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Should I dump my government bond funds?

Many passive investors are in a pickle over gilts (or US Treasuries or whatever your domestic government bond might be, if you’re tuning in from outside the UK).

Mechanical asset allocation rules dictate that we must sink a proportion of our savings into government bonds, according to our individual risk tolerance. But aren’t we on a hiding to nothing, as gilt prices have soared and yields dwindled thanks to government manipulation of the market?

It certainly seems so when an investing legend like Warren Buffet comments:

Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.”

Surely the only way for gilts to go is down as interest rates rebound? Surely some kind of ‘active’ evasive manoeuvre is required?

Are gilt prices about to fall to Earth with catastrophic impact?

What are gilts for?

Let’s ignore for now the fact that similar fears were widespread a year ago, only for the UK gilt sector to return 15% in 2011 and the index linked gilt sector to weigh in with a 21% rise.

Let’s even assume that this chart-topping performance makes it all the more likely that gilts must drop.

Before leaping into action we need to consider a few questions:

  • How catastrophic will the ‘inevitable’ bonfire of the bonds be?
  • Why do I have a gilt allocation anyway?
  • What if things don’t turn out according to the forecasts?

To answer the first question, the role of government bonds for investors who are building their capital is to reduce the risk of underperformance by equities.

The more your portfolio is insulated with gilts, the less violently it should convulse as it’s held to the bare wire of the market.

Hence ‘merely human’ investors are less likely to go panic-sell crazy during market turmoil, and you’re better diversified should equities not live up to their long-term performance billing.

These important protective features of gilts remain true even in the face of the current market situation, and particularly given the economic uncertainty faced by the world.

If we should slip into a Japanese-style economic ice age, your gilt positions will provide a stable source of income and a welcome redoubt against deflation.

And if you pare back your gilt allocation to a point where your portfolio is riskier than you can truly stand, you may well do far more damage to your long-term prospects than you would in that much-feared gilt bear market, if instead equities fall, your nerve snaps, and you belatedly sell your shares at low prices.

This is because bear markets in bonds are generally pretty tame in comparison to equity nose-dives.

How bad can the losses be?

According to Vanguard, the largest annual loss that a 100% UK bond portfolio would have suffered in the last 30 years is -6.27% (in 1994).

Compare that with the -29.93% sliced off UK equities in 2008.

Better still, gilt funds1 come with an in-built recovery mechanism. As the price declines, yields rise, so as your bonds mature they can be reinvested for a lower price into new gilts that pay higher levels of interest.

As Vanguard2 points out, this mechanism eventually works in our favour:

Over the long term it’s interest income – and the reinvestment of that income – that accounts for the largest portion of total returns for many bond funds. The impact of price fluctuations can be more than offset by staying invested and reinvesting income, even if the future is similar to the rising rate environment of the 1970s and early 1980s.

Duration is the key characteristic on your gilt fund factsheet that shows how badly it will be affected by a rise in interest rates and long it will take to recover.

For example, if a gilt fund has an average duration of 7 years then it will lose (or gain) approximately 7% of its net asset value (NAV) for every 1% rise (or fall) in interest rates.

A duration of 7 also means that the fund will recover its original value within seven years as higher interest payments compensate for falls in price (though the recovery can be faster in practice).

What action can I take?

One thing you can do, therefore, is to make sure you only invest in gilt funds with a duration that’s no longer than your time horizon. That way you can’t suffer a capital loss on your portfolio’s gilt allocation.

And if you’re strapping in for the long term then you can take comfort from the fact that you’re likely to be able to ride out sharp rises in interest rates.

Interestingly, though a rapid rise in interest rates would seem to be a nightmare scenario for bond investors, the Vanguard study I quoted above found it actually delivered the highest expected return over 10-years (in simulations upon intermediate holdings of US Treasuries) in comparison to scenarios that are more bond-friendly in the short-term.

But if such reassurance is not enough to stay your hand, then it is possible to maintain your allocation to defensive assets while reducing your exposure to a price drop (otherwise known as maturity risk).

You can do this by increasing your allocation to shorter-dated gilt funds at the expense of longer dated funds.

This works by shifting some of your allocation from a long dated gilt fund to an intermediate fund, or from an intermediate fund to a short-term fund.

The table below shows what kind of difference that would make in terms of duration, using some example UK-listed gilt funds:

Fund type Long dated Intermediate Short dated
Example fund Vanguard UK Long-Duration Gilt Index Fund Vanguard UK Government Bond Index Fund iShares FTSE Gilts (0-5) Years ETF
Duration 16 9.5 2.57
Yield-to-maturity 3.25 2.06 0.65

If interest rates rise by 1% then the iShares ETF’s duration reveals that it will only lose 2.57% of its value in comparison to a 9.5% loss for the Vanguard intermediate fund.

But if interest rates fail to budge, we can see from the yield-to-maturity that the short-term fund will pull in less than a third of the income of its intermediate rival.

If you’re more worried about volatility than long-term returns, a shift of this kind could make sense – particularly if you already have a high allocation to fixed-income.

Another way to trim your exposure to maturity risk would be to increase your allocation to cash.

The best instant access bank accounts yield 3% and you can get a two-year fix at 4%. That’s considerably better than the current yield on gilts, your portfolio will be less volatile, and there’s no risk of a capital loss.

As ever, the risk with cash is that it has delivered the worst historical return over the long-term and is highly susceptible to inflation.

The slippery slope

The elephant in the room for passive investors is that once you start trying to outsmart the market, how will you know when to stop?

Interest rate forecasts are a total lottery. After the credit crunch, it was widely predicted that interest rates would rise in 2010, then 2011, and now 2013. I’ve seen commentary that predicts a flatline until 2015.

Once rates do rise, when will be the right time to get back into gilts? Will you be able to do it when equities are crackling like a fried egg in Death Valley? Or will you be too busy diving in and out of gold?

If you’re a long-term investor, you shouldn’t dump your gilt funds. Historically, they’ve always been a drag on a portfolio, but they’re not there to boost returns. Gilts are there to diversify risk.

If your risk tolerance hasn’t changed, then your allocation to gilts shouldn’t change either.

Take it steady,

The Accumulator

  1. I’m going to refer to gilt funds throughout the rest of this post, as I assume that most passive investors won’t want to strain themselves buying and managing their own gilt ladders. []
  2. The study is based on the US market, but the UK is analogous enough for our purposes. []

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{ 39 comments… add one }
  • 1 gadgetmind May 1, 2012, 11:04 am

    All of that makes a lot of sense, but I’m still not only of gilts but positioned with a negative duration!

  • 2 Rob May 1, 2012, 12:21 pm

    So… if you put money in a savings account you need the bank and the government to collapse to lose your money. In a gilt you just need the government to collapse (although one might cause the other). So investing non-passively you might try and ride price changes (I know people do profit from this sometimes), but from a passive perspective you buy for the yield right. So the time to invest in gilts is when they yield more than savings accounts unless you are investing non-passively like a wiley old fox. Do I get full marks The Accumulator?

  • 3 Paul May 1, 2012, 2:23 pm

    All historical loss data on government bonds is meaningless as we are now in uncharted territory.

    Governments around the world are lying to their citizens about the depth of the dept crisis.

    Holding long-term government bonds is now the worst possible choice.

  • 4 The Accumulator May 1, 2012, 7:34 pm

    @ Rob – you’re investing in gilts to reduce volatility and to benefit from diversification. If you were investing for high yield you might as well be in junk bonds with all the risk that would entail.

    @ Paul – we’re always in uncharted territory. Historical data can only guide our expectations, it can’t tell us what will happen. Incidentally, financial repression has happened before, particularly after WWII. And if we tailspin into a deflationary scenario you’d be pretty glad of the long-term government bonds.

  • 5 Andy May 1, 2012, 11:11 pm

    Well I wish I had known more about asset allocation 12 years ago, but I didn’t and I didn’t allocate any of my portfolio to gilts. Just equities and cash.

    Now I can see the important role gilts play after reading Tim Hale and Bernstein, but I still can’t bring myself to invest in them with current interest rates. I realise things could get even worse, and that I’m guilty of trying to time the market. The Vanguard information is interesting though, so maybe I will reconsider.

  • 6 The Investor May 2, 2012, 9:42 am

    @Rob — Accumulator is right, but I’ll give you some marks as I agree cash on term deposits can be an acceptable part of the fixed income mix for private investors currently.

    However be under no illusions that cash and bonds are the same — they are not.

    UK gilts returned over 10% in 2011, as the price moved up in response to fears in the second half of the year. You would not have got that counter-weight to equity declines from holding cash.

    I think the Vanguard long-term return in a rising rate environment information is very interesting. My suggestion is you could get a similar or better result by moving your cash into gilts after yields have risen a bit, and avoid the initial capital hit.

    But as The Accumulator notes, passive investors should probably not even go there. Rebalance and get on with your life — that’s a major benefit of the passive approach, especially when you can’t be confident that trying to be clever will actually deliver superior results. It could do worse.

  • 7 gadgetmind May 2, 2012, 10:42 am

    > My suggestion is you could get a similar or better result by moving your cash into gilts after yields have risen a bit, and avoid the initial capital hit.

    That’s my current plan. I know it’s not best long-term, and I *really* want to be holding gilts, but the risk/reward situation on gilts is currently asymmetrical with lots of downside and little left to squeeze out in the way of upside.

  • 8 Neverland May 2, 2012, 11:31 am

    I have to say I disagree with the conclusion that the best thing to do is to do nothing

    This view to me seems rooted in the recent past with its light touch regulation and free markets

    We patently don’t have free markets now, e.g.:
    – central bank balance sheets all around the West have mushroomed 2-3x buying all sorts of assets to keep prices up;
    – the UK government seeks to set business lending targets for a partly nationalised UK banking industry;
    – the official BoE interest rate is at a 300 hundred year low;
    – the BoE now owns about a third of all gilts ever issued.

    I think if the facts have changed, you need to change your conclusions

    The facts have changed in my view

    Anyone investing in gilts/US treasuries is going to lose their purchasing power – just like they did 1945-1980, the last great era of government manipulation through financial repression

    You only have to look at the run up in the price of RPI linked gilts to see a lot of people agree with this view

  • 9 The Investor May 2, 2012, 12:50 pm

    @Neverland — So why are you so smart and the market is so dumb? 🙂

    I hold no gilts. But I do so very humbly indeed, I could easily be wrong.

  • 10 The Investor May 2, 2012, 1:11 pm

    p.s. Apologies, that sounded a bit short and you have given your reasons. I just think we should always be wary of knowing best, even those of us who aren’t pure passive investors. Most of the problems you cite surrounding gilts were true last year, and it didn’t stop them performing. (Might also want to consider the impact of regulation encouraging pension funds to buy).

  • 11 gadgetmind May 2, 2012, 1:14 pm

    A lot of people are totally out of equities and are sat on the sidelines in cash and gilts.

    I humbly filled my boots on equities last summer, and am still finding the odd bargain.

    Next week, I intend to humbly sell the last of my wife’s gilts and stick her in Vanguard LS 100% with *maybe* a side order of a strategic bond fund.

    Yes, I could follow the market, but I don’t think this is a great time for herd instinct, paralysing fear nor doing what usually works.

    Yes, I could be getting this wrong, and maybe this is a good time for me to learn a valuable lesson, but I’d take that on the chin. Humbly. 🙂

  • 12 Neverland May 2, 2012, 1:47 pm

    @ Investor

    You hold no gilts because the maths tells you its bad odds.

    The market isn’t dumb, a lot of the “market” for gilts doesn’t have an interest in profit maximisation: c. 30% of gilts are held by the BoE now as tool to hold down interest rates; (I’m guessing) another 30% is held by domestic banks, insurers and insurers who are being encouraged/forced to hold them by regulation

    Like I said, not a free market

    PS. I’m not actually that smart. I have a vast holding of index gilts, albeit bought a long time ago

  • 13 Simon May 2, 2012, 9:26 pm

    I too was worried about the value of a gilt fund (specifically the bond elements of a VG LS 60% equity fund) and what the effect of interest rate changes might be. I found the following Boogleheads post very useful.

    http://www.bogleheads.org/forum/viewtopic.php?f=10&t=94392#p1359305

    Actually the whole thread is to the point of this topic and very educational (for me at lest).

    After much thinking I have left my money in the VG LS 60% equities fund.

  • 14 The Accumulator May 2, 2012, 9:57 pm

    @ Neverland – my view does not concern the recent past. It’s based upon the theory of diversification and the empirical performance of assets that covers previous periods of financial repression. I agree it’s incredibly hard to buy gilts right now. Even a passive investor doesn’t have to bovinely buy when an asset is overvalued. But they should understand the risks of changing the plan. Value averaging could be a useful strategy to employ in this situation. It’s worth remembering that Benjamin Graham advised never to hold more than 75% in equities and never less than 25%. In other words, don’t stick all your eggs in one basket. The famed Permanent Portfolio is routinely creamed in one or two asset classes precisely because it’s a portfolio for all seasons. Priming your portfolio for only one kind of weather could leave you in difficulty if things don’t turn out as you expect.

  • 15 Rob May 2, 2012, 11:33 pm

    @TheInvestor and @TheAccumulator – I do see the diversification argument from making mistakes in this respect, but I’m still not convinced by bonds or gilts yet. I know that something like this will be important, but I’m still looking for a type of bond I really like the look of. What I really want is something very safe in absolute terms that can counter stocks. Looking at Greece and Italy I’m not sure that is that and I’m not sure how I’d go about ensuring bonds are safe. Still a tricky subject for me. What I want is something I can buy and sleep easily knowing that it won’t be gone in the morning, but I’m starting to doubt it can be found.

  • 16 The Investor May 3, 2012, 12:27 am

    “What I want is something I can buy and sleep easily knowing that it won’t be gone in the morning, but I’m starting to doubt it can be found.”

    It’s called cash. 🙂 Just beware that after 10,000 mornings you might need to wake up with a magnifying glass next to your bed to find it.

    I can’t really imagine any circumstance except perhaps takeover of the country by a rabid dictator in which UK gilts will not pay in full. My issue is what return you’re getting for holding to maturity (peanuts) and what real return you’re getting after inflation (monkey’s nuts). Overseas investors will have to consider currency impacts, too.

    But as The Accumulator rightly notes in these comments and above, you de-diversify at your peril. I’m happy with cash for now, but it is a risk. The fact is the gilt market is vast and liquid, and currently it’s happy with c.2% on ten years. I agree it is distorted, but then I expected inflation from QE eventually. No sign of that yet either.

    Thank goodness I think UK shares still look good value.

  • 17 gadgetmind May 3, 2012, 8:22 am

    A wise man once said that asset A being over-priced is never a good argument for buying more of asset B(even if they are usually negatively correlated) so whether or not you choose to buy gilts should not affect your exposure to equities.

    At the moment, buying gilts (even linkers) is a guaranteed way of losing some of your future purchasing power in exchange for retaining the rest of it.

    I have kept my equity exposure at about 75% and have put the remaining 25% into some corporate bonds, some strategic bond funds (mainly holding corporate bonds and short-dated/diversified linkers), and infrastructure funds.

    Infrastructure may be on a slight (5% ish) premium, but yields are good and mostly index linked. As with gilts, they will also suffer with rising interest rates, but aren’t in anything like as frothy a bubble.

    I guess we can all look back on this thread in 2017 and see which calls were right and which were wrong!

  • 18 Neverland May 3, 2012, 9:24 am

    @Accumulator

    I can see the benefits of diverse investments, however..

    I could diversify my portofolio with regular investments in lottery scratchcards

    They would provide returns tottally uncorrelated with equities, bonds or commodities and would therefore provide an excellent diversification tool

    That doesn’t mean the lottery scratchcards themselves would be a good investment however 🙂

  • 19 Neverland May 3, 2012, 9:31 am

    @Rob

    “What I want is something I can buy and sleep easily knowing that it won’t be gone in the morning, but I’m starting to doubt it can be found.”

    The closest thing to that is first a house to live in and next a building to rent out, but there is a whole thread on this board will the risks around that…

  • 20 Lee May 3, 2012, 1:10 pm

    Part of me can’t help but lose faith in the whole gilt arena, as when a government can manipulate its economy on a whim and pleasing, where is the safety?

    As irrational as it may be, I’d rather put cash under the mattress than invest in gilts.

  • 21 Rob May 3, 2012, 1:39 pm

    @Neverland – could what I want be land? Possibly agricultural? Maybe not buying directly. I’ll think about one… if it does lead somewhere thanks for the inspiration.

  • 22 The Investor May 3, 2012, 2:40 pm

    @Neverland — Hah, the scratchcard argument sounds a bit like the case for gold… 😉

    @Lee — I don’t think the government can manipulate the whole economy on a whim. We’ve had extraordinary low interest rates for three years, but money still isn’t really moving through the economy and we’re zig zagging in and out of recession.

    I agree with the mantra ‘don’t fight the Fed’ (and by extension the BoE) which is another reason why I’ve been relatively comfortable to be overweight equities, but I wouldn’t overplay what the authorities can do in the face of massive deleveraging or risk aversion, especially in the light of the past three years.

    Gilts are what they are and what they have always been. We have our own printing press and no reason not to pay in full. For UK investors the big risk is inflation and very lousy relative returns, assuming equities and corporate bonds or what have you perform. But if they don’t, gilts could still do well. Just ask the Japanese!

    Note: I don’t hold gilts, and favour cash. But again, humbly!

  • 23 OldPro May 3, 2012, 3:23 pm

    Why buy gilts when you can buy Good Old Lloyds preference shares at 9.5%… I have put a comment on your old article to alert you that they are now confirmed to resume payment… here is your old article:

    http://monevator.com/lloyds-preference-shares/

    I don’t know how to make it come up as a blue link… I am also being tongue in check to state they are a choice to make instead of govvies… just in case any schoolchildren are reading this!

  • 24 The Investor May 3, 2012, 3:27 pm

    @OldPro — Thanks for both your comments on the prefs. I did indeed see the news on the LLPC issue that I hold, and have updated that page you link to with a note at the top for newer readers.

    While nobody will ever treat bank preference shares as pseudo-corporate bonds again — let alone gilt substitutes! — the risk reward seems to have panned out in our favour here. I for one am glad to have the income locked away.

    As you say, definitely not relevant in a thread about alternatives to government bonds, however. These are risky, equity-like securities.

  • 25 gadgetmind May 3, 2012, 3:32 pm

    I don’t treat prefs as gilts, nor bonds, though some cumulative issues come close and even enjoy greater seniority. I do however treat them as yet another way to diversify income streams, which is never a bad thing.

  • 26 Davy Jones May 3, 2012, 7:33 pm

    Took a brief look at vanguards index returns from 13/05/1996 to 02/05/2011 , return on $10,000 investment.

    Vanguard Total Bond Market Index Inv – $24,346.39

    Vanguard Total Stock Mkt Ind Inv – $27,493.30

    Vanguard REIT Index Inv – $48,253.71

    I think Simon is correct , that if you are going to hold bonds , let vanguard do the rebalancing for you as most investors will not have the discipline to do this in a market downturn.
    Knowing & doing are two different things , if you stop percieving a chart as rising & falling & look at it SIDE on .. it now becomes a river growing stronger over time.

  • 27 The Accumulator May 3, 2012, 8:21 pm

    @ Neverland – that would be a thrill while it lasted. I can just picture the scene: 100K up in smoke, surrounded by discard piles, down to the last £50 in cards, furiously rubbing like you’re holding Aladdin’s lamp, begging lady luck for a visit: “C’mon baby, purleeeese”

  • 28 emanon September 4, 2013, 2:32 pm

    Just when i thought i had my asset allocation figured out, then i read this post which throws my allocation into doubt. I still don’t know enough about the bond makrets. I feel confident in equities of which i have allocated 60% into these with a mix of – domestic, developed and emerging markets. I was going to invest 20% into bonds, i have a 25 year time horizon to meet my goals but there seems to be some more educating to do. Although most of what i’ve read and seen doesn’t flag the concerns discussed. David Swensen highly recommends government bonds (inc. index-linked) as does Tim Hale.

    Can anyone recommend a good source to read in order to get fully up to date with buying a bond fund for my passive portfolio?

  • 29 emanon September 9, 2013, 9:30 pm

    @The Accumulator

    You talk about shifting allocation within the bond asset class in this post –

    “You can do this by increasing your allocation to shorter-dated gilt funds at the expense of longer dated funds.

    This works by shifting some of your allocation from a long dated gilt fund to an intermediate fund, or from an intermediate fund to a short-term fund.”

    is this practice of moving allocation with an asset class common. for example if i invest 60% of my portfolio in UK equities but in 2 years time i decide i want a more diverse range of equities and not just UK securities, so i decide to invest in emerging economy equities, whilst still maintaining the overall 60% in equities. I’m assuming this sensible move is advocated by the passive investor

  • 30 The Accumulator September 15, 2013, 9:51 pm

    Emanon – the role of bonds in a portfolio hasn’t changed, though the expected returns are certainly less than you might see supposed in any book written pre-credit crunch. The major passive investing writers I read regularly haven’t changed their position since that time: Swedroe, Ferri, Bernstein, Scott Burns. Bernstein in particular has been vocal about the fact that investors just need to suck up the crummy returns if they want to maintain a portfolio with a risk tolerance they can handle. I’m not aware of Swenson or Hale publishing since the credit crunch. Try the books written by Swedroe, Ferri or Bernstein post 2009 for an up-to-date snapshot on bonds. Counter to that, John Bogle seems to be recommending an increased allocation to corporate bonds, but I’ve only read a passing reference in an interview.

    To your second question, changing your asset allocation due to a change in your personal circumstances is highly recommended. Note, that’s not changing your asset allocation because Russian gas ETFs are hot right now. That’s changing your allocation because your goal has changed, time horizon, financial circumstances (perhaps you’ve lost your job or your exposure to inflation has increased, or you’re able to contribute more to your portfolio and diversify like you say), and so on.

  • 31 emanon September 15, 2013, 10:36 pm

    Thanks, the point about changing one’s asset allocation as things change, the most obvious dynamic variable being time, really isn’t covered much in all i’ve read so far, it’s actually a big grey area, at least for me. Thanks for clearing it up.

  • 32 The Accumulator September 16, 2013, 9:13 pm

    I think that’s partly because it’s such a personal decision, but of course it’s always useful to have a framework to work within. This piece on asset allocation rules of thumb may help, crude though they are: http://monevator.com/asset-allocation-strategy-rules-of-thumb/

  • 33 john November 7, 2013, 7:11 pm

    Am I right in thinking the nearer to an exit date the shorter the bond in the portfolio should probably be and inversely the further away the longer the bond duration?

    Also does anybody know if most global index bond trackers are a mixture of long, intermediate and short?

    What’s the latest thinking on holding govt bonds – a mixture of world and uk?

  • 34 Floatboy June 12, 2014, 10:35 am

    I know this is an oldish article but I have a bit of a dilemma regarding gilt funds in a diversified pension portfolio and this seems like the most pertinent article. I have been gradually transferring all my current active ISA investments into index funds. Then I thought I would look at my corporate pension and to my surprise found that the default target dated fund is designed to deliver ‘equity like returns’ by investing in vast amount of unspecified sovereign debt, hedge funds and all manner of investments which form the ‘don’t touch with a bargepole’ chapter of all the investment books I’ve read.

    Luckily I can choose a self investment option which allows me to construct a balanced portfolio from index funds. The issue is that the only bond funds available are ‘gilts over 15 years’ and ‘index linked bonds over 5 years’. Now, all the reading I have done suggests that on balance a medium duration fund is probably the most sensible option for long term investment (25 years) in the current interest rate environment and that long dated funds are not to be recommended because of the interest rate risk. But as shorter dated funds are not available to me.

    I was planning to put 30% of the portfolio in bonds but is this a crazy risk? Some books talk about matching the investment horizon but then talk about medium duration funds. As an alternative, I was wondering whether 20% long term gilts and 5% linkers (the majority are long dated so can’t really see what I’d be gaining) and 5% cash is more sensible? It’s just that whatever option I look at it doesn’t seem to perform the role of counterweight to the 70% equities which it needs to.

    Given that the gilts are supposed to be the safe asset, designed to reduce volatility does the forum think that long duration fund still represents the ‘least worst option’ given the 25 years I still have left to invest?

  • 35 The Accumulator June 12, 2014, 6:10 pm

    Hi Floatboy,

    With 25 years to go you can probably afford to be sanguine about this. Most commentators are recommending intermediate or short-term bond holdings because interest rates are so low and seem likely to rise. But that’s general advice that doesn’t and can’t take into account the next 25 years. Nobody can see that far ahead.

    Long dated bond funds are likely to fare best in deflationary or recessionary scenarios so are a good complement for a portfolio with an aggressive equity tilt like yours. The extra volatility of long term bonds versus intermediates won’t make much difference in an equity dominated portfolio while they should perform as well if not better than shorter-dated bonds during bear markets.

    A rough and ready summary would be:

    Long dated – best during deflation, worst volatility (in bond terms, this doesn’t compare to equity volatility)

    Intermediates – best risk adjusted return

    Short-dated – least volatile so particularly good for the unadventurous, those who are most concerned with capital preservation, are most vulnerable to interest rate rises.

  • 36 Floatboy June 13, 2014, 10:56 am

    Hi Accumulator

    That’s very helpful. Just to clarify:

    I get that long-dated bonds make sense for a heavy equity allocation in a bear market as presumably they should show a greater ‘zig’ while equities are ‘zagging’.

    But in a scenario (presumably a fairly likely one) of interest rates rising, is your reasoning that the initial ‘heavy’ losses which are likely to be experienced are likely to be negated as a result of accumulation and periodic rebalancing over the course of the 25 years. E.g. that new bonds purchased as part of the fund are likely to be at a higher yield.

    Obviously, I understand that no one can foresee rate movements or performance of asset classes, but just wanted to check that I had understood that locking in losses initially will probably (but is not guaranteed) to make a huge difference in the long term.

    I have read in the thread above about holding cash initially and purchasing bonds when rates move…but I have learned through bitter experience that market timing is not for me…I’d rather have a plan which I can rationalise and seems reasonable and stick to it.

  • 37 The Investor June 13, 2014, 1:12 pm

    @Floatboy — To over-simplify (but also I think to say something quite profound 😉 ) if you don’t expect one of your asset classes to go down in value over the next few years, then the truth is you’re not running a well diversified portfolio. Rising rates/yields will definitely hit bond values. It’s maths. However all told over the long-term your equity holdings (the real return engine) should make up for it.

    And eventually the bonds will be yielding (and reinvesting) at a higher rate, too, and begin to repair the early damage.

    And of course yields may not rise. Hard to imagine, but it’s been ‘imminent’ and the ‘no-brainer’ asset class to avoid for a couple of years now. Even more for some. Oops!

    Personally I don’t hold any government bonds at all currently. That is because I am a largely active investor, and I don’t like the look of them. (Instead I hold a fair slug of cash). If shares go down 30% and gilts spike 20% higher I’ll have nobody to blame but myself, because I am definitely *not* running a well-diversified portfolio!

    If you want to get away from market timing, then buy your assets, automatically rebalance, and forget about it. It doesn’t matter if *as things turn out* your bonds end up delivering no return over 20 years. You didn’t know that in advance. What matters is your overall portfolio return.

    Have a look at this table of returns in this article from various different allocation strategies (caveat: US data, but the point I am making is they all worked):

    http://monevator.com/weekend-reading-return-and-volatility-data-for-the-us-lazy-portfolios/

  • 38 Andrei May 15, 2016, 4:00 pm

    Lots of great information.
    Though I have to admit that I’m more confused/more wary of bonds than I was before!
    I currently have a 75/25 equity/bond split on quite a small amount in my Fidelity SIPP. Are many of the risks of gilts/bonds at the moment lessened if I am putting monthly amounts into their allocation from a low start point?

    In the future on a lower cost platform, I plan on going all in with a Vanguard LifeStrategy fund (probably LS60) so life will be easier then!

    At the moment, to avoid Fidelity’s 0.35% platform fee, I’m all in on ETF’s – both equity and the bonds. The equity part has been an easy decision, with ETF’s split between US,UK,Europe, Japan, Asia Pacific & Emerging Markets.

    It’s the correct bond allocation that I cannot get my head around.
    Fidelity do not offer many bond ETF’s and none of the international ones are hedged. I want my bonds to be as diverse as my equities so don’t want to go all in with gilts, be they standard, linkers or short term. An amount of low risk corporate bonds to add returns seems like a good idea too.

    At the moment I’ve got;
    (all iShares)
    5% Gilts Index
    5% Gilts Inflation Linked
    5% £ Corporate ex-financials
    5% EM Local Government Bonds
    5% $ High Yield Corporate Bonds

    I would like the bond component to be as simple as possible, so I don’t mess around with it. Ideally I’d just have 1 bond fund.

    On Fidelity I’ve been looking at Vanguard Global Bond Index Fund Acc with a total cost of 0.50%. This seems to tick all the boxes for me (apart from cost!) – Diverse, Hedged and 50/50 gov bonds/high quality corporate.

    Would this fund do the job of balancing by portfolio correctly? or are there too many corporate bonds in it?

    Many Thanks

  • 39 The Accumulator May 15, 2016, 8:34 pm

    If you buy a monthly amount then you can expect to buy more units of an asset class when it dips. If you expect bond prices to reduce then you’ll buy more in the future. Your future contributions will also presumably dwarf your low starting point, so again, any short-term rise in interest rates is likely to have a mooted effect on your eventual result.

    The Vanguard global bond fund is roughly 35% corporate. It’s also the fund that’s the mainstay of the fixed income component of the Vanguard LifeStrategy funds.

    You can read more about the LifeStrategy methodology here: https://www.vanguard.co.uk/documents/adv/literature/target-allocation-approach.pdf

    If you’re happy with that then the VG Global Bond fund seems a reasonable choice.

    Here’s a Vanguard paper on global diversification of bonds: https://advisors.vanguard.com/iwe/pdf/ICRIFI.pdf?cbdForceDomain=true

    I avoid exposure to corporate bonds because I believe that the role of fixed income is to lower volatility not to make a significant contribution to return. Corporate bonds tend to correlate with equities during times of economic stress making them poor diversifiers just when you need your bonds the most.

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