Which bond index funds to balance portfolio?

Victorwelldue

I've pretty much settled on a 70% equity / 30% bond split for my workplace pension and I'm fairly happy with my equity fund choices but I'm more perplexed by which bond funds to choose.

So I'm trying to understand what are the characteristics of bond index funds that I should be looking for, for this purpose. For example:

• Stick to UK or diversify with world? (If so in which proportions?)
• Stick to Gilts & T-Notes or diversify with corporate? (If so in which proportions?)
• Inflation index linked or not?
• High yield or not?
• Maturing over 5 years? 15 years? Does this even matter when it will only be index funds anyway?
• Diversify over multiple bond index funds or just stick to one or two?
• Are bonds enough? I also have limited choice to a couple of cash & property funds - should these be considered too?

Hopefully retiring in somewhere between 8 to 12 years.
  

GeoffTF

Here is an article:

https://monevator.com/are-bonds-a-good-investment/

It is a complex subject. Opinions differ, but international bonds should be hedged into sterling. Vanguard makes heavy use of hedged global bonds in its packaged portfolios. They are less volatile than gilt funds, but have higher costs. Its OK to just use those. Others do not like them. Its OK to just use a gilt tracker. Long dated gilts are likely to cushion equity market falls better, but are more vulnerable to interest rate rises. I would stick to top rated government bonds and perhaps top rated corporate bonds (i.e. not high yield bonds). If you want more risk, increase your equity allocation. Bonds are there for protection, not profit. You already have all the property companies in a global equity tracker. You do not need to overweight them. People often like to include some index linked bonds to provide some inflation protection. Vanguard includes some in its packaged funds.

dunstonh

Global will mean currency fluctuations.  So, it wont be as much as a risk reducer as UK fixed interest (or hedged)
Gilts will mean lower risk than corp bonds 
Index linked can be more volatile
High yield increases risk as much as equities.
Time to maturity - depends on your chosen level of management
multiple fixed interest funds will depend on which areas you choose.
property share is higher risk than conventional equity. bricks and mortar property is best avoided.  At least until the FCA have completed their consultation on future structures.
cash is a volatility reducer but it wont return any money in real terms (and may lose in real terms).  That said, increasing equities and reducing fixed interest and holding cash instead may give you a similar volatility level.

You are probably going to be limited by your workplace pension.   And if you are tracker biased then you probably don't want to be making the decisions too much and just go for a catchall.

JohnWinder

Retire in 10, and live another 25, it’s a 35 year horizon.
Bonds are for safety/stability in a 70/30 portfolio (#1).

Q1. #1 would suggest UK alone is not the safest, but plenty of folk in stable developed economies think home bonds are safe enough. Where your feeling lie on that spectrum says whether you’ll be all UK or just 50/50 UK/foreign.

Q2. #1 would suggest government only, and stable governments’ at that. If you want slightly better returns (that corporates' give) with more risk, just increase your stocks from 70% to 75-80%.
Q3. All fixed rate bonds have baked into their yield the market’s view on inflation down the track; just think about it: inflation has been ubiquitous, so any lender (you as a bond holder) will get your money back at maturity but it will buy less, so you need some compensation for expected inflation. If inflation turns out as expected, both linkers and nominal bonds will have very similar real yields (the only yield that counts in an inflationary world). If inflation turns out to be more than expected, the linkers will do better than nominal bonds. Deflation benefits nominal bonds. Is unexpected inflation a bigger threat to you than deflation or ‘normal’ inflation? If so you need some linkers. Logic might suggest close to 100% of your bonds, since bad inflation early in retirement is bad news, but a two way bet is half as linkers and half nominals.
Q4. Not. See A2.
Q5. It matters, and since you’re talking about bond funds, better to think in terms of ‘duration’ not maturity although they move together. Long bonds have given the best protection in a stock crash, but are the most sensitive to interest rate changes. Duration should be a bit matched to your time horizon, but it’s an imperfect art and choices are often limited. Perhaps compromise with intermediate term government bond funds.
Q6. See A3 and A1. Keep it simple, but you’d be lucky to get away with one or perhaps even two.
Q7. Bank accounts pay more than cash funds, and cost less don’t they?  Keep it simple: you’ll get property with diversified equities.

GeoffTF

dunstonh said:

Global will mean currency fluctuations.  So, it wont be as much as a risk reducer as UK fixed interest (or hedged)

That is why global bonds should be hedged into the local currency. If they are they are, they will be much less volatile than a local currency fund. Look at the charts for VAGP and VGOV. Portfolios with global hedged bonds rather than local bonds have lower volatility, particularity if they have a high bond percentage (Vanguard research). Nonetheless, VGOV tends to go up on sharp equity market falls, whereas VAGP does not, so it has fans (see the Monevator article linked above).

dunstonh said:

You are probably going to be limited by your workplace pension.   And if you are tracker biased then you probably don't want to be making the decisions too much and just go for a catchall.

I have attempted to give brief answers to the questions, for what it is worth. Nonetheless, the OP is likely to do best by just picking the catchall packaged fund. His pension almost certainly has one. What is wrong with it?

aroominyork

Considering just the UK vs. global (developed world, hedged) govt bond/gilt aspect, a global fund is likely to be less volatile although, over the long run, the two might perform similarly. The fees for the global fund are higher and you pay for the hedging; you also lose most of the index-linked holdings that a UK fund would give you. Below is VGOV (Vanguard's UK gilt ETF) and IGLH (Ishares' hedged developed world govt bond ETF) since the latter launched in early 2018.

I personally hold Vanguard's Global Bond Index which is about 60% govt, 40% corporate. It is cheaper than IGLH and I am happy to have some high quality corporate bonds as part of the mix.

dunstonh

I have attempted to give brief answers to the questions, for what it is worth. Nonetheless, the OP is likely to do best by just picking the catchall packaged fund. His pension almost certainly has one. What is wrong with it?

Nothing wrong with it.   However, the OP seemed to want to decide for themselves which types of fixed interest securities they want to hold.  So, it wouldn't meet that objective.

Linton

With developed world government bonds time to maturity can be a bigger factor than country of origin.  Bond index funds generally hold bonds with a motley collection of maturity dates, typically averaging 10-15 years.  This, I believe makes them at least questionable as a major component of a balanced portfolio bought to provide protection agtainst equity falls.

At the moment historic long dated bonds are priced well above face value. For example there is a Gilt maturing in 2055 at a price of £182.  You know with absolute certainty that the price will be £100 in 2055.  Therefore between now and 2055 there will be a close to halving in value which could occur before the relatively high interest return provides significant compensation. The opportunity for a price increase is small as at a much higher price the total returns between now and maturity would be negative in £ terms.

Equally, if you buy a long dated bond now paying 1.25% interest it would cost you about £100.Were general interest rates to rise to 4% today its value would also halve. 

This level of risk does seems to me to be a high cost for protection against equity falls which also could perhaps be around 50%.

GeoffTF

dunstonh said:

I have attempted to give brief answers to the questions, for what it is worth. Nonetheless, the OP is likely to do best by just picking the catchall packaged fund. His pension almost certainly has one. What is wrong with it?

Nothing wrong with it.   However, the OP seemed to want to decide for themselves which types of fixed interest securities they want to hold.  So, it wouldn't meet that objective.

That question was directed to the OP, rather than yourself or being purely rhetorical. The OP does indeed seem to want to decide for himself. Nonetheless, his questions indicate that he is not an expert in the subject. That raises obvious questions. As I have said, this is a complex subject. Even if he did become an expert in it, that would not necessarily help. The future is unknown. Nonetheless, there may be something wrong with the default option offered to him. It may have high charges, for example.

GeoffTF

Linton said:

With developed world government bonds time to maturity can be a bigger factor than country of origin.  Bond index funds generally hold bonds with a motley collection of maturity dates, typically averaging 10-15 years.  This, I believe makes them at least questionable as a major component of a balanced portfolio bought to provide protection agtainst equity falls.

The UK gilt market has an unusually long duration. VGOV (which is an aggregate gilt fund) currently has a duration of 14.2 years. VAGP (which is an aggregate global bond fund hedged into sterling) currently has duration of 7.7 years. If you want maximum protection against stock market falls, you want an investment that has the largest possible negative correlation with stock market prices. That investment is long dated government bonds. You think that they are overpriced, but the market disagrees. I bought VAGP rather than VGOV, but that may not have been the best choice.

GeoffTF

aroominyork said:

I personally hold Vanguard's Global Bond Index which is about 60% govt, 40% corporate. It is cheaper than IGLH and I am happy to have some high quality corporate bonds as part of the mix.

VAGP and the accumulating version VAGS are the ETF versions of the Vanguard's Global Bond Index fund. They are cheaper, but hold less bonds. VAGP and VGOV both have the same average quality of AA-. VAGP has a higher effective YTM, but also a higher OCF and transaction costs. Clearly, VAGP has a greater spread of credit risk. Vanguard UK's head of portfolio construction recently said in an interview that their global bond funds were are good starting point and ending point for any portfolio. That is the advice that they are giving their institutional clients.