Investing in different bond funds

masonic

redux said:

masonic said:

I agree with you, but the thesis of the OP was that long duration bonds will be most sensitive to interest rate reductions, therefore there will be significant capital gains when interest rates fall. I don't think any strategic bond funds are positioned in this fashion, so they wouldn't be a suitable choice for someone wishing to position themselves to exploit this prediction.

I suspect the OP is overlooking the possibility that future assumptions - whether or not they turn out to be exactly correct - will be already priced in.

So if interest rates are expected to be at current rate for a while then fall a bit, the consensus in the market isn't presenting a chance to buy ahead at an advantageous price for this happening

Of course, sometimes unexpected things happen, but I doubt we'll get Truss again

Exactly, the inverted yield curve shows that markets have priced in some degree of interest rate reduction. Even if interest rates settled at say 3%, long duration gilt yields don't look so mispriced that an adjustment would need to be made.

Tondrive

Linton said:

masonic said:

In the context of someone wishing to trade bonds specifically to capitalise on their superior knowledge about future interest rates, a tracker is an adequate vehicle, while an active fund would be at odds with this approach. However, the doubt would be that they are in fact able to predict such favourable movements in bond prices.

Unlike with equities, predicting the future is possible to a major extent with bonds since the position at maturity is 100% certain.  So for example prior to the recent rise in interest rates the significantly above par market price of inflation linked bonds gave rise to major risk.  One did not need the powers of Nostradamus or Old Mother Shipton to see this.  Now IL bonds are trading close to par and so have a far lower risk.

This sort of management is perfectly feasible if one is aiming for the short/medium term.  A passive fund cannot make such strategic choices whereas the Wealth Preservation funds can and do.  Perhaps the risk targetted multi-asset funds do as well, I dont know.

Yes three well known Wealth Preservation IT's are packed to the gunnels with US Tips and short dated bonds.
They may have got it wrong but i think they can managed that bond portfolio better than i could using passive trackers.
One of the IT's does use trackers for equities frequently but i don't think they do for bonds (must be a reason).
I personally feel the extra cost's for that type of asset may be worth paying.
Time will tell.

JohnWinder

‘ISTM that if you are going to buy bonds rather than equity the risk in the sale price of a broad bond fund can remove most of the advantages of buying bonds in the first place.  Better alterantives are:

1)  to invest a higher % of equity and hold a tranche of cash

2)  buy individual bonds with durations matching your objectives or very short duration bond funds

3) buy a managed fund where the fund manager moves between different types and durations of bond depending on economic conditions to reduce price volatility risk.’

Let’s look at those.

1. I think we’re talking about reducing the risk of an all-equity holding by adding bond fund(s), or cash instead of the bonds. If I was to propose 70/30 stocks/bonds is right for me, what would your stocks/cash alternative be? Less stocks and more cash than 30% would not be expected to provide as good returns, since bonds usually outperform cash over realistic investing horizons. So it would have to be 80/20 stocks/cash, or 90/10 etc. Any figure I plug into historical data gave me either better or worse returns than 70/30, but no figure will give a better risk adjusted return than 70/30. The cash options all give either better returns with more than commensurate risk measures, or worse returns without less risk. I used portfoliovisualizer, but others can use their own historical data sources. I doubt 1) is a given winner. But to put it into perspective, when there’s so much in equities, what you do with bonds doesn’t make a lot of difference.
2. Agree with the individual bonds, but very short duration funds come with interest rate risk, ie, if rates have dropped when the fund’s bonds mature, the replacement bonds pay less coupon. Whereas if you have a longer duration fund, your coupons are ‘locked in’ for a longer period. So, to choose a bond fund for duration, based on your prediction of the market rather than your investing horizon isn’t easy to get right. I don’t need to quote the case of 68 economists guessing next year’s direction of interest rate changes wrongly, to a man/woman.
3.   Maybe. Tempting in theory, more pricey in fees, but I don’t know about any evidence showing how well it’s likely to turn out.

JohnWinder

  So for example prior to the recent rise in interest rates the significantly above par market price of inflation linked bonds gave rise to major risk.  One did not need the powers of Nostradamus or Old Mother Shipton to see this.  Now IL bonds are trading close to par and so have a far lower risk.’

The wood and the trees comes to mind here. Yes, falling interest rates in recent years had pushed up the price of bonds, the prices of which could only fall back to face value (or inflation adjusted face value) as the bonds matured. And yes, bonds trading near face value don’t carry that risk of loss of principal. 

But we don’t need to worry about that, as interesting as it is and as informative as it is to understand. What a bond buyer needs to worry about is the yield, ie the overall return/year if the bond is held to maturity. That’s why we have this measure of the return on a bond, a single number measure that rolls up what the coupon is, what the purchase price is, what the principal will be worth at maturity. A single number makes things easy to compare, and it saves you having to guess how suitable the bond is for you instead of having to try to weigh up: ‘well, it’s price is well above par, but it’s coupon is better than a new bond I could buy today with a lower coupon - I wonder how those characteristics pan out?’

In short, not that long ago yields were low, now they’re higher. 

JohnWinder

Bonds and their funds have interest rate risk in the broadest theoretical sense, not just the risk of losing money, but risk as in return variation either down or up. Often measured as standard deviation, which is not just downward.

Buy bonds too long for you, interest rates might rise causing you to lose money before there is time for recovery. Or rates might fall, and you can benefit immediately from the ‘risk’ they exhibited.

Buy bonds too short, and the ones you replace them with might come with lower interest rates; or higher interest rates and you win when you reinvest.

The trick is: how to minimise interest rate risk (if you don’t want to take the chance of losing out while there’s a prospect of actually winning out). As noted many times in previous posts, the trick is duration match the bonds with the investing horizon, because you want the longest duration possible since longer bonds usually pay more than shorter bonds (a bit about this earlier on as well).

The other way to duration match is with two funds, a long and a short, and hold them in proportions that reflect your investment horizon. As your horizon shortens, you sell the longer bonds and buy more of the shorter, or their funds. This doesn’t guarantee riches beyond the dreams of avarice, but it minimises interest rate risk.