Buying into bond funds in 2020 - is the world enough?

RetSol · 17 July 2020 at 9:17AM

"Investing in bonds shields you from the volatility and inflation proofs your savings" is the conventional wisdom. But I see many posts on this Forum challenging this. I have just moved from 100% equity investments to 60/40 equities/bonds (all in OEICs in a S+S ISA/DC pot) in an attempt to de-risk a bit as I am retired. The posts on this subject I am seeing make me think that the 40% might be better off in cash as the thinking in many quarters seems to be that bonds no longer fulfil the aforementioned ("...") functions and carry additional risks. I am investing for the long-term (10+ years). Should I be re-thinking my use of bond funds? And, if so, why ?

Albermarle · 17 July 2020 at 9:25AM

I just replied to this on the other thread. For what it is worth here is my simplistic view again

The same negative sentiment about bonds was expressed before Covid hit . However in general they did their job during the recent downturn , and some bonds funds did surprisingly well . However with more QE and some bonds with an almost negative yield , then the bond bull run has probably had its last hurrah. However I do not think such a huge global investment market sector can really be ignored in a portfolio , although cash at retail interest rates ( especially if you have a fix at > 1.5%) looks a good ( partial ) alternative at the moment .

83705628 · 17 July 2020 at 9:42AM

All bond funds yield less than NS&I, it's not a sensible long term investment.
Investment grade - say 50% vanguard UK and 50% vanguard us - should yield upto 1.7% over the next 10 years after fees but before defaults.

bowlhead99 · 17 July 2020 at 10:02AM

The idea of having a 'diversified' portfolio is generally to assemble a bunch of assets that can each give a reasonable return but are not necessarily correlated with each other - so stocks, bonds, properties etc - and those components will go up and down at different times, so when rebalancing to maintain your allocations you will naturally be selling something that has gone up more to buy more of something that went down or went up less, which helps volatility and can enhance returns more than you might think.

Those components are less useful for reducing volatility if their returns are correlated with each other (e.g. interest rates go up so equities and long term bonds fall, or the economy goes into recession so equities fall and high yield bonds struggle). So a broad mix can be useful to cover every angle. Cash is not usually used, because if the premise is that the components "can each give a reasonable return", then cash is not very useful because cash is not going to even match inflation. But when the prices of some assets (e.g. short maturity government bonds) have been bid up to very high prices / very low yields, cash will not be worse than holding those expensive, low-yielding assets.

While many investors will be positioning away from certain bond types which don't appear to offer much in the way of return, and the usefulness of different types of bonds can differ at different points in an economic cycle (gilts, index linked, foreign government, investment grade corporate, high yield corporate, international developed/emerging markets etc), some of them will generally still have a place in a portfolio.

If you are investing outside a wrapper using cash deposits or premium bonds you can get 'not terrible' interest rates of 1% or so, dropping to about 0.7% if you are using an ISA, and in a pension the cash offerings are even lower - all cash options are looking worse than likely long term inflation. With bonds, the yields can be higher than those cash rates, or there can be the chance of capital appreciation if/when interest rates fall further, though you are taking investment risk (the credit risk of the borrower not repaying, the market risk of capital values changing as a result of prevailing interest rates or changes in economic conditions, and currency risk if the bonds are overseas and unhedged).

Capital appreciation rather than interest rate yields is what has driven the returns of bond funds over recent years, and people keep saying the only way is down, yet something else keeps happening to push them further up (this year was Covid, as central bank base rates fell to the floor again and QE resumed). Jupiter Strategic Bond has a mix of gilts and higher yielding holdings and is up 4% since the start of the year (though was down 6% at one point having suffered a 10% drop before recovering).

Clearly 4% in six months is better than cash rates, but you're not going to get 4% each and every 6 months period, because super safe government bonds literally have negative yields and super risky bonds can crash hard in recessions or when equities take a hit, and a position somewhere in the middle may do nothing or give an overall loss.

I posted some thoughts about how 'you can't get decent inflation-proofed safe returns in a pension without taking risk' in another thread today, which may be of interest even if not addressing your exact question. https://forums.moneysavingexpert.com/discussion/comment/77402079#Comment_77402079

Being 100% in equities is highly volatile as you know, so 40% or more in the category of 'not in equities' is fine. However, if cash or gilts for that 40% sounds highly unattractive because the prospective returns on low risk assets are poor, maybe you need to rationalise it a different way - for example by making your 'non equities' holding be greater (say 60% instead of 40%) but have that 60% be low-medium risk instead of low risk, and achieve that low-medium risk with a blend of equities, bonds, property, cash, gold, etc; a mixed-asset fund or two which have a strategy tilted more towards capital preservation than growth.

Practically speaking if you did a look-through of what was in the '60% low-medium risk' part of the portfolio, you would find that you (or the fund manager you trust to run that part of it) would still end up using bonds, and cash, as part of it, because that's how you create a lower-than-high-risk product out of something that includes equities. So arguably it is just smoke and mirrors, or a bit of 'man-maths' to help you get comfortable with the fact that bonds and cash are being used, but without directly having the non-equities piece of your portfolio tagged as 'bonds' while people are telling you that 'bonds' are useless. Whatever helps you sleep at night.

RetSol · 17 July 2020 at 10:16AM

Albermarle said:

I just replied to this on the other thread. For what it is worth here is my simplistic view again
The same negative sentiment about bonds was expressed before Covid hit . However in general they did their job during the recent downturn , and some bonds funds did surprisingly well . However with more QE and some bonds with an almost negative yield , then the bond bull run has probably had its last hurrah. However I do not think such a huge global investment market sector can really be ignored in a portfolio , although cash at retail interest rates ( especially if you have a fix at > 1.5%) looks a good ( partial ) alternative at the moment .

Thank you for replying (twice) - apologies for the inconvenience. My impression is that many bond funds have done OK recently, as you say.
Re depositing cash, the difficulty is that I don't think that there are too many fixes available at 1.5% plus atm. I missed the boat on the better fixed rates a few months ago. As for my cash generally, the fixes/bonuses which I have expire by next Spring and I am assuming (pessimistically) that the BOE base rate will be cut again this year so that from next Spring the return on my cash will be close to zero. I have some NS&I investment bonds but I suspect that the market-busting rates currently paid by NS&I will be cut from the Autumn as the UK economy is removed from life support.

Albermarle · 17 July 2020 at 10:37AM

Re depositing cash, the difficulty is that I don't think that there are too many fixes available at 1.5% plus atm. I missed the boat on the better fixed rates a few months ago.

I did not miss the boat and still have some older fixes as well. However as you say when they come up for renewal , I do not think the rates will be very exciting.....

RetSol · 17 July 2020 at 10:59AM

bowlhead99 said:

The idea of having a 'diversified' portfolio is generally to assemble a bunch of assets that can each give a reasonable return but are not necessarily correlated with each other - so stocks, bonds, properties etc - and those components will go up and down at different times, so when rebalancing to maintain your allocations you will naturally be selling something that has gone up more to buy more of something that went down or went up less, which helps volatility and can enhance returns more than you might think.

Those components are less useful for reducing volatility if their returns are correlated with each other (e.g. interest rates go up so equities and long term bonds fall, or the economy goes into recession so equities fall and high yield bonds struggle). So a broad mix can be useful to cover every angle. Cash is not usually used, because if the premise is that the components "can each give a reasonable return", then cash is not very useful because cash is not going to even match inflation. But when the prices of some assets (e.g. short maturity government bonds) have been bid up to very high prices / very low yields, cash will not be worse than holding those expensive, low-yielding assets.

While many investors will be positioning away from certain bond types which don't appear to offer much in the way of return, and the usefulness of different types of bonds can differ at different points in an economic cycle (gilts, index linked, foreign government, investment grade corporate, high yield corporate, international developed/emerging markets etc), some of them will generally still have a place in a portfolio.

If you are investing outside a wrapper using cash deposits or premium bonds you can get 'not terrible' interest rates of 1% or so, dropping to about 0.7% if you are using an ISA, and in a pension the cash offerings are even lower - all cash options are looking worse than likely long term inflation. With bonds, the yields can be higher than those cash rates, or there can be the chance of capital appreciation if/when interest rates fall further, though you are taking investment risk (the credit risk of the borrower not repaying, the market risk of capital values changing as a result of prevailing interest rates or changes in economic conditions, and currency risk if the bonds are overseas and unhedged).

Capital appreciation rather than interest rate yields is what has driven the returns of bond funds over recent years, and people keep saying the only way is down, yet something else keeps happening to push them further up (this year was Covid, as central bank base rates fell to the floor again and QE resumed). Jupiter Strategic Bond has a mix of gilts and higher yielding holdings and is up 4% since the start of the year (though was down 6% at one point having suffered a 10% drop before recovering).

Clearly 4% in six months is better than cash rates, but you're not going to get 4% each and every 6 months period, because super safe government bonds literally have negative yields and super risky bonds can crash hard in recessions or when equities take a hit, and a position somewhere in the middle may do nothing or give an overall loss.

I posted some thoughts about how 'you can't get decent inflation-proofed safe returns in a pension without taking risk' in another thread today, which may be of interest even if not addressing your exact question. https://forums.moneysavingexpert.com/discussion/comment/77402079#Comment_77402079

Being 100% in equities is highly volatile as you know, so 40% or more in the category of 'not in equities' is fine. However, if cash or gilts for that 40% sounds highly unattractive because the prospective returns on low risk assets are poor, maybe you need to rationalise it a different way - for example by making your 'non equities' holding be greater (say 60% instead of 40%) but have that 60% be low-medium risk instead of low risk, and achieve that low-medium risk with a blend of equities, bonds, property, cash, gold, etc; a mixed-asset fund or two which have a strategy tilted more towards capital preservation than growth.

Practically speaking if you did a look-through of what was in the '60% low-medium risk' part of the portfolio, you would find that you (or the fund manager you trust to run that part of it) would still end up using bonds, and cash, as part of it, because that's how you create a lower-than-high-risk product out of something that includes equities. So arguably it is just smoke and mirrors, or a bit of 'man-maths' to help you get comfortable with the fact that bonds and cash are being used, but without directly having the non-equities piece of your portfolio tagged as 'bonds' while people are telling you that 'bonds' are useless. Whatever helps you sleep at night.

That's incredibly helpful, Mr Bowlhead. As you say, I need an approach that allows me to sleep at night. I think that I have been spooked temporarily by the anti-bond sentiments which I have encountered. However, personally speaking, I am more potentially spooked by the "smoke and mirrors" effect of using mixed asset funds. I have deliberately chosen funds which are more or less "pure" equities or bonds. That way, I feel (rightly or wrongly) that I have a better idea of what I am investing in. It feels as though that is rather an old-fashioned approach these days but I have always been a contrarian and it's worked well enough for me so far.

Albermarle · 17 July 2020 at 11:22AM

Might be of interest.
https://monevator.com/bond-prices/

dunstonh · 17 July 2020 at 12:48PM

When you look at the fluid asset allocation models, you will see that they have been negative towards bonds for some time and Covid just reduced their allocations further. Now you are generally seeing only higher risk bonds used in the higher risk portfolio as investment potential and not lower risk bonds in lower risk portfolios as the downside protection is not as strong as usual and cash or gilts are viewed as the least worst options.

RetSol · 17 July 2020 at 6:38PM

I have sold some units today, taking some profits, which gives me enough cash to top up my income from my DB pension etc over the next 18 months. I will stick to my investment allocation but with a bigger cash buffer as a result of today's sale of units. I need to rebalance now but, after that, I will strap myself in, wait for the next period of extreme volatility (which I believe will come) and then close my eyes.... .