Cash or bonds?

aroominyork

My son has £87k set aside for when he and his wife (the eagle eyes among you will notice he’s got married since I last posted about this) buy their first home. All except £30k is wrapped in ISA/LISA. They currently live in Paris, will probably be there for a while and property prices there are astronomic. So maybe they will buy in 2-3 years, maybe in 5, maybe in 10… who knows. His approach to investing this money (guided by me) has been to expect equities might fall 40% and bonds by 15% when he wants to sell the investments t buy a property; he figured he would risk a 15% loss so invested accordingly in a mix of VLS and cash.

We’ve just reviewed this. I suggested we reduce the bond risk to 10%, given most of the pain of rising interest rates is behind us. He also wants to reduce his max loss to 10%. And he wants a global index funds (rather than UK-weighted VLS) for the equities.

I have suggested he ignores bonds since a hedged global aggregate bond index fund is not projected to return much more than a money market fund like CSH2. That would let him increase the equity allocation a little and have £22k in equities and the balance in cash.

Does that sound logical? How would you approach it?

retiredbanker1

Are they still investing in LISA/ISA whilst living in Paris?
Is this allowed?

I know they can still have the accounts but I thought you could not invest further whilst abroad?

Is it a case of the bank and HMRC not been informed that they are now living abroad?

aroominyork

He files a joint return with his French wife. He's aware he needs to address residency issues.

masonic

aroominyork said:

My son has £87k set aside for when he and his wife (the eagle eyes among you will notice he’s got married since I last posted about this) buy their first home. All except £30k is wrapped in ISA/LISA. They currently live in Paris, will probably be there for a while and property prices there are astronomic. So maybe they will buy in 2-3 years, maybe in 5, maybe in 10… who knows. His approach to investing this money (guided by me) has been to expect equities might fall 40% and bonds by 15% when he wants to sell the investments t buy a property; he figured he would risk a 15% loss so invested accordingly in a mix of VLS and cash.

We’ve just reviewed this. I suggested we reduce the bond risk to 10%, given most of the pain of rising interest rates is behind us. He also wants to reduce his max loss to 10%. And he wants a global index funds (rather than UK-weighted VLS) for the equities.

A 10% maximum drawdown would equate to a very low proportion of equities in the portfolio, perhaps 15-20%. That could be increased further by loosening the timescale, if he were happy to to flex his purchasing timeline by a couple of years based on the state of the economy. Probably then the 25% you seem to be targeting would be appropriate.

aroominyork said:

I have suggested he ignores bonds since a hedged global aggregate bond index fund is not projected to return much more than a money market fund like CSH2. That would let him increase the equity allocation a little and have £22k in equities and the balance in cash.

A hedged global aggregate bond index fund could have a wide range of possible returns over the coming years, as could a money market fund. If interest rates were to double from here, then clearly the money market fund would be the place to be, however, if they halved, then the money market fund could be quite unattractive and the bond index fund would have good returns. If rates stay the same and there isn't a crash in equities, then they will probably deliver comparable returns.

It would also be worth considering a ladder of individual bonds if his provider supports it. Index linked gilts and/or TIPS could also have their place. Opening a new UK savings account is off the table of course if he is non-resident. Given that this defensive part of the portfolio is going to be the majority of it, there is an argument for diversification and not taking a gamble using your current view of the economic outlook.

Has he not considered UK residential property exposure through his investments? This would serve as something of a hedge against house price risk.

Before doing anything to the portfolio, the residency issue would need to be addressed. Any subscriptions to his S&S ISA and LISA will be invalid if made during a tax year he was non-resident. He may also see some of his other accounts closed when the relevant banks learn he is now an EU resident. His first priority should be ensuring he has accounts that he will be able to continue to operate as a non-resident, since it seems he will be there for the foreseeable.

aroominyork

Thanks, masonic. Very helpful.

If equities have 40% drawdown potential and other assets are in 0% drawdown, a 10% portfolio risk allows 25% in equities. But of course we are talking about nominal rather than real/inflation-adjusted risk, which is where your linkers idea comes in. I am one of those who took a while to understand why linkers took such a hit when inflation rocketed; eventually I understood they are as exposed to interest rate risk like nominal gilts, and the hike in inflation rates outweighed the inflation protection. So am I right in thinking they would protect against stickier than expected inflation if interest rates are held around their current levels?

A hedged aggregate bond fund is an interesting idea, to hedge the money market should interest rates move. But I don’t think we’ll look at UK property funds; not only are they a bit sophisticated for this exercise – risks of gating etc. – but son/d-in-law are more likely to buy property outside the UK (I realise there would be a small hit to liquidate the LISA for this purpose).

Re. residency, they only landed back in Paris a couple of months ago so it’s on the to-do list. He isn’t planning to add funds to the L/ISA, although I was thinking he could move his ISA to ii to benefit from its Friends & Family offer linked to my account. I haven’t looked at the process but guess he would have to tick a box declaring UK residency?

masonic

aroominyork said:

Thanks, masonic. Very helpful.

If equities have 40% drawdown potential and other assets are in 0% drawdown, a 10% portfolio risk allows 25% in equities. But of course we are talking about nominal rather than real/inflation-adjusted risk, which is where your linkers idea comes in. I am one of those who took a while to understand why linkers took such a hit when inflation rocketed; eventually I understood they are as exposed to interest rate risk like nominal gilts, and the hike in inflation rates outweighed the inflation protection. So am I right in thinking they would protect against stickier than expected inflation if interest rates are held around their current levels?

A hedged aggregate bond fund is an interesting idea, to hedge the money market should interest rates move. But I don’t think we’ll look at UK property funds; not only are they a bit sophisticated for this exercise – risks of gating etc. – but son/d-in-law are more likely to buy property outside the UK (I realise there would be a small hit to liquidate the LISA for this purpose).

Re. residency, they only landed back in Paris a couple of months ago so it’s on the to-do list. He isn’t planning to add funds to the L/ISA, although I was thinking he could move his ISA to ii to benefit from its Friends & Family offer linked to my account. I haven’t looked at the process but guess he would have to tick a box declaring UK residency?

Equities (in the form of a broad based global index) can periodically fall 50%, and in the extreme have a loss potential of around 75%. It would be best to assume a 25% equities portfolio with 75% risk free assets could fall about 12% once or twice in a generation and 18% once or twice in a lifetime. For a 15% equities portfolio, those numbers would be 7.5-11%. That's before correcting for the return of your low risk assets and inflation (which would largely cancel each other out). It's also on a peak to trough basis, so over rolling 3 or 5 year periods, those maximum losses would be smaller. One confounding factor is that the relevant measure of inflation in this scenario would be house price inflation, so perhaps that will be negative in an extreme crash situation and allow more equities to be comfortably held.

Index-linked gilts just offer a diversification within your lower risk basket. You would not want a long duration fund, rather individual holdings in a ladder, or some short dated fund, which may have to be a global inflation linked fund.

Any property exposure should be accessed via REITs or other closed-ended debt vehicles, not open ended funds. But if the eventual house purchase is likely to be outside the UK, getting appropriate exposure is going to be a challenge, so not worth the bother.

Any ISA application would require him to be both resident in the UK and currently living in the UK (though ISA guidance below suggests transfers are ok, in practice an application may still be refused by the provider). It sounds like he will probably qualify for residency in this tax year (but you should check the HMRC criteria), so use of this year's ISA allowance would be allowed into his existing accounts. If not already fully utilised, I would recommend doing this ASAP, before letting the providers know of his recent move abroad.

See https://www.gov.uk/tax-foreign-income/residence and https://www.gov.uk/individual-savings-accounts/if-you-move-abroad

aroominyork

A bond fund is interesting as a hedge against the impact of interest rate changes on the money market, though would a gilt index fund would be most closely correlated, although more volatile? Interest rate changes would only affect future returns of the money market fund - it would not affect the underlying capital; whereas a bond fund would see the underlying value affected. So how much would you invest in each if looking for the "perfect" hedge? As a blindish guess, would you hold a multiple of the bond fund's duration in the money market if anticipating holding them for the duration period, eg £7000 MM and £1000 bonds if holding for seven years; or £7000 and £2000 respectively if holding for 14 years?

masonic

aroominyork said:

A bond fund is interesting as a hedge against the impact of interest rate changes on the money market, though would a gilt index fund would be most closely correlated, although more volatile? Interest rate changes would only affect future returns of the money market fund - it would not affect the underlying capital; whereas a bond fund would see the underlying value affected. So how much would you invest in each if looking for the "perfect" hedge? As a blindish guess, would you hold a multiple of the bond fund's duration in the money market if anticipating holding them for the duration period, eg £7000 MM and £1000 bonds if holding for seven years; or £7000 and £2000 respectively if holding for 14 years?

By combining bond funds with different effective durations (a money market fund is after all just a bond fund with very short duration), you are modifying the duration of your own bond portfolio, but the funds will continually roll over maturing bonds. This would modulate your interest rate risk/opportunity. But you always face a capital gain or loss when you sell. 

Whereas, if you combine a MM fund (negligible capital fluctuations) with longer duration individual holdings, you can control what happens to the capital each time a bond matures and can choose to wind down the portfolio without capital loss. You can also make an informed decision whether to sell any of your holdings early should interest rates fall and a capital gain opportunity presents itself.

aroominyork

All understood, but this type of laddering is good for people with the confidence, interest and ability to make tactical decisions. I know that applies to you (getting out of bonds when rate raises were inevitable but not yet priced in; hedging equities when Truss/Kwarteng temporarily sunk Sterling) but it's not for us. However your thoughts will help us find a sensible middle way. Many thanks.