Bonds v bond funds

MK62

Bobziz said:

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.

This is given by the breakeven RPI figure, usually quoted with the linker data........if RPI inflation runs lower from today until maturity you'd have been better off with a conventional gilt........higher and the reverse is true, and the linker would have been better. The breakeven figure is the market's expectation of inflation over the period to maturity........if correct, both gilts returns would be the same.

OldScientist

InvesterJones said:

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).

It varies between different index providers. Some of the FTSE gilt indices (see https://www.lseg.com/en/ftse-russell/indices/gilts ) do hold bonds to maturity ('all stocks', 'under 5 years' and 'under 10 years' indices), although this is not true for their world indices (which all start from 1 year). I think all of the MSCI gilt and bond indices start from a maturity of 1 year.

I've done some calculations with some US indices and historical yield curves and holding until maturity does tend to reduce the annualised returns by a few basis points (the exact amount depended on the index) compared to stopping at 1 year (I've found no US indices that go to maturity - weirdly, an obscure one went to 1 month). Of course, the rolling ladder holder can choose exactly what maturity bonds they want to hold and doesn't have to allow bonds to mature (although that may save transaction fees).

JohnWinder

? 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.

That sounds like a misunderstanding to me. Ignoring default, a nominal bond gives you back at maturity £100, the face value (assuming that is the face value; some countries might use 1000 dollars etc). An inflation linked bond gives you £100 plus whatever the inflation since issuance adds to that, eg total £110 if there's been 10% total inflation since issuance. In some countries the maturity value is never below 100 dollars even if there has been deflation overall since issuance; other countries might pay back less than the 100 whatevers face value with deflation.
Secondly, no interest payments??????  A bond is a contract to return the principal, and to pay interest regularly as specified by the bond's coupon. I imagine there might be zero coupon bonds somewhere in the world, but not UK I think. So I'd reject the idea of 'no interest payments'

Bobziz

JohnWinder said:

? 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.

That sounds like a misunderstanding to me. Ignoring default, a nominal bond gives you back at maturity £100, the face value (assuming that is the face value; some countries might use 1000 dollars etc). An inflation linked bond gives you £100 plus whatever the inflation since issuance adds to that, eg total £110 if there's been 10% total inflation since issuance. In some countries the maturity value is never below 100 dollars even if there has been deflation overall since issuance; other countries might pay back less than the 100 whatevers face value with deflation.
Secondly, no interest payments??????  A bond is a contract to return the principal, and to pay interest regularly as specified by the bond's coupon. I imagine there might be zero coupon bonds somewhere in the world, but not UK I think. So I'd reject the idea of 'no interest payments'

Thanks, so for UK linkers there is no deflation floor on the final redemption payment, but you will always get coupon payments which are also inflation/deflation adjusted. So with this in mind, is there a scenario, assuming that you didn't buy the gilt when it was first issued, in which your overall return is negative ?

leosayer

JohnWinder said:

? 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.

That sounds like a misunderstanding to me. Ignoring default, a nominal bond gives you back at maturity £100, the face value (assuming that is the face value; some countries might use 1000 dollars etc). An inflation linked bond gives you £100 plus whatever the inflation since issuance adds to that, eg total £110 if there's been 10% total inflation since issuance. In some countries the maturity value is never below 100 dollars even if there has been deflation overall since issuance; other countries might pay back less than the 100 whatevers face value with deflation.
Secondly, no interest payments??????  A bond is a contract to return the principal, and to pay interest regularly as specified by the bond's coupon. I imagine there might be zero coupon bonds somewhere in the world, but not UK I think. So I'd reject the idea of 'no interest payments'

There is a concept of UK Gilt and US Treasury "STRIPS" (Separate Trading of Registered and Interest Principal Securities) which have zero coupon, however I don't know how to purchase such a thing.

Linton

Bobziz said:

JohnWinder said:

? 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.

That sounds like a misunderstanding to me. Ignoring default, a nominal bond gives you back at maturity £100, the face value (assuming that is the face value; some countries might use 1000 dollars etc). An inflation linked bond gives you £100 plus whatever the inflation since issuance adds to that, eg total £110 if there's been 10% total inflation since issuance. In some countries the maturity value is never below 100 dollars even if there has been deflation overall since issuance; other countries might pay back less than the 100 whatevers face value with deflation.
Secondly, no interest payments??????  A bond is a contract to return the principal, and to pay interest regularly as specified by the bond's coupon. I imagine there might be zero coupon bonds somewhere in the world, but not UK I think. So I'd reject the idea of 'no interest payments'

Thanks, so for UK linkers there is no deflation floor on the final redemption payment, but you will always get coupon payments which are also inflation/deflation adjusted. So with this in mind, is there a scenario, assuming that you didn't buy the gilt when it was first issued, in which your overall return is negative ?

If you sell at maturity then market forces should not permit a current price that guaranteed a loss in £ terms assuming expected inflation - I can’t see any rational investor buying at such a price. However if you sell prior to maturity or actual inflation is less than expected you could make a £ loss. 

The only way to ensure you can’t make a loss in real terms would be to buy at par or below and hold to near maturity.  

Coupons on currently available IL bonds can be very low.

JohnWinder

'Thanks, so for UK linkers there is no deflation floor on the final redemption payment, but you will always get coupon payments which are also inflation/deflation adjusted. So with this in mind, is there a scenario, assuming that you didn't buy the gilt when it was first issued, in which your overall return is negative ?'

I think 'yes', whenever you buy it. 'Yield' rather than 'return' seems to be the jargon for what bond investing gets you. Before you make your purchase you can/?should calculate (or have someone else calculate) the yield to maturity. Spreadsheet programs on computers do it for you easily if you feed them with purchase/maturity dates, coupon% and frequency, purchase price, and whatever else is in the formula.

Ignore deflation for a moment as it doesn't seem to happen anymore, certainly not for months/years on end which will be the holding to maturity period for your linker. So, expecting there'll be inflation, as investors do, nominal bonds will be yielding 3%/year for example. Comparable linkers will be yielding, say, 1% because the market expects 2%/year inflation (average) until the bonds mature. So linker yields which are always interpreted as 'real' or inflation adjusted will always be les than similar duration nominal bonds whose yield is expressed as 'nominal' not 'real' yield.

In recent years several countries including Japan, ?Australia, ?Germany had nominal bonds offering negative yields, as they tried to boost the covid pandemic economies. Thus the linker real yields would have been negative as well. 

Who would buy negative yielding bonds? Anyone who wanted a predictable return, and thought all the other investment options were less appealing in terms of risk and return. No different from how you'd choose any investment at any other time; the best risk/benefit on offer, as you perceive it.

MK62

Bobziz said:

JohnWinder said:

? 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.

That sounds like a misunderstanding to me. Ignoring default, a nominal bond gives you back at maturity £100, the face value (assuming that is the face value; some countries might use 1000 dollars etc). An inflation linked bond gives you £100 plus whatever the inflation since issuance adds to that, eg total £110 if there's been 10% total inflation since issuance. In some countries the maturity value is never below 100 dollars even if there has been deflation overall since issuance; other countries might pay back less than the 100 whatevers face value with deflation.
Secondly, no interest payments??????  A bond is a contract to return the principal, and to pay interest regularly as specified by the bond's coupon. I imagine there might be zero coupon bonds somewhere in the world, but not UK I think. So I'd reject the idea of 'no interest payments'

Thanks, so for UK linkers there is no deflation floor on the final redemption payment, but you will always get coupon payments which are also inflation/deflation adjusted. So with this in mind, is there a scenario, assuming that you didn't buy the gilt when it was first issued, in which your overall return is negative ?

If you mean negative return as is you get less £ back than you invested......it's possible, but very unlikely unless we get a lengthy period of deflation (ie negative inflation).
If, on the other hand, you mean less back in real terms (ie after adjusting for inflation) then that was the norm for several years up until a few years ago when the near zero era of interest rates ended......however, as long as you buy when the real yield is positive (as it is now) then in real terms the value of your investment should be protected (however it should be noted that this doesn't necessarily mean that the nominal value wouldn't go down if we get a period of deflation)
Linkers effectively lock in the future value of your investment, but the £ amount returned could be more or less than that invested. Conventional gilts lock in the future £ amount of your investment but the value of that could be more or less than that invested.

Albermarle

goodValue said:

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.

Regarding your first sentence, probably some perspective is necessary.
During a 30 year retirement then you will inevitably see periods of downturns in share markets . Quite a few in fact. They will happen and most will bounce back within a couple of years. So it is be expected and normal. The worry for retired investors is for a prolonged downturn, that happens every now and again.