Fixed interest funds – yield and rebalancing

aroominyork

This issue started on a thread where I mentioned holding a corporate bond fund and the ever-helpful masonic said “If you are holding long term for yield rather than rebalancing purposes, then price fluctuations should not be a concern.” In my 70% equity/30% fixed interest portfolio, my instinct would be to rebalance across all holdings. Why would fixed interest be different from equities?

It has taken a couple of days for the penny to start dropping. A while back someone posted that you should only invest in bonds for the yield and not for capital growth. But I have seen bond fund managers talking about capital growth. Is it right that capital growth happens when, assuming stable interest rates/macro factors, the risk of default in a holding falls, hence delivering good risk-adjusted returns (high yield, unlikely default) leading to the bond’s price rising? This article says “a global, unconstrained bond portfolio might derive around 70% of its total return from income and only 30% from capital gains”, though I cannot get my head around what seems an implied assumption that bonds are generally expected to appreciate in value.

Next… why would you not rebalance fixed interest the same way as equities? I’ll have a go at answering: we expect equities to have peaks and troughs so rebalancing aims to sell high, buy low and stay invested. Bonds are different: if a bond look like it is going to default and hence its price falls, you do not buy a stack more and expect the cycle of the market to bring the price back up. Is that right?

So let’s come back to “If you are holding long term for yield rather than rebalancing purposes, then price fluctuations should not be a concern.” A bond fund is priced at 100p and generates income of 5p, so 5%. The fund’s price falls to 90p but the income remains 5p, so 5.55%. The income is unchanged so it does not matter that the fund’s price falls if what I want is 5p income each year. Hence I do not need to buy more units in the fund. But hasn’t the fund’s price fallen because of an increased risk of defaults, and wouldn’t that mean it might only generate 4.5p so I need to buy extra units if I want my full 5p?

InvesterJones

aroominyork said:

This issue started on a thread where I mentioned holding a corporate bond fund and the ever-helpful masonic said “If you are holding long term for yield rather than rebalancing purposes, then price fluctuations should not be a concern.” In my 70% equity/30% fixed interest portfolio, my instinct would be to rebalance across all holdings. Why would fixed interest be different from equities?

It has taken a couple of days for the penny to start dropping. A while back someone posted that you should only invest in bonds for the yield and not for capital growth. But I have seen bond fund managers talking about capital growth. Is it right that capital growth happens when, assuming stable interest rates/macro factors, the risk of default in a holding falls, hence delivering good risk-adjusted returns (high yield, unlikely default) leading to the bond’s price rising? This article says “a global, unconstrained bond portfolio might derive around 70% of its total return from income and only 30% from capital gains”, though I cannot get my head around what seems an implied assumption that bonds are generally expected to appreciate in value.

Yield curve. If you don't hold to maturity (e.g. funds) then you are selling based on the price of the bond. If you buy bonds with long duration then sell them when they've got a shorter duration then you get a capital gain whenever the yield is higher at the long end than short end (price being inverse to yield) - which it usually is, except for the much dreaded inverted yield curve state.

Next… why would you not rebalance fixed interest the same way as equities? I’ll have a go at answering: we expect equities to have peaks and troughs so rebalancing aims to sell high, buy low and stay invested. Bonds are different: if a bond look like it is going to default and hence its price falls, you do not buy a stack more and expect the cycle of the market to bring the price back up. Is that right?

So let’s come back to “If you are holding long term for yield rather than rebalancing purposes, then price fluctuations should not be a concern.” A bond fund is priced at 100p and generates income of 5p, so 5%. The fund’s price falls to 90p but the income remains 5p, so 5.55%. The income is unchanged so it does not matter that the fund’s price falls if what I want is 5p income each year. Hence I do not need to buy more units in the fund. But hasn’t the fund’s price fallen because of an increased risk of defaults, and wouldn’t that mean it might only generate 4.5p so I need to buy extra units if I want my full 5p?

The fund risk of default should be built into the yield - i.e. you compensate for this risk by getting a higher yield - it's part of the reason a normal yield curve shows higher yield for long duration.

I think the rebalancing comment is more about the intent of holding bonds - ie if you are holding bonds in order to provide a diversifying % of your assets vs for a fixed income.

Hoenir

aroominyork said:

though I cannot get my head around what seems an implied assumption that bonds are generally expected to appreciate in value.

After over a decade of exceptionally low interest rates many more recently issued bonds have a correspondingly low coupon. Current price will reflect this and they'll be trading at under nominal par value. As the maturity date approaches the market price will gravitate towards par value when the bonds re redeemed and the capital value returned.  

MK62

aroominyork said:

This article says “a global, unconstrained bond portfolio might derive around 70% of its total return from income and only 30% from capital gains”, though I cannot get my head around what seems an implied assumption that bonds are generally expected to appreciate in value.

Leaving index linked gilts aside, it's not the PAR value of a bond which will appreciate, but the price paid at purchase might well be below PAR and so on maturity (or sale for more than the price paid) this will produce a capital gain. On the flip side, if bought above PAR, and held to maturity (or sold for less than the price paid), a capital loss will occur.

With a bond fund, such as the example above, it's an average......the total return on some bonds might be 90% income and 10% capital gain, and others might be 50/50, or 10/90.......and on those where there is a capital loss, the net total return will all be derived from income. On zero coupon bonds, the total return is all derived from capital gain (since there is no coupon (income).

Linton

MK62 said:

aroominyork said:

This article says “a global, unconstrained bond portfolio might derive around 70% of its total return from income and only 30% from capital gains”, though I cannot get my head around what seems an implied assumption that bonds are generally expected to appreciate in value.

Leaving index linked gilts aside, it's not the PAR value of a bond which will appreciate, but the price paid at purchase might well be below PAR and so on maturity (or sale) this will produce a capital gain. On the flip side, if bought above PAR, and held to maturity (or sold for less than the price paid), a capital loss will occur.

With a bond fund, such as the example above, it's an average......the total return on some bonds might be 90% income and 10% capital gain, and others might be 50/50, or 10/90.......and on those where there is a capital loss, the net total return will all be derived from income. On zero coupon bonds, the total return is all derived from capital gain (since there is no coupon (income).

Yes. To add more explanation...
 
Over sufficient time safe bonds with interest reinvested will always increase in value because they are priced so that the Yield To Maturity matches the then current interest erates.  But one can assume that the then current interest rates are positive and one knows that future returns are guaranteed to maturity.  So safe bonds can never make a loss at maturity no matter when you bought.  

Of course if you sell when the bond is far from maturity anything could happen.

poseidon1

A useful real world example of buying a corporate bond below par, and holding to redemption for capital gain would be a corporate bond acquisition I made for my retired mum at the end of 2016 to mitigate the near zero rates of interest then being paid on bank deposits.

The bond was International Personal Finance Plc  6.125% 2020.  I had personally held bonds with the company since 2014, and was fully aware of its relatively high risk business model ( door step lending in Eastern Europe and Mexico). However I was prepared to personally guarantee her investment and risk £10,000 investment on her behalf at below par purchasing £10,600 nominal.

This went onto deliver her £1,623.15 of interest until May 2019 when it was exchanged for their 7.75% 2023 bond. This has since paid a further £3,696.75 of interest until its redemption on 14 December 2023 whereby she received £10,600 ( a £600 tax free capital gain). It should be noted in passing, that IPF have since issued a 12% bond to replace the 2023 redemption, but although I have personally taken a stake therein, I decided not to do so for my mother's redemption funds.

A useful contrast to the return on this corporate bond, is a bond fund I invested on her behalf with Royal London ( Global bond). Purchased units to the value of £7500 in April 2019 at an intial yield of 6.5%. This has delivered steady and reliable income to date, but at the height of the depression in world bond prices, this fund was showing a worrisome capital loss of 20%. Interestingly as of today that loss has since shrunk to 9.33%, which no doubt reflects a recovery in Royal London's bond portfolio values as a result of  the possibility of central banks cutting their base rates in 2024.

What is the takeaway here? The IPF bond acquisition was an example of high risk/ (reasonably)  high reward ( company could have gone bust), which in the end  played out to my mother's benefit.
By contrast, the supposedly safer Royal Life Bond fund portfolio, has taken a bit of a beating in terms of capital values, but despite this hiccup has been reliable with regard to interest payments. For that reason, i can continues to justify holding on her behalf. If it recoups the current 10% deficit in the coming months, may well consider changes at that point. 

masonic

There's a couple of factors here. First, if you are investing in bonds long term for income (rather than reducing portfolio volatility), you have probably gone out and bought a sufficient quantity to meet an income goal. 

Suppose some years later there is a recession, so interest rates fall, bond prices increase to compensate, and equities fall. This creates a rebalancing opportunity. You could exploit this. However, if you do, you may come up short on future income - effectively borrowing from your future self in order to bag a potential capital gain when the stock market recovers. Nothing wrong in this if you have enough time ahead of you. But you may need to be a forced seller of investments in the short term, which likely means selling more of those bonds that have risen than the equities which have fallen, thereby creating a vicious circle. Instead you might opt to do nothing, continue to receive your income, and have a quiet life.

Conversely, if interest rates rise and bond prices fall, there may be no need to buy more of the bonds that are already generating a sufficient income for your needs, and you could better deploy the capital elsewhere.

The second point, which has already been mentioned by others is that interest rate changes tend to be the main driver of bond price fluctuations unless you delve into the most risky part of the market where credit spreads and individual company risks can cause large fluctuations. So selling bonds that are rising in value or buying them when they are falling in value is perfectly reasonable for rebalancing purposes. It is just something someone holding them for their cash flows might have pause to do.