Bonds v bond funds

InvesterJones

goodValue said:

A simpler way is to buy a multi-asset fund, such as Vanguard Lifestrategy 60 (60% shares 40% bonds) or one of many other managed funds that work in a similar way.

I do want a very simple strategy to follow, but this may be too simple as it does not allow you to change your percentage of bonds.
That said, this may be the option that I eventually choose.

You can just switch to different proportion funds when you want to change. Or there are target retirement date funds from Vanguard, at I think a little extra cost, which will do that for you.

goodValue

I think I'm getting a clearer picture of bonds, but may be making some incorrect assumptions:
 short term bonds are not as risky as longer term bonds and so will not give you a big surprise later on
 but if you want to follow the idea of increasing bond allocation, during retirement, you would have to include longer
    term bonds to get the benefits of this asset allocation strategy (the risk/reward playoff)

Is the idea of not having bonds in your asset allocation (ie having just stocks, and cash/money market funds) a widespread one?

InvesterJones

goodValue said:

I think I'm getting a clearer picture of bonds, but may be making some incorrect assumptions:
 short term bonds are not as risky as longer term bonds and so will not give you a big surprise later on
 but if you want to follow the idea of increasing bond allocation, during retirement, you would have to include longer
    term bonds to get the benefits of this asset allocation strategy (the risk/reward playoff)

Is the idea of not having bonds in your asset allocation (ie having just stocks, and cash/money market funds) a widespread one?

Again, bit of a difference between single bonds and bond funds. Single bonds held to maturity are only as risky as the credit-worthiness of the organisation you're lending to - stable, financially trustworthy governments are generally seen as unlikely to default, even in the long term. If you hold to maturity then you know exactly how much you'll return, and it's unaffected by markets or rate changes. But bond funds, where the bonds are not held to maturity, are subject to the whim of how much the bonds are valued by the market when the fund sells, therefore, are affected by changes in price, which duration has a big influence on.

No, you don't have to include longer term bonds in your allocation to get whatever benefit you're looking for (sounds like you're looking for de-risking of equity performance via asset diversification).

It might be possible to find an article talking about the amount bonds or cash/MMF people have in their portfolios - I can't think of one off the top of my head, but again, it comes down to what the reason is they're doing that - their reasons may not be the same as yours. In recent years it's made a lot of sense to swap out the bond element for cash/MMF if people are hedging against a short term dip in equities, because the return on cash/MMF has been higher AND the very short duration means less risk.

Eyeful

1. You are supposed to reduce your market risk as your retirement date approaches & for some time after it has passed. Look up " sequence of risk".

2. Have you considered getting a "Target Day Fund"? 
https://www.ii.co.uk/ii-accounts/sipp/sipp-investment-ideas/target-retirement-funds

3. The Right Way to Use Bonds video below. Hope it helps you understand. 
https://www.youtube.com/watch?v=0lwpyHYokrg

goodValue

My primary goal was to avoid the results of a downturn of stocks during retirement. I thought that this was traditionally done by progressively increasing the % of bonds in your asset allocation.

A secondary concern was what would be the makeup of these bonds - a selection of bonds, a selection of bond funds, a mix of short term and long term bonds?

I clearly don't yet have the knowledge to make decisions on this.

I was surprised to find out that the means of achieving the primary goal might no longer be appropriate but is dependent on an understanding of market conditions.

I am struggling to understand all the information the forum has given (partly due to jumping to the wrong conclusions), and so I need to improve my investment knowledge step by step.

Therefore I'm going to have to look through in detail the sources of information you have all given.

gm0

Bernstein - Four Pillars of Investing.  Revised.  Amazon.  

Clear on this subject - portfolios and bonds and why and why not certain things

JohnWinder

Or read a free pdf copy of early edition at https://archive.org/details/fourpillarsofinv00bern 
Or here https://investucatett.com/wp-content/uploads/2017/09/The-Four-Pillars-of-Investing.pdf 
You can help to become your own bond wizard by observing the long term (and short term - just change the start/end dates) of stock and bond returns. This will inform on your primary objective. The brilliant website you need is: 
portfoliovisualizer.com, and use 'tools>backtest asset class allocation'. Make a dummy portfolio of 100% stocks, then another of 100% bonds, and see how their returns and volatility compare over the last 40 years. Then do it for shorter date ranges. You'll find that the dream of bonds going up when stocks go down does not always hold; indeed their returns can move in the same direction for many years. 
Bonds have three risks: default or credit risk; 'duration' or interest rate risk; inflation (not if you own linkers). I can't think of much about bonds/funds that don't arise from those three issues.

OldScientist

It may be best to think about bonds in terms of what you actually want them to do for you, which in turn largely depends on whether you are retired or still accumulating.

For ease of understanding, most bond applications can be illustrated by swapping bonds for fixed rate savings accounts. All examples are in nominal terms, so the effect of inflation is ignored. Tax is also ignored.

Income from single bond/account

A single bond is held for a known income and, eventually, return of capital. For example, currently the best buy 3 year savings account is offering 4.52%. Assuming this offers interest paid out annually (or monthly), £10k invested would provide an income of £452 per year over the next 3 years with £10k returned at the end of the 3 year period. A roughly equivalent gilt (TR27, see https://www.yieldgimp.com) offers a coupon of 4.25% and is priced close to 100, so £10k would provide just under £425 per year (two payments of £212, six months apart).

Income from a collapsing ladder of bonds/accounts

Multiple bonds (accounts) are held that mature roughly one year apart. The coupons (interest) and maturing values are used for income (in other words at the end of the period, the capital is consumed). For example, the best buy 1, 2, and 3 year accounts currently have interest rates of 5%, 4.6%, and 4.52%, respectively. If we divide our £10k into 4 equal chunks, then assuming that each account retains its interest payments, we can spend £2.5k over the next year, £2.5*1.05=£2.63k, the year after that, £2.74k the year after, and £2.86k in the final year. A look at yieldgimp will find broadly equivalent gilts. In this particular example, the income has some inflation protection (i.e., provided inflation is below the interest rate of about 4.5%).

To cover longer periods of time (e.g., after the 5 year limit for most fixed rate accounts) with fully inflation protected income, it is more usual to construct a collapsing ladder consisting of inflation linked gilts.

Rolling ladder (no income)

This is similar to the collapsing ladder except each time the bond/account matures, the proceeds (together any money from the coupons/interest) is reinvested at the highest required maturity. Taking our 3 year example, we might start with £3.33k in each of the three accounts. After one year, the first account matures with approximately £3.5k. This is then invested in a new three year account. Of course, the interest rate at which it will be reinvested is currently unknown. At the end of the second year, the second account will mature with £3.64k and be reinvested in a new 3 year account (interest rate unknown). Finally (for this example), at the end of the third year, the third account will mature with £3.8k and needs to be reinvested in yet another 3 year account. After this the future maturing amounts are unknown. If you are accumulating, then new money can be added each time an account matures, while withdrawals can be taken from the maturing funds.

This last case is similar in form to a bond fund – each time a bond matures (or reaches the lower maturity limit defined by the index or the manager decides to sell in the case of active funds) the proceeds are reinvested in new bonds. The important difference between this form and the single bond or collapsing ladder forms is that future behaviour (after the period of the highest maturity has elapsed, 3 years in the example) is unknown.

The performance difference between a DIY rolling ladder of bonds and a bond fund with the same limits of maturity is minimal (because they are essentially the same thing), although there may be tax advantages to the ladder in a GIA (but not in SIPP or ISA) and possibly a small advantage with fees (although bid spreads may be higher for retail investors in the case of bonds).

I have not included a discussion on duration here, but that is also essential to understanding the effect of changes in interest rates/yields on bond funds. It is one reason why talking about 'bonds' without including what duration is being considered is essentially meaningless.

Bobziz

Thanks @OldScientist useful. Are you able to explain the potential yield outcomes at maturity of an index linked single bond v's a nominal bond for the same/similar duration please. I understand that you pay a premium for the linker to remove inflation risk, but what are the scenarios in which you may do better or worse than a nominal bond and to what extent ? I believe there's a floor which is presumably the guarantee that you'll get at least your capital payment back, but potentially no interest payments.

InvesterJones

OldScientist said:

This last case is similar in form to a bond fund – each time a bond matures (or reaches the lower maturity limit defined by the index or the manager decides to sell in the case of active funds) the proceeds are reinvested in new bonds. The important difference between this form and the single bond or collapsing ladder forms is that future behaviour (after the period of the highest maturity has elapsed, 3 years in the example) is unknown.

The performance difference between a DIY rolling ladder of bonds and a bond fund with the same limits of maturity is minimal (because they are essentially the same thing), although there may be tax advantages to the ladder in a GIA (but not in SIPP or ISA) and possibly a small advantage with fees (although bid spreads may be higher for retail investors in the case of bonds).

Great post. Regarding the above, perhaps worth mentioning that if you could find a bond fund with the same limits of maturity as a ladder then great, but in practise there are almost no bond funds that hold bonds until maturity, and that fact alone becomes quite a distinguishing feature between bond funds and single bonds (which can be held to maturity).