Vanguard U.K. Gilt UCITS ETF more "risky" than VG UK S/T Inv Gde Bond Index Fund (VGUKSP)?

OldBill

I had always thought that, in the UK, Gov bonds (gilts) were always the "safest", most "low-risk" - & therefore most desirable (because "safest") - bonds.

1. Vanguard's U.K. Gilt UCITS ETF (VGVA) are 99.6% AAA graded bonds, & have a risk reading of 5/7;
2. Vanguard's UK S/T Inv Gde Bond Index Fund (VGUKSP) contains no gilts at all.  It has a mix of bonds graded thus:
BBB (30%)
AAA (27.4%)
A (25.4%)
AA (16.9%)
The fund has a risk reading of 3/7.

Why is Fund #2 less risky than the gilts fund?  Fund #1, with a 5/7 risk reading is the same as the VG Global FTSE All-Cap fund - & that's an equities fund! 

Shouldn't a bond fund - especially one consisting solely of gilts, be a lower risk than an equities fund?

What am I not understanding here?

masonic

A bond fund is very different than a bond. With a bond you can buy and hold to maturity and obtain a fixed return. Whereas a bond fund continuously reinvests the proceeds from maturing bonds into new bonds. With a fund, you are therefore exposed to the market price of the bond portfolio when you buy and sell units in the fund. The longer the portfolio of bonds has to maturity in aggregate, the more the market price can swing based on current and expected interest rates. 

A gilt ETF will have a very long average maturity because the UK govt tends to issue very long dated debt securities. The short term investment grade bond fund (the clue is in the name) only contains bonds that are approaching maturity, so the duration risk you take on is minimal. A bond that is close to maturity and known to mature at par is not going to deviate much from its redemption price.

If you invested in VGVA in Dec 2021 and sold in Oct 2022, you would have crystallised a loss of 35% over less than 12 months. Clearly that is not a low risk investment! Even VGUKSP fell about 12% over the same period. By contrast the maximum peak to trough loss in the past 3 years for Vanguard FTSE Global All Cap is only 11%, though it did drop nearly 30% at the start of the pandemic.

Hoenir

OldBill said:

Why is Fund #2 less risky than the gilts fund? 

Potential short term volatility. Risk comes in many forms. Default is just one. 

GeoffTF

Vanguard's professional website is throwing a wobbly, so I cannot give a link. It is a long time since the UK government had an AAA credit rating. Currently it is AA-.

The risk rating of a fund and the credit rating of its underlying securities are two entirely different things.

JohnWinder

Nice answers above. The bonds in bond funds have two main risks: duration risk nicely put in the first reply, and default risk in the second. Unexpected inflation risk is another for nominal bonds, since they return £100 at maturity by which time £100 might buy a lot less than it does now. You can also imagine something called 'reinvestment' risk: if you owned a bond maturing fairly soon it wouldn't have much duration risk, but if interest rates drop as it matures you will be reinvesting in a lower yielding bond if you put the maturing bond money into another bond (thus suffering the reinvestment risk), whereas the person holding the longer maturing bond doesn't need to buy the new lower yielding bond when you do.

OldBill

Guys:

I'm very grateful for your swift & informative responses.

From what you have said, can I then keep holding VGUKSP in full confidence that the "3" grading allotted to it is less risky than the "5" of the VGVA fund?  It looks that way from what you have said - but I just want to be absolutely sure!

masonic

I wouldn't get too hung up on risk grades which are generally related to recent volatility. I'm not sure, but suspect, the risk grades of some bond funds has gone up since the recent interest rate rises that caused them to crash, and will go back down in the future.

In any case, there are edge case scenarios in which either fund could perform worse, but in most cases the volatility of the short duration fund will be lower.

Altior

The risk rating doesn't ever account for where we are in the cycle. Gilt funds are much less risky now than they were three years ago, as the 'once in a century' re-rating has already taken place. But the 'surprise' volatility over the last couple of years will mean that the perceived risk has increased. It could be seen as counter-intuitive.  

Hoenir

Altior said:

The risk rating doesn't ever account for where we are in the cycle. Gilt funds are much less risky now than they were three years ago, as the 'once in a century' re-rating has already taken place. But the 'surprise' volatility over the last couple of years will mean that the perceived risk has increased. It could be seen as counter-intuitive.  

There'll always be Black Swan events. Infrequent. But highly uncomfortable at the time if you've personally planned and are dependent on the status quo being maintained.  

Altior

Hoenir said:

Altior said:

The risk rating doesn't ever account for where we are in the cycle. Gilt funds are much less risky now than they were three years ago, as the 'once in a century' re-rating has already taken place. But the 'surprise' volatility over the last couple of years will mean that the perceived risk has increased. It could be seen as counter-intuitive.  

There'll always be Black Swan events. Infrequent. But highly uncomfortable at the time if you've personally planned and are dependent on the status quo being maintained.  

As so often the case, investing isn't as simplistic as identifying the risk rating of a fund (or whatever) and taking it as gospel without doing the work to look under the hood. Extreme example, but in my view there was very little risk in getting involved with purchasing Shell and BP during peak lockdown fear. We can establish a general risk of a certain asset class or fund based on volatility on a long period of time, but then it has to be applied to the pricing and context at the point of assessing the perceived risk. 

I've been applying a similar theory now to investment options that have been dramatically re-rated due to inflation/ central bank rate hikes. There is short term risk for sure, but I am confident that it will work out well medium to long term. Of which gilt/bond funds are one. 

OldBill

masonic said:

I wouldn't get too hung up on risk grades which are generally related to recent volatility. I'm not sure, but suspect, the risk grades of some bond funds has gone up since the recent interest rate rises that caused them to crash, and will go back down in the future.

In any case, there are edge case scenarios in which either fund could perform worse, but in most cases the volatility of the short duration fund will be lower.

I'll stick with the short duration bonds.

Thanks again, guys.