How long do bond funds take to recover after a sharp rise in yields?

JohnWinder

gradually return to normal behaviour if not to previous values

Why would they not return to previous values when the chart shows they do?

And yes, when interest rates fall you get a sugar hit with a price rise, and then a future during which the yield from your fund is lower than it used to be (because interest rates are now lower).

JohnWinder

Here we go, about to derail an exceptionally informative thread:

I was also wondering what would happen during a severe recession, i.e. would my bond portfoilio recover at that point for it to be used to cover that period.

Poor quality corporate bonds will be massacred. There might be some amount of 'flight to quality' as people move money from stocks and corporate bonds to government bonds pushing up their value. There might be interest rate falls to stimulate the economy. There might be interest rate rises to combat the inflation of stagflation. Unexpected inflation would permanently take some purchasing value from your nominal bonds.Take your pick.

quirkydeptless

JohnWinder said:

Here we go, about to derail an exceptionally informative thread:

I was also wondering what would happen during a severe recession, i.e. would my bond portfoilio recover at that point for it to be used to cover that period.

Poor quality corporate bonds will be massacred. There might be some amount of 'flight to quality' as people move money from stocks and corporate bonds to government bonds pushing up their value. There might be interest rate falls to stimulate the economy. There might be interest rate rises to combat the inflation of stagflation. Unexpected inflation would permanently take some purchasing value from your nominal bonds.Take your pick.

Oh no, please don't derail the thread

I'll accept the answer is

and move on

michaels

OldScientist said:

Since I was curious, I thought I'd plot the response of an intermediate duration (i.e., 15-1 as before, duration~7 years) fund consisting of Inflation linked gilts using the yield curves from June 2021 and July 2023.



While the basic form is the same (i.e., there is a large drop with the rise in rates, a real return of -27% in this example), in real terms, the crossover takes 2 years longer (~9 years) than it did in the nominal case (~7 years).

So for me the question is why did we see increases in real yields at the same time as we saw the sharp jump in nominal yields in response to an unanticipated inflationary episode - if anything I would expect savers to flee to index linked bonds if the inflation path became less predictable.

Generally the two drivers of bond prices should be real yields compared to other assets and level of risk.  The jump in the real return on linkers thus suggests that the risk of holding such assets has increased?

OldScientist

Qyburn said:

So just to pose a simple naive question, I think people are saying that following interest rises, bond funds will gradually return to normal behaviour if not to previous values, as their existing bonds mature and are replaced. If that's roughly correct, what will happen if interest rates start falling?

In the absence of any more interest rate changes, the funds will gradually return to the values they would have had if the rise in rates hadn't happened because after the rate rises, the value falls immediately, but the yields are then higher. To my mind, the key point is that the 'gradually' depends on the duration of the bond fund (short durations including cash recover quickly, long durations take a long time).

If the rates dropped quickly (i.e. a step), the price and NAV would increase immediately, and would then go up at a slower rate (because the yields had changed). Active bond fund managers try to shorten the duration when they think rates are going up and lengthen it when they think it is going down - how they predict this is anyone's guess.

The day-to-day, month-to-month, and year-to-year variations in yields rather obscure this fundamental behaviour.

OldScientist

michaels said:

OldScientist said:

Since I was curious, I thought I'd plot the response of an intermediate duration (i.e., 15-1 as before, duration~7 years) fund consisting of Inflation linked gilts using the yield curves from June 2021 and July 2023.



While the basic form is the same (i.e., there is a large drop with the rise in rates, a real return of -27% in this example), in real terms, the crossover takes 2 years longer (~9 years) than it did in the nominal case (~7 years).

So for me the question is why did we see increases in real yields at the same time as we saw the sharp jump in nominal yields in response to an unanticipated inflationary episode - if anything I would expect savers to flee to index linked bonds if the inflation path became less predictable.

Generally the two drivers of bond prices should be real yields compared to other assets and level of risk.  The jump in the real return on linkers thus suggests that the risk of holding such assets has increased?

I too was surprised, since a simple model of implied inflation assumes it is equal to an average of the inflation over the previous N years (7 appears to be a good fit for linkers with 15 year maturities), although I note that the average of annual CPIH over the last 7 years is about 3.6%, so maybe not too surprising after all (although for RPI it is 5.2%).

Speculating on nominal or inflation linked bonds would involve guessing whether inflation is going to be higher than implied in current prices (choose linkers) or lower (choose nominals). Maybe the market doesn't have a clear view (except at the shortest maturities, which did have large implied inflation earlier this year).

Linton

michaels said:

OldScientist said:

Since I was curious, I thought I'd plot the response of an intermediate duration (i.e., 15-1 as before, duration~7 years) fund consisting of Inflation linked gilts using the yield curves from June 2021 and July 2023.



While the basic form is the same (i.e., there is a large drop with the rise in rates, a real return of -27% in this example), in real terms, the crossover takes 2 years longer (~9 years) than it did in the nominal case (~7 years).

So for me the question is why did we see increases in real yields at the same time as we saw the sharp jump in nominal yields in response to an unanticipated inflationary episode - if anything I would expect savers to flee to index linked bonds if the inflation path became less predictable.

Generally the two drivers of bond prices should be real yields compared to other assets and level of risk.  The jump in the real return on linkers thus suggests that the risk of holding such assets has increased?

No, I do not believe your analysis is correct.  My understanding is...

 Short term inflation is not a major direct factor in setting safe government bond yields (eg UK fixed gilts) - actual or nominal.

Interest rates are set by the central banks based on their assessment of the economic circumstances.  The nominal yield is set by the government when it issues the bond. Once you know the current interest rates the calculation of the current price of the bond and hence the yield to maturity in £ terms is fixed mathematically.  Inflation does not come into the calculation.  Risk is not a factor either since gilts can be deemed risk-free barring end of the world scenarios.

Two factors have caused the current situation
1) Interest rates had been steadily decreasing for the previous 40 years and had reached unrealistic values - should you really only have to pay <1% to borrow money?   Such values also severely restricted the central banks' abillity to manage the economy - nominal interest rates cannot go negative.
2) Post COVID there was seen to be a danger of serious inflation.

Both led the central banks globally to raise interest rates both to get them back to reasonable values and to dampen down economic activity to reduce inflation.  This happened a lot faster than anyone expected.  The effect was that existing fixed  bonds which provided very low nominal yields suddenly became undesirable and hence their price fell.


The price of index linked bonds is also fixed mathematically given the yield on fixed bonds of the same duration and the expected inflation in the long term - index linked bonds are generally long term.  Expected long term inflation has not changed much.  What has changed is that the yield on long term fixed bonds of the same duration has risen dramatically.  So people would rather buy fixed rate bonds than pay the previous price of index linked bonds that would have been expected to provide a much lower yield. Hence the collapse in index linked bond prices.

coyrls

As I understood it, another factor driving the yields of index linked bonds down was that pension companies were “forced buyers” of index linked bonds.  Has the rise in interest rates also reduced the demand from pension companies for index linked bonds?

Linton

coyrls said:

As I understood it, another factor driving the yields of index linked bonds down was that pension companies were “forced buyers” of index linked bonds.  Has the rise in interest rates also reduced the demand from pension companies for index linked bonds?

I am not sure about this.  In general I would have thought pension companies would normally just buy IL bonds when issued and hold them until maturity.  In which case the demand would be driven by the liabilities and have little impact on the market.

Taking the risk of buying fixed bonds to meet an inflation linked liability does not sound like what a pension company should do.  Though it could well make sense for capped pensions.

Bostonerimus1

JohnWinder said:

Here we go, about to derail an exceptionally informative thread:

I was also wondering what would happen during a severe recession, i.e. would my bond portfoilio recover at that point for it to be used to cover that period.

Poor quality corporate bonds will be massacred. There might be some amount of 'flight to quality' as people move money from stocks and corporate bonds to government bonds pushing up their value. There might be interest rate falls to stimulate the economy. There might be interest rate rises to combat the inflation of stagflation. Unexpected inflation would permanently take some purchasing value from your nominal bonds.Take your pick.

In 2014 I used most of my bonds to buy into a DB pension with the idea that I wasn't  really changing my overall asset allocation, just swapping one sort of fixed income for a more stable and illiquid version. My remaining bonds are in US Vanguard's Wellesley Income fund which I like because they have an average duration of 7 years and concentrate on high quality corporate and government bonds. So no high yield junk. I hate to think about the current and future consequences of people in retirement owning long tern bond funds, ie. 15 years or longer, with less than stellar credit ratings.