Bond Malaise

JohnWinder

One man's poison....

Less reward is on the horizon, and bonds have more risk now, so we move from 60/40 to 70/30? Not sure; my risk appetite didn't increase, is it smart to increase risk to chase reward? Everyone will have their own view I suppose. If I could be comfortable with that extra risk I'd have taken it previously and had better rewards then.

Buy higher risk bonds? Same problem, for me.  Do it by all means, but reflect on what it means first.

[Deleted User]

JohnWinder said:

One man's poison....

Less reward is on the horizon, and bonds have more risk now, so we move from 60/40 to 70/30? Not sure; my risk appetite didn't increase, is it smart to increase risk to chase reward? Everyone will have their own view I suppose. If I could be comfortable with that extra risk I'd have taken it previously and had better rewards then.

Buy higher risk bonds? Same problem, for me.  Do it by all means, but reflect on what it means first.

The issue is that long duration bonds are higher risk and lower reward than 3 years ago.  So you are getting more risk if you do nothing. The shift in equity/bond split might keep you on the efficient frontier. 

I am not a fan of junk bonds personally but it depends on objectives and role in the portfolio. But there are other instruments which can mitigate inflation/yield risk. Like certain foreign bonds or pref shares. 

NedS

JohnWinder said:

Yes, clearly. But you'd anticipate their return would be less that corporate bonds. Investors in efficient markets are offered rewards for taking more risk: corporates are more likely to default, so the yield is higher commensurate with the market's view on how much default is expected. Which kind of leads you to think: why would you bother trying to choose corporate bonds when you can simply hold more equities for more return and more risk? Not that it would be a crime, but there's something to be said for keeping it simple.

But don't forget, nominal government bonds will be hammered if inflation goes nuts. You get protection from that with inflation linked bonds.

Because they occupy a space on the risk/reward spectrum between low yield/low risk government bonds and higher risk/higher rewards equity. Corporate bonds are less volatile that equity, and during a crisis, share price and dividends are far more likely to suffer first (Covid!) before the company defaults on it's debt. In a simplistic view, unless the company goes bust you should get your 5% - 6% coupon each year, and the default risk can be mitigated through holding a well diversified fund. For these reasons I am happy to hold some corporate debt funds as part of my well diversified income portfolio.

Further, some companies are now so indebted as to be almost too big to fail (may not Evergrande). Those who have lent billions to Carnival are probably not willing to let them go under (inheriting a share of 6 cruise ships isn't of much use to a corp bond fund) so there is pressure to keep lending them more or refinance the debt to keep them afloat (no pun intended!), all the time paying those juicy coupons.

And a well managed fund like Fidelity MoneyBuilder mentioned by the OP also has the flexibility to build a portfolio based on the risks/rewards as they see them at that time depending on their view of corp bonds vs government bonds.

JohnWinder

Deleted_User said:

The issue is that long duration bonds are higher risk and lower reward than 3 years ago.  So you are getting more risk if you do nothing.

I'll say I don't know one way or the other about that, but this push-back comes to mind.

Risk with long duration bonds can be based on what you think about them, now compared with another time, or it can be quantified as standard deviation calculated from price variations. If long duration bond fund standard deviations for the last year/2 years is greater than for the preceding year/2 years, then they HAVE had higher risk recently but that doesn't mean they are now and going forward going to have a higher standard deviation. So on that basis I'd question whether these bonds are more risky now. Fundamentally, they shouldn't be, as the duration is the same (if it is), the government's credit worthiness is the same. We could say: inflation is going to get worse, or interest rates will rise, but they're predictions about risk, not a statement of verifiable fact like a standard deviation. Similarly, their reward from now forward can only be speculation; so to say they have lower reward is open to challenge in my view.

As to keeping one on the efficient frontier, well, might/might not, I don't know how anyone could know ahead of time.

michaels

JohnWinder said:

Deleted_User said:

The issue is that long duration bonds are higher risk and lower reward than 3 years ago.  So you are getting more risk if you do nothing.

I'll say I don't one way or the other about that, but this push-back comes to mind.

Risk with long duration bonds can be based on what you think about them, now compared with another time, or it can be quantified as standard deviation calculated from price variations. If long duration bond fund standard deviations for the last year/2 years is greater than for the preceding year/2 years, then they HAVE had higher risk recently but that doesn't mean they are now and going forward going to have a higher standard deviation. So on that basis I'd question whether these bonds are more risky now. Fundamentally, they shouldn't be, as the duration is the same (if it is), the government's credit worthiness is the same. We could say: inflation is going to get worse, or interest rates will rise, but they're predictions about risk, not a statement of verifiable fact like a standard deviation. Similarly, their reward from now forward can only be speculation; so to say they have lower reward is open to challenge in my view.

As to keeping one on the efficient frontier, well, might/might not, I don't know how anyone could know ahead of time.

I guess 'reversion to mean' may be a consideration - if bond prices are in the middle of their historic range then believing there is an equal likelihood of them going up or down is psychologically easier than holding that same belief when they are at an all time high.

JohnWinder

For these reasons I am happy to hold some corporate debt funds as part of my well diversified income portfolio.

I think you make a good case to justify corporate bonds. They lie somewhere between equity and government bonds in risk and return, sure. If there was perfect market efficiency with the equity market(s) tightly interwoven with the bond markets, then there'd be no risk/return bargains or badly priced assets such that whether you chose this equity or that bond what you lost in return you'd gain in better risk. No one pretends there is such efficiency but with investment choices as easy to make as they are you'd imagine it's all pretty efficient. If so, you don't need a raft of different asset types in your portfolio: you just need a high risk high return one and a low risk low return one which you mix to suit your tolerance/needs. To add something extra suggests one thinks there are some bargains based on market inefficiency, and that you can benefit from it.

I have my doubts that there's much or anything to be gained that way, and nothing has jumped out from the data to suggest to me that if you want to keep a portfolio simple that you'll lose out in terms of risk and return.

If you look at the return charts of corporate bonds they seem to act very much like ?30% equity and ?70% government bonds.

They're not a silly asset, but I don't think folk looking to keep things simple need to fear they're missing out not having them

Linton

JohnWinder said:

Deleted_User said:

The issue is that long duration bonds are higher risk and lower reward than 3 years ago.  So you are getting more risk if you do nothing.

I'll say I don't know one way or the other about that, but this push-back comes to mind.

Risk with long duration bonds can be based on what you think about them, now compared with another time, or it can be quantified as standard deviation calculated from price variations. If long duration bond fund standard deviations for the last year/2 years is greater than for the preceding year/2 years, then they HAVE had higher risk recently but that doesn't mean they are now and going forward going to have a higher standard deviation. So on that basis I'd question whether these bonds are more risky now. Fundamentally, they shouldn't be, as the duration is the same (if it is), the government's credit worthiness is the same. We could say: inflation is going to get worse, or interest rates will rise, but they're predictions about risk, not a statement of verifiable fact like a standard deviation. Similarly, their reward from now forward can only be speculation; so to say they have lower reward is open to challenge in my view.

As to keeping one on the efficient frontier, well, might/might not, I don't know how anyone could know ahead of time.

You seem to be trying to apply equity thinking to bonds.  I am afraid it does not work, safe bonds are a totally different animal.  In particular risk is nothing to do wth standard deviation but rather to basic mathematics.  The key point is that the price for a given bond is tightly linked to prevailing interest rates which generally only move slowly.  Consideration of reasonable bounds to interest rates enables one to calculate the resultant maximum and minimum price at which a particular safe bond could trade in its entire lifetime. 

Since soon after the 2008 crash short and medium term bonds have been priced close to their maximum bound because of the very low interest rates.  Long dated bonds were not affected so much initially but have increased in price significantly over the past 5 years.  So for example a 3.5% gilt was issued in 2014.  It is now priced at £143.  Were interest rates to return to 2014 levels  the price would return to £100. There are many long dated bonds issued prior to 2014 at higher interest rates.

JohnWinder

michaels said:

I guess 'reversion to mean' may be a consideration - if bond prices are in the model of their historic range then believing there is an equal likelihood of them going up or down is psychologically easier than holding that same belief when they are at an all time high.

Yes, but to unpick that for would-be bond investors...

Again, no idea about whether mean reversion will prevail, but let's say it does. Bond fund investors are unwise to hold a fund with a duration which is longer than their 'spending duration', because the value loss from interest rate rises won't be compensated for by the better coupons until however many years after the last interest rate rise that the fund duration is. So someone 55 years old with perhaps 30 years investing time left and 10 years before they need to start their retirement income stream should be comfortable holding a bond fund with a duration of 8 years.

If that's the case, wouldn't that bond holder prefer to hold a fund which will soon have a yield of 5%/year rather than 1%/year as a consequence of interest rates rising from 1% to 5% in the next 3 or 4 years?  Clearly, it's a much better yielding fund, and any price damage from rising interest rates has been compensated for by age 67 (4 years of rate rises and 8 years of duration).

Investors need to understand, a bit, about what they're doing, but it seems to me that anyone holding a sensible duration bond fund now would be praying for interest rates to rise.

Linton

michaels said:

JohnWinder said:

Deleted_User said:

The issue is that long duration bonds are higher risk and lower reward than 3 years ago.  So you are getting more risk if you do nothing.

I'll say I don't one way or the other about that, but this push-back comes to mind.

Risk with long duration bonds can be based on what you think about them, now compared with another time, or it can be quantified as standard deviation calculated from price variations. If long duration bond fund standard deviations for the last year/2 years is greater than for the preceding year/2 years, then they HAVE had higher risk recently but that doesn't mean they are now and going forward going to have a higher standard deviation. So on that basis I'd question whether these bonds are more risky now. Fundamentally, they shouldn't be, as the duration is the same (if it is), the government's credit worthiness is the same. We could say: inflation is going to get worse, or interest rates will rise, but they're predictions about risk, not a statement of verifiable fact like a standard deviation. Similarly, their reward from now forward can only be speculation; so to say they have lower reward is open to challenge in my view.

As to keeping one on the efficient frontier, well, might/might not, I don't know how anyone could know ahead of time.

I guess 'reversion to mean' may be a consideration - if bond prices are in the model of their historic range then believing there is an equal likelihood of them going up or down is psychologically easier than holding that same belief when they are at an all time high.

Safe bond prices, eg UK Gilts, will only wander around a mid point if interest rates wander about a mid point.  UK interest rates have been broadly falling for the past 40 years, so if interest rates do revert to mean this is over a period far longer than the lifetime of most bonds. 

I guess this isnt what you mean but.....In a sense Gilts do revert to mean since they start at £100 and revert to £100 at maturity.  However if interest rates are moving in one direction the bond can spend its whole life above or below the "mean".

[Deleted User]

We could say: inflation is going to get worse, or interest rates will rise, but they're predictions about risk, not a statement of verifiable fact like a standard deviation. Similarly, their reward from now forward can only be speculation; so to say they have lower reward is open to challenge in my view.

Central Banks have been manipulating the price of bonds.  They have been buying humongous amounts of bonds.  That jacks up the prices and lowers yields.  This is going to end.  CBs may even start selling the bonds they accumulated.  And yes, we are seeing high and persistent inflation. It does not need to rise for bonds to be hammered.  Its already passed the target.  Last but not least, we know that nominal yields can only go below zero by so much. And eventually investors will get tired of negative real yields. 

The future is never a certainty. Its an event tree with probabilities.  And these probabilities have changed quite dramatically from 5 years ago. The risk-reward calculation looks very different now.