Price vs. Total Return on bond funds

aroominyork

There have been different views on here about whether you should just look to bond funds to pay income, or whether it’s valid also to look for capital growth. On HL charts because you can tab between Price and Total Return if you look at charts of an Inc. version of a fund – example below (Merian Global Strategic Bond). So my question is… does the price represent growth, and would it be fair to see that as cumulative premium/discount to NAV; while the difference between Price and total Return (c.10% over five years on the example below) shows the interest payments?

JohnWinder

To short-circuit a lot of arguing we might need to agree on what terms like 'growth' and 'NAV' mean. But even without that, would answering your question in the more favourable way, 'yes', give us something that is actionable to improve our returns? I doubt it. Did you have some strategy in mind?

If interest rates never changed, then I suppose the fund manager could buy new bonds for £100, and sell or redeem them for £100, so the value of the bonds in the fund never change. The only gain for the fund would be from reinvesting coupons. But as interest rates fall, the manager might have to pay £110 for a new bond, thus losing £10 in capital (and price for the fund if coupons were not reinvested). Is that relevant, or even correct?

Linton

As @JohnWinder says, in an ideal world where interest rates are constant bond prices would remain constant and the total return would simply arise from the interest and reinvestment of the interest.

However since the 1980s until recently interest rates have been falling leading to increased prices for existing bonds. So investors buying into bond funds and subsequently selling gained a premium to their total return from capital growth. As interest rates dropped to near zero the capital growth premium became larger than the interest component.

Clearly this is not a sustainable situation and has now reversed. Whilst interest rates are rising Investors who sell will make a capital loss reducing the effect of the higher interest rates. In the early stages this will lead to a negative total return as the price falls happen immediately whereas higher interest rates take time to make a significant difference.

This is nothing to do with actual price and NAV since with OIECs they are required to be the same. Premium/discount only applies to closed funds like ITs.

Winebottle

The difference between price and total return is the interest payments.

Does price represent growth? I would say no. Some people may define growth as price increases but I think of it as a growth in earnings/returns to investors. You don't get that with fixed income in the way you do with equities.

The fund mentioned doesn't trade at premium to the NAV. It's an OEIC that is priced daily based on NAV. Instead, any price increase is driven by increases in the price of the bonds it holds caused by falls in interest rates/credit spreads.

Linton

Having thought again and ignored your use of the terms NAV and premium/ discount I believe you are broadly correct in that the difference between price and TR represents the effect of the reinvested interest.

However seeing the price movements as representative of the behaviour of the asset value of the individual underlying bonds is too simple in my view.  For example this is a global fund and so will be affected by currency movements.  The fund will be buying and selling bonds to follow its strategy and buying additional bonds to replace any that mature and so could make trading gains and losses.

Finally I believe but do not know for sure that the TR graph is including the compounded reinvestment of interest whereas the price is a snapshot.  So the two graphs are not comparing the same fund. Even a very low interest rate will appear increasingly significant over time. Ideally I guess one would like to see a graph where the interest is assumed to remain in cash.

masonic

There are three elements of return:

1) Interest paid by the underlying bonds

2) Capital gains/losses of the underlying bonds while held, which can be regarded as 'income pulled forward' or 'income pushed back' into capital.

3) Capital gains/losses when traded

Point (3) can generally be ignored when holding bond index funds that hold to (near) maturity. Points (1) and (2) are different in tax treatment in unwrapped accounts, but (2) must start and finish at zero (ignoring defaults). Therefore, if you don't look at (1) and (2), you could get a misleading picture of your future returns potential and the past 6 months could have been surprising for you.

I would only regard capital gains achieved by (3) as growth, after subtracting any capital losses through defaults.

MK62

Linton said:

As @JohnWinder says, in an ideal world where interest rates are constant bond prices would remain constant........

....and inflation?....

Linton

masonic said:

There are three elements of return:

1) Interest paid by the underlying bonds

2) Capital gains/losses of the underlying bonds while held, which can be regarded as 'income pulled forward' or 'income pushed back' into capital.

3) Capital gains/losses when traded

Point (3) can generally be ignored when holding bond index funds that hold to (near) maturity. Points (1) and (2) are different in tax treatment in unwrapped accounts, but (2) must start and finish at zero (ignoring defaults). Therefore, if you don't look at (1) and (2), you could get a misleading picture of your future returns potential and the past 6 months could have been surprising for you.

I would only regard capital gains achieved by (3) as growth, after subtracting any capital losses through defaults.

Indeed, however that is for the very long term.  For the past 40 years most investors would have regarded (2) as part of their return and so are shoocked by recent events.

Linton

MK62 said:

Linton said:

As @JohnWinder says, in an ideal world where interest rates are constant bond prices would remain constant........

....and inflation?....

If you are includintg inflation linked bonds, yes.  Otherwise I dont think so.

aroominyork

JohnWinder said:

Did you have some strategy in mind?

Not a tactical trading one, No. My bonds are skewed towards corporate and I want to hold more gilts/govt. Options are index (either aggregate, eg Vanguard Global Bond Index, or govt eg IGLH) or an actively managed fund. Merian is mostly govt so might fit the bill; my question was based on mulling whether its recent price rise mostly i) is an indication that the manager has done well at predictably the global macro environment, ii) suggests the fund is overpriced (ie trading at a premium) and might re-set.

Linton said:

As @JohnWinder says, in an ideal world where interest rates are constant bond prices would remain constant and the total return would simply arise from the interest and reinvestment of the interest.

Why is that ideal? Why shouldn’t people want fund managers to identify bonds which will rise in price? Should the bond market only be made up of index funds?

MK62

Linton said:

MK62 said:

Linton said:

As @JohnWinder says, in an ideal world where interest rates are constant bond prices would remain constant........

....and inflation?....

If you are includintg inflation linked bonds, yes.  Otherwise I dont think so.

Fair enough.....I think we'll have to agree to disagree on that one.