Best allocation across Cash, Bonds & Equities?

[Deleted User]

Unlike Equity there is no argument that can be made about the market knowing best. 

Bonds are priced based on a range of factors, including risk, duration, interest rates, inflation, government actions etc.  And its the market that is doing the pricing. If a particular bond is mispriced market actors move in and the price is adjusted.  As with shares, it all comes down to demand and supply. 

In summary, the argument for “market knows best” is exactly the same as for shares.  One could argue that at least some bonds are not quite as liquid and therefore there is more opportunities for mispricing (particularly junk bonds) but suggesting that duration is one and only criterion for buying bonds is incorrect. 

Linton

Deleted_User said:

Unlike Equity there is no argument that can be made about the market knowing best. 

Bonds are priced based on a range of factors, including risk, duration, interest rates, inflation, government actions etc.  And its the market that is doing the pricing. If a particular bond is mispriced market actors move in and the price is adjusted.  As with shares, it all comes down to demand and supply. 

In summary, the argument for “market knows best” is exactly the same as for shares.  One could argue that at least some bonds are not quite as liquid and therefore there is more opportunities for mispricing (particularly junk bonds) but suggesting that duration is one and only criterion for buying bonds is incorrect. 

The thread is talking about high level asset allocation.  When bonds are specified one normally means low risk mainly government bonds.  Junk bonds are something quite diffeent.

The government bond market is highly liquid which is why there is no chance of significiant mis-pricing.  The point I am making is that most safe bonds are not purchased on the basis of a 10-year bond being better or worse value than a 40 year one.  A 10-year bond will be purchased because the purchaser wants a 10-year bond and a 40-year one wont do. Just because a bond is the highest ranked on a cap weighted index says nothing whatsoever as to its suitability for a particular private investor - it is probably there because the government just happened to issue more of them.

MX5huggy

But a 40 year bond will do because the market is highly liquid and I can sell it in 10 years.

Thrugelmir

MX5huggy said:

But a 40 year bond will do because the market is highly liquid and I can sell it in 10 years.

If you are of the view that the Fed is going to raise rates twice in 2023. Then locking into a 40 year bond may not be appropriate. Whereas a 10 year, or shorter duration bond provides an exit point. With the ability to reinvest the proceeds at a higher rate of return. 

MX5huggy

 But the price of the 40 year bond will reflect that.

Thrugelmir

MX5huggy said:

 But the price of the 40 year bond will reflect that.

Yields are surprisingly low even for long dated gilts. Demand exceeds supply. 

[Deleted User]

Linton said:

Deleted_User said:

Unlike Equity there is no argument that can be made about the market knowing best. 

Bonds are priced based on a range of factors, including risk, duration, interest rates, inflation, government actions etc.  And its the market that is doing the pricing. If a particular bond is mispriced market actors move in and the price is adjusted.  As with shares, it all comes down to demand and supply. 

In summary, the argument for “market knows best” is exactly the same as for shares.  One could argue that at least some bonds are not quite as liquid and therefore there is more opportunities for mispricing (particularly junk bonds) but suggesting that duration is one and only criterion for buying bonds is incorrect. 

The thread is talking about high level asset allocation.  When bonds are specified one normally means low risk mainly government bonds.  Junk bonds are something quite diffeent.

The government bond market is highly liquid which is why there is no chance of significiant mis-pricing.  The point I am making is that most safe bonds are not purchased on the basis of a 10-year bond being better or worse value than a 40 year one.  A 10-year bond will be purchased because the purchaser wants a 10-year bond and a 40-year one wont do. Just because a bond is the highest ranked on a cap weighted index says nothing whatsoever as to its suitability for a particular private investor - it is probably there because the government just happened to issue more of them.

There are different market participants. Some need to match duration to liability. Others don’t.  Thats part of how market pricing is defined. Not sure why you think that the market is mis-pricing bonds. 

[Deleted User]

For me the concern isn’t with life insurance companies buying bonds of a very particular duration but with the governments messing with the markets by buying their own bonds (aka easing).  That’s price manipulation.  Governments certainly can and do impact pricing at whim.    But the governments are “manipulating” stock prices too.  In the end, its a market participant and the market still rules. 

JohnWinder

Linton said:

 I fail to see what relevence this has to meeting a private investor's objectives.

If you want to buy safe bonds it must make more sense to copy the institutions and choose ones with maturity dates that match your needs.  For example, buying bonds that mature around your planned retirement date for a pension, or perhaps a ladder of bonds that mature at 10-year intervals.

As far as I can see there are no funds that assist an investor wishing to do this.  There are funds of bonds that mature in say 3-10 years.  But if course in 5 years time it will still hold bonds that mature in 3-10 years.

I think the way around bond funds having fixed duration, and we having moving durations, is to buy two funds, one with a short duration and one with a duration as long as our own duration. Then, as our duration falls, one re-balances between the two bond funds to get an 'average' duration matching our own, eg by selling some of the long duration fund and buying more of the short. This gives you the benefit of holding more of the long duration fund, which should have better returns, for as long a time as possible.

Linton

MX5huggy said:

But a 40 year bond will do because the market is highly liquid and I can sell it in 10 years.

Yes but were interest rates to rise significantly in the next 10 years your 40 year bond could be worth half its current value.  The problem is that bonds only provide a guaranteed return if you keep them until maturity.

For example a 15 year bond issued for £100 in September 2020 is now worth £96.40.  But a 55 year bond issued for £100 in 2013 is now worth £197.  However when it matures it will only be worth £100.  No-one knows what will happen between now and then - it cant increase it price by the same amount again since it would have a significant negative return even if you kept it until maturity.  However it has plenty of room to drop by 50%.