Please help me understand why bonds might be better- or worse- than cash.

Ray_Singh-Blue

Hi all. I have been hanging around these parts for a few years now, and have settled on the following asset allocation:

50% stocks, 50% bonds.

EXCEPT that so far, I haven’t been brave enough to buy bonds. The defensive, fixed income part of my portfolio remains in cash.

 My thinking has been this:

 A. As an individual, rather than an institutional investor, I have the option to use savings accounts rather than buy bonds or bond funds. So, I can save at 1.35% interest, rather than buy a 2 year UK Government Gilt yielding -0.16%

 B. Most bonds pay a fixed interest rate that becomes more attractive as interest rates fall, driving up demand and the price of the bond. If interest rates rise, investors will no longer prefer the lower fixed interest rate paid by a bond, resulting in a decline in its price.

 C. Interest rates are at historic lows, near zero or even below in some places. It is possible that they might drop further, but this would my knowledge be unprecedented & so I do not wish to bet on this happening. I think it is more likely they will rise than fall, in my investing lifetime.

Putting A + B + C together, I have so far opted for cash rather than bonds. Hoping for better returns.

The problem is that I have been WRONG WRONG WRONG, and I cannot work out why.

 

For example, UK interest rates rose in 2017 (from 0.25% to 0.5%) and again in 2018 (from 0.5% to 0.75%) and remained static in 2019. So I would have expected the value of bond funds to drop. Yet Vanguard’s UK government bond index returned over 4% per year during this period.

By comparison, my cash savings returned about 1.5% per year.

If I have invested £100 in bond funds over the last 5 years I would have £121. But because I saved cash I only have £107 

Questions:

1. Are my assumptions A,B and C correct?

2. Can you help me understand why bonds became more valuable, rather than less, when interest rates rose in 2017 and 2018?

3. Are you buying bonds right now?

Thanks for your insights and advice,

 Ray

barnstar2077

I can't insert the link atm, but the latest video on Penshioncraft's youtube channel "Where to invest in 2021" has a couple of segments about bonds.  If you look in the info under the video they are time stamped.  It may prove interesting. 

NottinghamKnight

You are right that you have more flexibility than many institutions so cash savings may well be considered more sensible than bonds. I keep premium bonds as a proxy for gilts as the return is higher, but with no potential for capital appreciation or loss. 
I think 2 is where you may be getting unstuck as it's bot necessarily the base rate now or in the short term but longer term expectations that determine movements, there's also a huge weight of money from institutional demand and the biggest factor is QE which it could be argued has pushed effective interst rates massively negative. 
Bonds have been in a bull market for years and even decades as long term interest rates have continued to decrease, it will have to stop somewhere. I have 5-10% in bonds but more than that in cash and premium bonds. 
I'm not buying bonds currently.

Another_Saver

Ray_Singh-Blue said:

Hi all. I have been hanging around these parts for a few years now, and have settled on the following asset allocation:

50% stocks, 50% bonds.

EXCEPT that so far, I haven’t been brave enough to buy bonds. The defensive, fixed income part of my portfolio remains in cash.

 My thinking has been this:

 A. As an individual, rather than an institutional investor, I have the option to use savings accounts rather than buy bonds or bond funds. So, I can save at 1.35% interest, rather than buy a 2 year UK Government Gilt yielding -0.16%

 B. Most bonds pay a fixed interest rate that becomes more attractive as interest rates fall, driving up demand and the price of the bond. If interest rates rise, investors will no longer prefer the lower fixed interest rate paid by a bond, resulting in a decline in its price.

 C. Interest rates are at historic lows, near zero or even below in some places. It is possible that they might drop further, but this would my knowledge be unprecedented & so I do not wish to bet on this happening. I think it is more likely they will rise than fall, in my investing lifetime.

Putting A + B + C together, I have so far opted for cash rather than bonds. Hoping for better returns.

The problem is that I have been WRONG WRONG WRONG, and I cannot work out why.

 

For example, UK interest rates rose in 2017 (from 0.25% to 0.5%) and again in 2018 (from 0.5% to 0.75%) and remained static in 2019. So I would have expected the value of bond funds to drop. Yet Vanguard’s UK government bond index returned over 4% per year during this period.

By comparison, my cash savings returned about 1.5% per year.

If I have invested £100 in bond funds over the last 5 years I would have £121. But because I saved cash I only have £107 

Questions:

1. Are my assumptions A,B and C correct?

Yes, and no one knows what's going to happen with interest rates in future, we can only hope to make less inaccurate guesses (I'm no exception).

2. Can you help me understand why bonds became more valuable, rather than less, when interest rates rose in 2017 and 2018?

You are using the BoE base rate. Your assumptions are correct but the gilt market is a supply/demand market and does not have to follow the BoE base rate, though over the long run they intuitively ought to stay close otherwise it wouldn't make sense (i.e.if gilts were 10% and cash were 1% no one would hold cash, vice versa no one would lend to the government, sic the cash and gilts market sort themselves out),

You should go on dmo.gov.uk and look at historic yeilds data with the same maturity as the Vanguard fund, I think about 19 or 20 years.

3. Are you buying bonds right now?

No, but my mum and dad's sipps do because interest paying cash isn't an option for that and I needed something to diversify the equity.

Thanks for your insights and advice,

 Ray

...

Thrugelmir

Ray_Singh-Blue said:

 B. Most bonds pay a fixed interest rate that becomes more attractive as interest rates fall, driving up demand and the price of the bond. If interest rates rise, investors will no longer prefer the lower fixed interest rate paid by a bond, resulting in a decline in its price.

For example, UK interest rates rose in 2017 (from 0.25% to 0.5%) and again in 2018 (from 0.5% to 0.75%) and remained static in 2019. So I would have expected the value of bond funds to drop. Yet Vanguard’s UK government bond index returned over 4% per year during this period.

Institutions unlike retail investors don't have the option of parking their cash in short term deposit accounts. Therefore Gilts provide them with a safe and accessible place to put the money. 

JohnWinder

You've done nothing wrong. Well, the true believers in bonds think you should be in bonds and not cash because long term bonds should return more than cash - after all, you're taking more risk. Secondly, people have been saying for ten years exactly what you're now: rates can't fall any further, or most likely won't, but they did.

Despite that, you've done nothing wrong because although your investment choices have not provided the highest return they might have during the period you've described your results, almost no one ever manages to fluke the perfect asset choice for the future (however long that is for them or you). With any sensible asset allocation, and yours is based on a decent understanding, you will spend a decent proportion of your time lamenting that you didn't have more of X, and for the rest of the time you will be lamenting you had so much of X. Unless of course you make a sensible plan and start believing in yourself. The enemy of a good plan is the pursuit of the perfect, or something like that. There are plenty of good enough plans, so don't mess with one in pursuit of the perfect and damage the good enough one.

masonic

There are a few other aspects to consider:

1. Bonds and cash are different animals: Cash has zero volatility and is therefore by definition uncorrelated with equities, whereas government bonds are negatively correlated with equities. This means that to balance your portfolio at the same overall volatility level, you'd need more in cash and less in equities than an equivalent equities:bonds split. When rebalancing your portfolio, you'll get less bang for your buck from cash. When money piles into bonds, that gives a short-term benefit to existing bond holders through rising prices, while when money piles into cash it is to the short- and long-term detriment of existing savers whose interest rates are slashed but they see no capital appreciation.
   
2. Some of the risk comes from holding a bond fund over which you have no control: If you hold government bonds directly, then your outcome is fixed at the point you buy them providing you hold them to maturity. Right now, you could invest in 10 year gilts and achieve a yield to maturity of about 0.25% (for example, current price £144, coupon 4.75%). As the bond nears maturity the price will tend towards the par value of £100, though it may fluctuate on the way. It is guaranteed to mature at par. There is a risk of a different outcome if you need to sell that bond before maturity. However, if your criteria for selling is a crash in equities, most likely you will be above the natural regression to par and your outcome will be more favourable than holding to maturity. Bond funds, which may sell bonds before maturity for other reasons (such as constraints in their mandates, or to try to generate higher returns) expose investors to higher risk of negative outcomes.
3. There are practical aspects to consider: It is less easy to manage a portfolio that includes a large amount held in cash. Rebalancing may be impractical if your investments are held in a SIPP or ISA, you may have to restrict yourself to (generally lower paying) cash ISAs to side-step the annual ISA allowance and some S&S ISA providers may not allow you to transfer part of your ISA.

One part I think you have been missing in your thinking is to look at the bigger picture with respect to investment expectations. The period you mention was a rather gloomy one for UK investors, so it is perhaps not surprising that while the FTSE stagnated and declined, UK government bonds were a beneficiary.

I have been gradually increasing the amount of cash I hold and gradually reducing my bond holdings over the past year or so. I will continue to do so in 2021. I see a lot of downward pressures on interest rates easing over the coming years, but I'm not going to wager too much on that prediction as I could well be wrong.

Albermarle

Thanks for your insights and advice,

Although you should be aware that most investment advice would be better described as opinion.

Last year there were plenty of posters on this forum warning about investing in bonds, but most bond funds have done well in 2020, although more earlier in the year than currently. Was that their last hurrah ? Who knows ?

One positive point for cash currently is that you can save at interest rates above inflation .

HansOndabush

If I have invested £100 in bond funds over the last 5 years I would have £121. But because I saved cash I only have £107 

Actually your cash investment has lost value to inflation of approx 13% over the last 5 years so your apparent gain of 7% is actually a 6% loss of purchasing power.

We have moved from a risk-free return environment 20 years ago to a return-free risk environment today. By which I mean simply to preserve one's wealth or purchasing power, it is necessary to take some risk.

HansOndabush

Albermarle said:

Thanks for your insights and advice,

One positive point for cash currently is that you can save at interest rates above inflation .

Was that a joke?

eskbanker

HansOndabush said:

Albermarle said:

Thanks for your insights and advice,

One positive point for cash currently is that you can save at interest rates above inflation .

Was that a joke?

Seems factual to me, savings interest rates are generally poor but many still exceed CPI at only 0.3% currently....