real terms and in some cases nominal terms too. US TIPS perhaps being an exception.

The QE policy followed by central banks has clearly been a visible and very major contributor to where bond valuations currently are. However, institutional investors are also major drivers of it. Large DB pension funds, as they mature, are natural buyers of high quality bonds, and this has been 'hard wired' over time by statutory measures which mean that they are in many cases holding more than they might otherwise wish to in gilts etc.

IL gilts are the only natural full hedge asset for UK DB pension funds. However, the total value of DB liabilities is around 3x the size of the entire ILG market......as DB funds have matured, and are managed with a very tight focus on liability matching, the supply/demand equation has pushed prices of gilts upwards to the point where real yields have been negative for some years now. Same applies to conventional gilt market.

The same type of regulatory pressures apply to pension funds and insurance companies globally, hence where annuity rates have been for some time. Also, there are limits on how much they will want to hold cash with commercial banks given the potential for default risk. No FSCS for them....

Therefore, it's a demographic thing to some extent, similar to Japan, and indeed there is some evidence that demographics are likely to be a major driver of future market returns. One main difference between UK and Japan is that there hasn't been a major correction in property prices in the UK.....yet.

Turning back to bonds, it's possible to see a scenario where high quality bonds (essentially government/supranational) bonds continue to perform relatively well, with yields falling even further. However, that can really only be squared with a persistently deflationary environment, which most central banks will give their eye teeth to avoid. Deflation of itself needn't be a bad thing, but when debt levels remain at historically elevated levels, it would be a suffocating grind, and continual pressure on bank balance sheets. There are only so many ways that the current secularly high level of debt can be resolved, none of them pretty.

Bonds may well be a diversifier, in a portfolio, but there are times when they won't be, when discount rates rise again, and most assets come under valuation pressure - 1994 was a relatively mild example of this, 1974 in the UK was a much more extreme one.

It strikes me that there is a great opportunity here for governments to issue debt at generationally low rates to fund spending which has a clear positive payback - infrastructure, some health and education spending. By that I mean areas which will be cost effective and improve productivity. Not just to fulfil election promises to raise pay, pensions etc.

Anyway, I think that there is enough evidence to challenge the received wisdom that individual savers should hold more bonds as they grow older, particularly if they already have a DB/State pension which is basically their bond portfolio already. Right now, I hold next to nothing directly in bonds for the reasons outlined above. I have some investment trust holdings with significant government bond holdings, which are either inflation linked or very short dated quasi cash. I would also suggest that for individual investors, holding cash is a quite decent alternative to bonds right now, provided an eye is kept on the FSCS compensation limits. Certainly there is little incentive to hold long duration for private investors I think.

If there is a inflationary resolution to debt levels, then holding nominal bonds will turn the 'low risk' mantra on its head, as the FCA definitions don't really take any account of anything but short term volatility in defining risk.

Ultimately, I suspect that we will see some pretty messy outcomes in financial markets as the economics and populist politics collide.....a lot of parallels with mid 1930s right now..

I do not see how inflation can be generated, we are in a structurally low inflation environment and will be for a long time given demographics, technology etc. The bond market is pricing this in - low inflation low growth for a very long time. The FED has now turned dovish and is following the rest of the western world in lowering rates and the long end of the yield curve is not reacting positively to it - yields have fallen there too suggesting rate cuts wont make a difference.


There needs to be a fiscal response so i agree with what you say that governments should focus on fiscal spending in areas to boost productivity. This wont necessarily increase inflation which is a good thing but it should boost nominal growth in order to reduce the debt burden somewhat and hopefully raise long term real rates.


No one knows what the future will hold but we can all position our portfolio in a way to capture the most likely outcome whilst limiting the downside to some extent. Perhaps select equities do offer this by strategically selecting within sectors and countries.

itwasntme001

dharm999 wrote: »

Found that article

https://portfoliocharts.com/2019/08/20/the-top-4-portfolios-to-recession-proof-your-investments/

It's not quite what I originally thought, but still shows 40% being a maximum allocation to equities. I'm not so sure about the allocation to gold. Personally I have an amount in cash and P2P instead of gold

I am not convinced at all by the link - sure the permanent portfolio holds its values given past large draw-downs but what about actual long term returns? Did the article only use past 15 year return data to justify their portfolio from a risk/reward point of view?


Also even if long term returns look a bit lower then other portfolios and so the much reduced risk makes the permanent portfolio look superior, this small difference in return can compound into much larger difference long term.


A poor analysis in my view.

itwasntme001

Perhaps some significant cash holdings at this juncture is a sensible approach given:

- stocks appear to be high (technicals look very weak and can not break through highs)
- bonds appear to be very high and risky for long duration given low yields which means high sensitivity
- PE/hedge funds either way too risky for little return or can not be accessed
- Gold, other commodities way too volatile, hard to value and buying large amounts means buying ETFs which have significant roll down costs (although can always buy miners - but that's even more volatile!)

Wait for good opportunities in mispriced assets to take advantage of may be the most sensible thing to do right now. Holding large amount of cash may look down upon on this forum but i think under a low inflation and low return environment such as what we are right now, there's very little opportunity cost and inflation risk in doing so.

MarkCarnage

I agree that it is currently challenging to see where a general pick up in inflation will come from, and in many ways that's a good thing, but the need to reduce debt levels will mean that growth will be low too.

However, my point is that a lot of this, perhaps all of it, is now in the price for Government bonds, and anyone expecting a repeat of performance experienced over recent years and indeed since early 80s is I think in for disappointment. It also begs questions of projected return rates generally - this has been a bee in my bonnet for a few years now. In turn this will or should maintain remorseless focus on cost of investing, which will not be good news for many providers.

I think that there will be quite a few equities which will provide decent returns in this environment, but equally a lot will struggle. My portfolio is global and with a strong focus on funds holding stocks that could be described as disruptive technology or with strong brands/balance sheets.

I do hold gold indirectly to a limited degree too, as an insurance policy against extreme scenarios, including generalised trashing of paper currency. Liquidity is important too.

itwasntme001

MarkCarnage wrote: »

I agree that it is currently challenging to see where a general pick up in inflation will come from, and in many ways that's a good thing, but the need to reduce debt levels will mean that growth will be low too.

However, my point is that a lot of this, perhaps all of it, is now in the price for Government bonds, and anyone expecting a repeat of performance experienced over recent years and indeed since early 80s is I think in for disappointment. It also begs questions of projected return rates generally - this has been a bee in my bonnet for a few years now. In turn this will or should maintain remorseless focus on cost of investing, which will not be good news for many providers.

I think that there will be quite a few equities which will provide decent returns in this environment, but equally a lot will struggle. My portfolio is global and with a strong focus on funds holding stocks that could be described as disruptive technology or with strong brands/balance sheets.

I do hold gold indirectly to a limited degree too, as an insurance policy against extreme scenarios, including generalised trashing of paper currency. Liquidity is important too.

Yes i hold some funds doing the same as well as individual stocks (mainly in tech, some defensive div payers with strong balance sheets, real estate stocks, healthcare trusts etc).


Hold a tiny amount (relative to portfolio) in physical gold for pure insurance. I think also holding leveraged real estate is a good way to play this as rates will remain low so pickup carry and overtime debt should get inflated away. I am thinking about buying more properties.

Linton

dharm999 wrote: »

Found that article

https://portfoliocharts.com/2019/08/20/the-top-4-portfolios-to-recession-proof-your-investments/

It's not quite what I originally thought, but still shows 40% being a maximum allocation to equities. I'm not so sure about the allocation to gold. Personally I have an amount in cash and P2P instead of gold

It mostly talks about asset behaviour during the 2008 crash. At that time 20 year gilt yields were in the 4.5%-5.0% range, a very different situation to the current 0.9%.

MarkCarnage

itwasntme001 wrote: »

I do not see how inflation can be generated, we are in a structurally low inflation environment and will be for a long time given demographics, technology etc. The bond market is pricing this in - low inflation low growth for a very long time. The FED has now turned dovish and is following the rest of the western world in lowering rates and the long end of the yield curve is not reacting positively to it - yields have fallen there too suggesting rate cuts wont make a difference.


There needs to be a fiscal response so i agree with what you say that governments should focus on fiscal spending in areas to boost productivity. This wont necessarily increase inflation which is a good thing but it should boost nominal growth in order to reduce the debt burden somewhat and hopefully raise long term real rates.


No one knows what the future will hold but we can all position our portfolio in a way to capture the most likely outcome whilst limiting the downside to some extent. Perhaps select equities do offer this by strategically selecting within sectors and countries.

Linton wrote: »

It mostly talks about asset behaviour during the 2008 crash. At that time 20 year gilt yields were in the 4.5%-5.0% range, a very different situation to the current 0.9%.

Indeed, hence my comment earlier. I'm not sure that any back test that only goes back to the 1970s will be reflective of where are now.

Also, what might have worked in a US context may well not in a UK one.