Bonds - still so confusing...

aroominyork · 8 October 2017 at 5:07PM

A few months into DIYing I still find bonds are the sector I don’t sufficiently understand (despite having read bowlhead et al from dawn til, well, an hour or two after dawn).

Equities, by comparison, seem relatively straightforward. Either go passive, or choose your geographies, sectors and company sizes then sit back and hope. Why do bonds confuse me so? They are meant to be the main way to balance risk in a portfolio, but much of what’s written is about their downside, eg of the 20-30 year bond run reversing. A few days ago I read in a post a rule of thumb that during an equities crash, bonds go up 0.5% for each % that equities fall, and while I wish it were that simple I fear it’s not.

I am approaching this with a retirement portfolio with a ten year horizon invested 65% equities, 30% bonds, 5% property/other. The bonds are 10% higher risk (Schroder High Yield Opps and GAM Star Credit Opps), 18% strategic (Royal London Ethical and Morgan Stanley Sterling Corporate) and 2% within VLS.

I understand (I hope correctly) that as long as interest rates remain low and no sectors of the economy goes wotsits-up, the high yield funds will perform better. So I have two questions. The first is whether, if there is a bond bear market, do investors hang on to their bonds (high yield and cautious/strategic) the way they hang on to equities after a crash, waiting for them to recover, or is the strategy different for bonds?

My second question is about the role of strategic bonds, whose rises have generally slowed in the last year; is this because the managers see an interest rate rise, the end of the bond bull market and/or an equities correction as more imminent and so are investing more cautiously? And if so, what can I reasonably expect to happen to these funds when one or both of those events happen? If there is not a good chance of the ‘equities down 1%, bonds up 0.5%’ scenario playing out, and given the warnings about the end of the bond run, do bonds have too many more potential downsides than upsides for them to be a worthwhile investment?

The cause of the next crash will presumably affect bonds as much as equities. Presumably, if it was not caused by the banks (as 2007/8) and was not in sectors where the banks were exposed, then bond funds invested heavily in banks/financials would be safe havens.

So that’s my conundrum, having a chunk of my portfolio invested for reasons I don’t fully understand (and, I expect, writing a number of things in this post which demonstrate that).

bostonerimus · 8 October 2017 at 5:23PM

You should start by thinking about individual bonds rather than bond funds. An bond is just a loan with the promise to pay the money back at the end of a term with interest. So if you hold to term you'll get back your principal plus some interest as long no one's gone bust. There's a market for these bonds and obviously if your bond is paying less than current interest rates you'll have to sell it a discount to get people to buy...ie it's price will fall. So a classic technique was to buy a number of individual bonds of various terms in solid organizations ie Gilts or big companies and just wait for them to mature. You get some interest and your capital is very safe.

Now if you buy a fund made up of many bonds with different durations that are being continually bough and sold you end up with your bond fund valuation going up and down. There are products sold by Guggenheim in the US that are made up of bonds all of the same duration. So you hold them until they mature and net the interest.

aroominyork · 8 October 2017 at 5:39PM

Thanks boston - that much I understand. It's the dynamics of the market and how bonds relate to the wider world that I don't grasp, eg that bond markets are more dependent (I think ) on what is happening with equities than the other way round.

Superscrooge · 8 October 2017 at 5:50PM

There are some good articles on 'Investing in Bonds' on the Monevator website that will help answer your questions

http://monevator.com/tag/bonds/

chucknorris · 8 October 2017 at 5:59PM

bostonerimus wrote: »

You should start by thinking about individual bonds rather than bond funds. An bond is just a loan with the promise to pay the money back at the end of a term with interest. So if you hold to term you'll get back your principal plus some interest as long no one's gone bust. There's a market for these bonds and obviously if your bond is paying less than current interest rates you'll have to sell it a discount to get people to buy...ie it's price will fall. So a classic technique was to buy a number of individual bonds of various terms in solid organizations ie Gilts or big companies and just wait for them to mature. You get some interest and your capital is very safe.

Now if you buy a fund made up of many bonds with different durations that are being continually bough and sold you end up with your bond fund valuation going up and down. There are products sold by Guggenheim in the US that are made up of bonds all of the same duration. So you hold them until they mature and net the interest.

I'll be selling quite a bit of property over the next few years, I already have quite a bit in shares, and I will re-invest some more, but I do want something in bonds. But I won't touch bond funds, I'll but individual corporate bonds and hold them to maturity.

aroominyork · 8 October 2017 at 6:06PM

Superscrooge wrote: »

There are some good articles on 'Investing in Bonds' on the Monevator website that will help answer your questions

http://monevator.com/tag/bonds/

Monevator says most investors should steer clear of corporate bonds and stick to gilts. "I prefer asset classes to play a clearer role in my portfolio: Equities to deliver growth, and domestic government bonds to reduce risk. Corporate bonds do not strictly fulfill the defensive criteria outlined for bonds at the start of this post." Confuses the picture even more!

dunstonh · 8 October 2017 at 7:31PM

Monevator says most investors should steer clear of corporate bonds and stick to gilts.

I thought monevator was passive biased? If so, they shouldnt be making management decisions like that as that makes it active.

coyrls · 8 October 2017 at 7:41PM

aroominyork wrote: »

My second question is about the role of strategic bonds, whose rises have generally slowed in the last year; is this because the managers see an interest rate rise, the end of the bond bull market and/or an equities correction as more imminent and so are investing more cautiously? And if so, what can I reasonably expect to happen to these funds when one or both of those events happen? If there is not a good chance of the ‘equities down 1%, bonds up 0.5%’ scenario playing out, and given the warnings about the end of the bond run, do bonds have too many more potential downsides than upsides for them to be a worthwhile investment?

To be clear, there is no such thing as a strategic bond. There are bond funds that are placed in the strategic bond fund category. Funds in the category generally have a more flexible mandate than is the case in other bond fund categories. They can short bonds and move in an out of different bond types. If you are looking at a strategic bond fund, you should research their mandate because there are all sorts of funds with different strategies that are lumped together in the strategic bond fund category.

Alexland · 8 October 2017 at 8:25PM

Hi,

Yes it's a lot harder to get you head around than shares.

You probably got that rule of thumb from one of my recent posts. It's not as precise as bonds go up 0.5% for every 1% stocks go down but the point I was trying to make was that they are historicly less volatile and across most trading days have an inverse corellation to stocks. When traders are worried about stocks they flock to the safety of bonds but they don't find them as exciting.

Now that might not be happening with your investments because most of us are experiencing the general turbulence of Brexit currency fluctuations. If the pound goes down then both US bonds and stocks go up.

UK corporate bonds and gilts will be less volatile at the moment (although there will be overseas investors). The UK might get another credit rating downgrade which might harm gilts but sterling would also be hit so your overseas shares would go up. If the brexit process improves in the UK the pound will strengthen, your overseas shares will go down and the gilts may be upgraded a credit notch.

In addition while bonds are generally low risk they are looking pretty risky right now if interest rates start rising; especially the long dated ones. Even if the UK is not in a position to raise rates the rest of the world may be and that would affect demand for UK bonds.

My view is people are chasing yield like sheep and once heard bonds are safe (maybe incorrectly thinking they might somehow be related to a bank fixed term savings account) so do not see the risks. Inflation linked gilts are also looking very overvalued. Short dated bonds don't carry the interest rate risks but are so close to redemption (and already have the remaining coupons priced in) they will not move much in either direction so what's the point.

So to control volatility and risk in your portfolio corporate bonds and gilts have a role (maybe up to 20%) but for the remaining ballast you may need to look wider. You could consider buying a UK share fund that is less sensitive to currency movements (M&G Index Tracker is an old favourite but there may be cheaper ETFs) or maybe funds that use a hybrid of bonds and market hedging (such as the Orbis Balanced fund) or maybe a technique of moving into cash or gilts when the pound is weak to capture the gains.

In terms of crashes there is a limit to the protection you can get without significantly damaging growth. Unfortunately unless you have a crystal ball you cannot avoid them and they will cause the values of your holdings to drop. This is where you need confidence in the diversification and long term success of the shares you own. If it's a global crash its also an opportunity to reallocate any spare cash to equities regardless of currency rates.

Good luck,
Alex

A_T · 8 October 2017 at 9:19PM

Alexland wrote: »

So to control volatility and risk in your portfolio corporate bonds and gilts have a role (maybe up to 20%) but for the remaining ballast you may need to look wider. You could consider buying a UK share tracker which will be less sensitive to currency movements (M&G Index Tracker is an old favourite but there will be cheaper ETFs) or maybe funds that use a hybrid of bonds and market hedging (such as the Orbis Balanced fund) or maybe a technique of moving into cash or gilts when the pound is weak to capture the gains.

A FTSE All Share Index tracker won't offer much protection when sterling strengthens. It's dominated by the 100 which in turn is dominated by companies which invest heavily overseas.

Alexland · 8 October 2017 at 9:28PM

It would still be less currency sensitive - circa 50%. Or you could zoom in to the FTSE 250 & 350 depending on how the rest of your portfolio looks.

Another option I missed out would of course be the pet rock gold which has no intrinsic earning power, offers long term below inflation returns but is the last resort if traders loose confidence in both shares and bonds.

Bonds - still so confusing...

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