Bond funds question

Pat38493

So I am wading through Tim Hale's book on investment strategies.

Chapter 6 - when looking at bond funds, I am supposed to get the "average weighted duration" of the fund.  If I understand, bonds with longer durations are deemed higher trade risk due to the uncertainty over the longer period, hence they are more volatile?  Am I getting that.

The part I don't get, and maybe this is a stupid question that means I have not understood the early parts, is that these funds are basically trading in bonds, which seem to give a fixed "coupon" income periodically, and then you get your initial investment back at the end?  Are there also funds that hold bonds until they reach maturity i.e. what if I wanted to actually hold the bonds themselves rather than a fund that trades in bonds, and is there any reason I would do that?

Linton

In the US I believe there are bond funds that mature on a specific date but none in the UK.

I guess bond funds would often hold bonds until maturity unless trading was necessary to keep the overall balance stable.  However that does not help you when you decide to sell.

Holding bonds directly would enable you to get much tighter control of their behaviour and configure it to your needs.  eg you could arrange for bonds to mature when you retire.  However I believe all bonds are not available on all platforms and the ongoing direct management of bonds  could take up more time than appropriate.  Detailed management of bonds beyond simply aiming for a specific maturity date would seem to be a highly technical task requiring good numeracy skills and understanding of bond behaviour.

So in my view bond management is best left to the experts to use as part of a wider objective.  For that reason all my bonds are either held within income funds or in Wealth Preservation funds (OK almost all with just one global bond fund that I must get round to selling some time).  In the case of WP funds sophisticated management of global bonds is important.  For example Capital Gearing Trust has switched significantly between US and UK inflation linked bonds and betweeen index linked bonds and equity over the past year.

gm0

Bond duration - from very short 3 months/1 year to medium - 5-7 to long 30 years.  Has a strong impact on how much it reacts to interest rates. Short not much. Long a lot more.  Book will mention the yield curve (the different interest rates paid from short to long).

Bond fund average duration tells you about this behaviour for this mix in this fund.  So you buy the fund that suits your needs.

A fund of lots of bonds means that credit default is diversified away.  One bond with company X depends upon company X being around to pay it.  A fund with thousands and you as a small unit holder in it. Not so worried if one company defaults.

Bond funds whizz up and down with sentiment (to a level), interest rates to a level (based on duration as above). 
Bond fund managers replace bonds as they age and keep the bond fund focused on the mix - gilts, corporates, junk and duration that they announced to buyers.  They buy and sell bonds and may change mix - depending upon mandate (fund factsheet)

So the capital value of a fund can go up and down with these other factors. 
Like last year.  Interest rate reversal and rapid rises.  Bang Bang Bang.  Capital value of long bond funds are down.  So the yield (that fixed payment coupon as a % of the capital value is up).  As it has to be to be higher than the risk free rate.
But there are capital losses if you bought the fund in 2021.  Not realised unless you sell the fund units now.

In contrast if you just buy a bond (at a known price to its nominal value of pay £105 for £100 say.  And hold it to the end you get the nominal value £100 back at the end and the coupons meanwhile.  You don't care what happens to the price inbetween.  Irrelevant.  So now the specific counterparty matters (UK government for a gilt. Or Unilever or whatever). 

And you don't care about market price, interest rate movements etc.  You get the coupons.  You get your £100 back in year N.  
If you paid more or less than £100 then you know what that was right up front.  Completely different animal to a bond fund with a maintained duration.

I am not aware of any retail "hold to the end" products which package up bonds.

NedS

gm0 said:

In contrast if you just buy a bond (at a known price to its nominal value of pay £105 for £100 say.  And hold it to the end you get the nominal value £100 back at the end and the coupons meanwhile.  You don't care what happens to the price inbetween.  Irrelevant.  So now the specific counterparty matters (UK government for a gilt. Or Unilever or whatever). 

And you don't care about market price, interest rate movements etc.  You get the coupons.  You get your £100 back in year N.  
If you paid more or less than £100 then you know what that was right up front.  Completely different animal to a bond fund with a maintained duration.

I am not aware of any retail "hold to the end" products which package up bonds.

You can buy individual bonds, both company bonds or government gilts, on many platforms. For example, search for TN24 or TN25 - these are government gilts maturing in 2024 or 2025 (1 and 2 year gilts, now). As @gm0 says above, if you buy and hold them to maturity, you know exactly what return you will get, unlike a bond fund. These short term bonds are often used in a bond ladder, allowing you to get a safe return on capital you know you will need next year, or the year after etc. Not really any different to sticking the cash in a 1 year or 2 year fixed interest account, except you can do it in your SIPP ready to fund next years cash withdrawals.

If you want more of a 'tracker' fund rather than locking in that fixed return in a 1 or 2 year gilt, you can buy a cash or money market fund that tracks the Sonia overnight rate, and will closely track the BoE base rate. Last night's Sonia rate was 3.43% and I would expect that to rise by ~0.5% given the rise in BoE base rates today. I currently use the CSH2 ETF (or the Royal London Short Term Money Market Fund) for this purpose - I was going to buy some 1 or 2 year gilts, but figured (correctly) that interest rates were still rising so didn't want to lock in those lower rates just yet. If short term gilt rates go above 4% I'd probably switch and lock in those rates at that point for 2 years as I expect rates to peak this year and maybe start falling in 2024, at which point my floating rate cash fund yields will also drop.

I would only really use a conventional 'bond fund' as a diversifier to equity to dampen volatility, but until recently they were overpriced (as we've seen this year with massive capital loses) and were not offering any real diversification as they appeared correlated with equities - both bond and equities crashed together which is not what you generally want when buying a bond fund.

I do like some selective junk bonds in a crisis when yields spike disproportionately high due to overblown fears over default risks. That's the time to buy them if you are brave enough.

JohnWinder

‘Chapter 6 - when looking at bond funds, I am supposed to get the "average weighted duration" of the fund.  If I understand, bonds with longer durations are deemed higher trade risk due to the uncertainty over the longer period, hence they are more volatile?  Am I getting that.’

Yes, you are. Two risks with bonds or their funds investors consider are: credit risk (the issuer will default on their payments); and interest rate risk (a bond paying 2% will suddenly become less valuable if a comparable new bond paying 3% becomes available). We can estimate roughly how much the price will fall, by multiplying the 1% difference by the duration in years; 10 year duration bond would fall 10% in price. But then Hale shows this in table 6.2, and considers other bond risks as well. And I suppose credit risk increases with duration also; more time for the company issuing the bond to go belly up.

‘is that these funds are basically trading in bonds, which seem to give a fixed "coupon" income periodically, and then you get your initial investment back at the end?’

Yes, the bonds in the fund pay a coupon to the fund manager regularly, but we the fund investor may not get a predictable ‘dividend’ each quarter or half yearly, and I suppose it’s because when interest rates are low the coupons might not cover the costs of running the fund, like buying new bonds, trading costs, wages etc. ‘At the end’ means when you sell, because the bond fund will carry on long after we’re dead, so do you get your initial investment amount returned to you when you sell? No. If interest rates rose quickly while you held the fund, all the fund’s bonds will have dropped in price, and thus the fund would have dropped in value. This is easy to visualise: find a graph of a bond fund on trustnet or somewhere and have a look at how the price of the fund varies over time. Now imagine you bought at any one time and sold at another, you’d either get more or less back.

‘Are there also funds that hold bonds until they reach maturity i.e. what if I wanted to actually hold the bonds themselves rather than a fund that trades in bonds, and is there any reason I would do that?’

Typically bond funds hold bonds until they mature as it reduces trading costs and following an index doesn’t need buying and selling frequently. Whether they do or don’t, it would change how a bond fund affects you. As alien as it appears at first, while it’s easy to understand how owning a single bond works for you, owning a bond fund is quite different (because the fund is always x years away from maturing since it keeps buying new bonds) from owning a bond which keeps getting closer to maturity.

Reasons to hold individual bonds rather than a fund is mainly: you have a known £ requirement for a known time in the future, so you buy a bond that will mature at that time and will give you a known return of principal (and a bit of interest along the way).  A bond fund’s value in 4 years time is completely unknown. Another reason is there are no suitable bond funds for you, eg in UK there are no inflation linked bond funds that have a short-ish duration. As a general rule, it’s useful for your bonds/funds to have a similar duration to the duration of your spending needs, as this minimises interest rate risk. You won’t understand that until you read a bit more, but keep in mind the importance of duration as you continue reading.

Linton

JohnWinder said:

‘Chapter 6 - when looking at bond funds, I am supposed to get the "average weighted duration" of the fund.  If I understand, bonds with longer durations are deemed higher trade risk due to the uncertainty over the longer period, hence they are more volatile?  Am I getting that.’

Yes, you are. Two risks with bonds or their funds investors consider are: credit risk (the issuer will default on their payments); and interest rate risk (a bond paying 2% will suddenly become less valuable if a comparable new bond paying 3% becomes available). We can estimate roughly how much the price will fall, by multiplying the 1% difference by the duration in years; 10 year duration bond would fall 10% in price. But then Hale shows this in table 6.2, and considers other bond risks as well. And I suppose credit risk increases with duration also; more time for the company issuing the bond to go belly up.

‘is that these funds are basically trading in bonds, which seem to give a fixed "coupon" income periodically, and then you get your initial investment back at the end?’

Yes, the bonds in the fund pay a coupon to the fund manager regularly, but we the fund investor may not get a predictable ‘dividend’ each quarter or half yearly, and I suppose it’s because when interest rates are low the coupons might not cover the costs of running the fund, like buying new bonds, trading costs, wages etc. ‘At the end’ means when you sell, because the bond fund will carry on long after we’re dead, so do you get your initial investment amount returned to you when you sell? No. If interest rates rose quickly while you held the fund, all the fund’s bonds will have dropped in price, and thus the fund would have dropped in value. This is easy to visualise: find a graph of a bond fund on trustnet or somewhere and have a look at how the price of the fund varies over time. Now imagine you bought at any one time and sold at another, you’d either get more or less back.

‘Are there also funds that hold bonds until they reach maturity i.e. what if I wanted to actually hold the bonds themselves rather than a fund that trades in bonds, and is there any reason I would do that?’

Typically bond funds hold bonds until they mature as it reduces trading costs and following an index doesn’t need buying and selling frequently. Whether they do or don’t, it would change how a bond fund affects you. As alien as it appears at first, while it’s easy to understand how owning a single bond works for you, owning a bond fund is quite different (because the fund is always x years away from maturing since it keeps buying new bonds) from owning a bond which keeps getting closer to maturity.

Reasons to hold individual bonds rather than a fund is mainly: you have a known £ requirement for a known time in the future, so you buy a bond that will mature at that time and will give you a known return of principal (and a bit of interest along the way).  A bond fund’s value in 4 years time is completely unknown. Another reason is there are no suitable bond funds for you, eg in UK there are no inflation linked bond funds that have a short-ish duration. As a general rule, it’s useful for your bonds/funds to have a similar duration to the duration of your spending needs, as this minimises interest rate risk. You won’t understand that until you read a bit more, but keep in mind the importance of duration as you continue reading.

Yes,much as I and others have been saying.  However perhaps a "not"  would make things clearer!

In general investors only use bond funds in the UK.  More sophisticated use of individual bonds is not mainstream and the choice readily available from the platforms is limited (or non-existant).  Essentially bonds are seen as simply diversifiers for a long term portfolio and are not well understood which is a pity since now they are returning a respectable level of interest they could provide much greater benefit.

JohnWinder

Thanks for the editing correction. No wonder people get confused.

NedS

Linton said:

In general investors only use bond funds in the UK.  More sophisticated use of individual bonds is not mainstream and the choice readily available from the platforms is limited (or non-existant).  Essentially bonds are seen as simply diversifiers for a long term portfolio and are not well understood which is a pity since now they are returning a respectable level of interest they could provide much greater benefit.

Which I guess is where strategic bond funds come into their own, rather than just buying a passive bond fund that tracks an index, as this allows the manager to focus on specific areas they think are most attractive in terms of risk and reward.

JohnWinder

‘In general investors only use bond funds in the UK.  More sophisticated use of individual bonds is not mainstream and the choice readily available from the platforms is limited (or non-existant).’

Indeed we never seem to hear of individuals using individual bonds to fund a particular spending need. But most of what we read here is people needing to fund part of their retirement spending with retirement funds, that means they have a clearly known amount they’ll need to spend each year even if it’s only baseline spending and doesn’t cover discretionary spending like big holidays. Inflation linked bonds are perfect for that, because you can be fully confident those spending needs will be met, no matter how badly your portfolio value fell last year and our’s all did.

And yes, it’s a more sophisticated use, but many people use an advisor, and you can’t get more sophisticated than that. So why aren’t the advisors putting people into liability matched inflation linked bonds? The advisors will need to give us their reasons, but here’s a possible one: a bunch of inflation linked bonds purchased to meet spending needs 15 years into the future need absolutely no attention for the next 15 years. How could one justify charging a client for that on an ongoing basis which is the current charging model for ongoing client advice? Is the model getting in the way of us being offered the full range of retirement investing?

coyrls

JohnWinder said:

‘In general investors only use bond funds in the UK.  More sophisticated use of individual bonds is not mainstream and the choice readily available from the platforms is limited (or non-existant).’

Indeed we never seem to hear of individuals using individual bonds to fund a particular spending need. But most of what we read here is people needing to fund part of their retirement spending with retirement funds, that means they have a clearly known amount they’ll need to spend each year even if it’s only baseline spending and doesn’t cover discretionary spending like big holidays. Inflation linked bonds are perfect for that, because you can be fully confident those spending needs will be met, no matter how badly your portfolio value fell last year and our’s all did.

And yes, it’s a more sophisticated use, but many people use an advisor, and you can’t get more sophisticated than that. So why aren’t the advisors putting people into liability matched inflation linked bonds? The advisors will need to give us their reasons, but here’s a possible one: a bunch of inflation linked bonds purchased to meet spending needs 15 years into the future need absolutely no attention for the next 15 years. How could one justify charging a client for that on an ongoing basis which is the current charging model for ongoing client advice? Is the model getting in the way of us being offered the full range of retirement investing?

I would think the main reason would be that until recently, the price of index linked gilts meant that they were guaranteed not to protect you against inflation.

JohnWinder

You could be right. In which case now that linker yields are positive we should hear of people taking them up, or at least being offered them - watch this space. 

In which case #2, linker yields were positive for many years previously, but we didn’t hear anyone saying ‘I’m sorry that strategy has come to an end after 15 golden years, what do we do now?’.

And in which case #3, should we assume the advisors have been offering the strategy despite the negative linker yields recently, and the clients have been rejecting it? Or don’t they have that autonomy, it’s simply not been offered?