What caught my eye this week.
Behold! Interest rates have risen from the dead! Excuse the fervent tone, but the Bank of England has not lifted rates for as long as Monevator has been in existence. That’s no mean feat given that my first articles were written in September 2007.
(Curious? The first article on this site explains how to calculate dividend yields. Heady days).
So will rates now steadily rise towards the dizzy heights of 5% or more of yore?
I doubt it. I wouldn’t hold your breath on them being above 1% in a year’s time, personally.
Who knows though? Neither the Bank nor the market expects more than a couple of hikes over the next two years, as the BBC reports, but such forecasts are far from infallible:
Mr Carney told the BBC that the Bank expected the UK economy to grow at about 1.7% for the next few years, which he said would require “about two more interest rate increases over the next three years” […]
The financial markets are indicating two more interest rate increases over the next three years, taking the official rate to 1%.
I had a discussion with a reader in the comments to last week’s Weekend Reading. The reader wondered ahead of the hike whether using an active bond fund might make sense?
His reasoning was that bond market moves were more predictable than the gyrations of equities, and hence the case for passive investing was weaker.
I begged to differ.
It still regularly surprises me how people who have sensibly decided they have no edge in the stock market appear to think they can saunter up to the multi-trillion pound bond market and know better than it – which is really what deciding you can select a market-beating bond fund manager amounts to.
I don’t mean to pick on this thoughtful reader in particular. There have been literally hundreds of people commenting on Monevator articles for the best part of a decade making calls on the bond market. Maybe two or three said they thought government bonds – which have mostly risen throughout – looked like a good buy. Most of the rest proclaimed they were getting out of bond funds, or at most suffering them through gritted teeth, before an imminent crash.
I’d guess at least half these people were self-declared passive investors.
The reader wrote:
If the BoE raises rates next week, the affect on bonds is entirely predicatable. I would have thought just buying a bond fund that re-rates downwards is not a great idea.
At least a bond manager should have been able to foresee and mitigate the affect of a rate hike (not entirely, but just so that the damage is less than in a simple tracker)?
But as I replied, things are not so clear cut:
The short answer is that the affect of a rate rise is NOT entirely predictable.
First-level thinking that says ‘rates have gone up so bond fund will go down’ will get a person nowhere in active investing. You need to be thinking second or third level (and be lucky!) and for years on end to beat the market as an active investor.
To give just a couple of counter examples, if rates rise but the BOE attaches commentary that’s more bearish than expected about the prospect of further rises, UK bonds and bond funds could easily rally.
If the rate rise spooks the stock market or drives the pound higher and there’s a mini equity crash, again bonds could rally.
Perhaps most obviously of all, since the BOE has been hinting at a rate rise for months, it could all be baked into the price by now and the actual rise be a non-event
These are just three of many dozens of possible scenarios.
Equally, rates could certainly rise and bond funds could fall — it’s totally possible. But in active investing (and I speak as one) you have to get these calls right again and again — so that you’re mostly right more than you’re wrong, and with the right-sized positions. Not once or twice to talk about at dinner parties. 🙂
Secondly, there’s the risk/reward of predicting and positioning for a rate rise, as an active bond fund manager. Pundits and commentators to this blog have been saying rates will rise and bonds crash for nearly a decade. Even I threw the towel in — after years of warning readers not to be so sure — and asked if a bond crash might finally be upon us back in June 2015.
Luckily, humility won the day and I concluded it looked that way but I wasn’t sure, and that pure passive investors should probably do nothing to change their strategy, or alternatively only tweak it.
As things turned out yields fell even further (i.e. Bond prices rose and there was no crash). The US 10-year yield has only this month finally gotten back to where it was that summer of 2015 — having nearly halved along the way! The UK 10-year gilt yield is still below where it was then, even after months of talk about an imminent Bank Rate rise.
Also — the US Federal Reserve raised rates for the first time in December 2015 and a second time in December 2016. Did bond funds fall as was “entirely predictable”? 🙂
No, yields rose (i.e. bond prices fell!) after the first rate rise. They then rallied with the Trump election, before sliding again after the second rate rise in December 2016.
But let’s leave aside the fact that bonds did the opposite of what they would supposedly obviously do. At some point I am sure rates will rise and yields will indeed rise too (i.e. bond prices and bond funds will fall for a while).
The point is an active bond fund manager has to get these bets right with the right amount of money at the right times to outperform. If a bond manager had decided it was ‘obvious’ yields would rise after those rate cuts I mentioned above, positioned accordingly, and were wrong, then they were now down say 20% over a few months versus the benchmark. They now have to make that back by being right later, and more again to start to outperform.
This stuff is hard. 🙂
Active bond managers are about as expensive as active fund managers, and in corporate bond investing at least they take as much research oomph behind them too. Yet expected bond returns are lower than equities, and right now they are very low. This means the higher fees for active bond management eat up even more of your return.
Oh, and none of this is to even get into the mathematics of reinvestment — rising yields are bad for bond funds in the short term, but in the long-term they can boost returns (due to reinvesting higher yields) which means someone who only looks at their portfolio every five years say might not even notice there’d been much of a correction unless it was truly catastrophic.
So there we have it — bond price moves are not entirely predictable, the consensus about the direction of even central bank rates has been wrong for a decade, passive investors reinvesting their bond income might even welcome rate rises over the medium to long term, and in the meantime with active bond funds yielding maybe 3-4%, TERs of say 1+% are monstrously expensive.
I don’t see going active with bonds is an obvious decision. 🙂
Incidentally I’ve noticed that for some reason, even people who accept the logic of passive investing in shares seem to think bonds are no-brainers. They are not!
The bond market is an even bigger, deeper, harder, and even more competitive market. Perhaps only currencies are bigger/harder (bordering on random in my view over anything other than the multi-decade view, and perhaps even then.)
Oh, and as a coda, UK government bond yields fell and prices rose in the immediate wake of the Bank of England rate rise. Things clearly aren’t quite so predictable…
I didn’t know that would happen. And again I want to stress I have no problem (just far too little time) with readers finding their own way and asking questions. After 15 years as an investing obsessive, I’m still learning new things every day. If anything I’m less confident about what I do know than a decade ago.
I need to be uncertain, because for my sins I’m an active investor. My returns live and die by my speculations. My uncertainty has been hard won. Spend a few years honestly tracking your returns and you’ll discover nothing is “entirely predictable” in investing.
Happily, most readers are, like my co-blogger, passive investors. And if you’re going to be a passive investor, then be a passive investor. Whether in bonds or equities or anything else.
Embrace it! In most cases it will be better for your returns than being almost passive. And you will certainly have a lot more free time and less hassle in your life.
[click to continue…]