What caught my eye this week.
Here’s a sign that we’re neck deep in a bull market in global equities – shares are by far the riskiest mainstream asset class, but we hear much more concern, comments, and confusion about bonds.
In the absence of high inflation, the government bond portion of your portfolio is very unlikely to blow up. And even if we did see high inflation, it’d be a slow-motion car crash sort of disaster, as opposed to the hurricane of a true equity market crash.
Yet people fret about the bogeyman of a bond market rout, with some even saying they feel safer with 100% in shares. (I’d say cash is a far better replacement right now, if you must play swapsies).
Bond phobia is clearly a global affair, because other sites are wading in on bonds more, too. Here are a couple of good articles from just the past week:
- Why your bond ETF is not losing money [Canadian perspective, so don’t worry about the specifics. It’s an excellent general primer.] – Canadian Couch Potato
- Rates change, but the role of bonds doesn’t [This one is US, so just ignore the bit about IRAs] – Vanguard blog
We’ve also written a lot of articles about low-risk government bonds in the past. Enjoy!
Note: Some links below are Google search results – in PC/desktop view these enable you to click through to read the piece without being a paid subscriber.1
From Monevator
Investing with principles: What you need to know – Monevator
There was an interesting discussion about UK share dealing accounts for ex-pat investors in the comments on our broker table – Monevator
Out of the archive-ator: Lump sum investing Vs drip-feeding – Monevator
News
Legislation to cut the dividend allowance from £5,000 to £2,000 from April 2018 has been postponed due the Finance Bill being rushed through Parliament before the urgent General Inauguration. Will probably return after the coronation, sadly. There have been a few other postponements, too – Guardian
Government also quietly drops that new £1,000 tax break for micro-entrepreneurs – ThisIsMoney
Britain’s top financial regulator Andrew Bailey (of the FCA) says debt is a bigger problem than we think. As I said on Twitter: “If you owe the banks £100,000 in consumer debt, you have a problem. If a million people owe £100,000, the Bank of England has a problem.” – ThisIsMoney
Vancouver’s curbs on empty homes is working: Should we do it in London? – Daily Mail
Nationwide will not lend on homes with punitive leasehold clauses – Telegraph
Old £5 notes are no longer legal tender as of 6th May, but you can swap them for good money at the Post Office – Guardian
The Bank of Mum and Dad – now dubbed BoMaD in some excitable quarters – is the UK’s 9th largest lender – Mortgage Finance Gazette
50 cent trading mystery focuses on $20bn London fund [Search result] – FT
Look at the widening gap between the average asking prices quoted by estate agents & the average sold price. Negotiate, negotiate, negotiate pic.twitter.com/uJKMhuvr6F
— Henry Pryor (@HenryPryor) May 3, 2017
Products and services
Virgin’s new five-year ISA pays a joint table-topping 1.75%. Be still my beating heart… – Telegraph
…although to be fair that’s slightly more than borrowers will pay for HSBC’s new super-cheap 1.69% five-year fixed rate mortgage (£999 fee, 60% LTV) – CityAM
Portfolio Charts is going global, so you can now test how various asset allocation strategies would have worked in the UK – Portfolio Charts
Remember Thriva, the DIY blood test for the Instagram generation? Not only will you get £10 off your first kit with the following link, you can use the code MAYBE50 to get a further 50% reduction – Thriva
Comment and opinion
Open the Lifetime ISA up to over-40s, say fund groups [Search result] – FT
Professor Eugene Fama explains why he believes you can’t time or beat the market [Video] – Bloomberg
“Why I lost my bet with Warren Buffett”. (You know, the ‘hard charging hedge funds will beat a cheap tracker’ bet). A spirited but too-much protested riposte – Ted Seides
What’s the most appropriate planning age for retirees? – Wade Pfau
The timing is right for emerging market equities – Wisdom Tree
Investing in Europe: Where is the return? – Enterprising Investor
This is the easy part (on the bull market) – Bason Asset Management
S&P 500 valuation and projection – UK Value Investor
GMO’s James Montier thinks US equities are in a big bubble. But the perma-bear could stomach a “kamikaze” portfolio made up of emerging market value shares – Finanz und Wirtschaft
The ultimate alternative investment: Happiness – Tony Isola
How to earn a living from Instagram as a ‘micro-influencer’ – Guardian
7 money-making lessons from Jacob Fugger, the richest man who ever lived – MarketWatch
Off our beat
The woman who invented the fidget spinner hasn’t made much money from the craze – Time
Men without women, by Haruki Murakami – Guardian
Our apathy makes politics vulnerable to capture [Search result] – FT
Forget contracts, there are no guarantees in life – Mr Money Mustache
Yanis Varoufakis’ thoughts on negotiating with the EU and the tactics they will use on Theresa May are worth a read – Guardian
The siren song of homogeneity – Noahpinion
And finally
“Books tell you how to become rich from stocks. Software programs and training courses claim to help you trade successfully. Their authors assert that, with their help, you can make a comfortable from living by playing the market. Before you succumb, ask the following question: if I had a system that held the secret of lazy riches, would I publicize it in a book that will earn – at most – a few thousand pounds? Writing a book is hard work, believe me.”
– John Kay, The Long and the Short of It
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- Note some articles can only be accessed through the search results if you’re using PC/desktop view (from mobile/tablet view they bring up the firewall/subscription page). To circumvent, switch your mobile browser to use the desktop view. On Chrome for Android: press the menu button followed by “Request Desktop Site”. [↩]
Glad to see Portfolio Charts expanding into UK. It was a useful resource even when it was USA only. I’d encourage everyone to check it out and have a play. Good fun.
-Bonds – bad because inflation is sure to rise with brexit
-Cash – bad as inflation is to rise with brexit and interest rates are pathetic
-Shares – bad as the market is at all time highs do can only go down
My thinking waa to stick with shares due to highest risk/reward and being the lesser of all evils. Please let me know if I’m completely wrong!
Great timing. Thinking of putting a bit into unhedged 6year duration US Treasuries just in case.
Fantastic list as always, many thanks. I hope it is indeed taking less time to produce and you’re enjoying a well deserved lie in!
John Kay’s book is not my favourite. Useful books have concrete suggestions for investors like books of Joel Greenblatt, Larry Swedroe, Lars Kroijer or John Kingham. Their step by step guidance books are full of investment philosophy.
Have a great weekend TI – and not too many bullet-points, we don’t want you slipping back into good habits!
Regarding the Henry Pryor link, any recommendations for finding out more? I’m going to be buying for the first time soon and I’m bloody clueless! Is the asking price basically 20% higher than it’s likely a property actually sells for? What measurements should I use to determine that I’m not getting stroked?
On the expat account opening link, I opened an account with De Giro Uk a couple of months ago without difficulty with a HK address and 30 year non Uk residence. And their charges are A1 even if the website is an bit flaky when you are used to UK ones .(Barclaysstcockbroker who also allow me to trade with a non Uk address although I am not sure whether that is because I was UK resident when I opened it and they have let it slide)
Right then, can anyone recommend a fund, ETF or IT investing in Emerging Market “value” equities, please? I might try a soupçon of Kamikaze investing.
@dearieme: perhaps ZIEM or PSRM?
Thank you. What are those in English?
I just took them from the Morningstar ETF screener. Here are the FT links: https://markets.ft.com/data/etfs/tearsheet/charts?s=ZIEM:LSE:GBP and https://markets.ft.com/data/etfs/tearsheet/holdings?s=PXH:PCQ:USD – let me know what you find if you do some research.
ZIEM = BMO MSCI Emerging Markets Income Leaders UCITS ETF
PSRM = PowerShares FTSE RAFI Emerging Markets UCITS ETF
That micro-influencer article just riles me up no end. State of the world when someone is earning a living by taking photos of coffee and blossom on their iPhone and occasionally plugging some absolute tat. Just bizarre.
Boom. Loving the new weekend reading. Hoping it’s easier to produce, TI.
@Aron – agreed.
I had a look at the NotAnotherMummyBlog to which Grauniad’s article links. While my knowledge of mummy blogs largely comes from articles such as this and this, I imagine if an advertising agency shagged a mummy blog that would be their bastard offspring.
Five thousand years of civilisation and this is where we end up.
Glad the links are still broadly hitting the mark for people! It is taking less time and getting Friday nights onwards on is a big-payoff. (Well, will be once I stop wondering what to do on a Saturday morning with myself… 😉 ) And yes, I do need to be careful not to slip back… I like to do something longer at the top so I can put a ‘more’ link on the Monevator front page (instead of having all the links on there) and I don’t like to mess up my coffee image, or do a More… in the link list. (You see how my brain works? Count your blessings! 🙂 )
@YamiKuriboh — Shares do indeed have the highest risk/return. Just remember the risk is real. Nobody knows the future.
@aron @hosimpson — Seen this? https://twitter.com/FraserNelson/status/860747756914302976
The thriva link doesn’t seem to work on mobile phones.
P.s. Long time reader (2+ yrs), first time commentor
@hosimpson – Just looked at that blog… *sigh* that Cadbury easter egg post is the epitome. Firstly why do people even care about some randomer sharing photos of her daughter holding some eggs and secondly why are people unable to do such menial and trival things without by ‘inspired’ by an advert.
@TI – Yeah I seen many similar posts on Twitter. Newsquest, Trinity Mirror & NWN Media seems to be the publishers they’ve bought the ad space from and they probably have a local paper in every area of the UK. On average it’s probably a couple of £k to get a full front page as well. I look forward to see Corybyn’s face plastered everywhere.
Dearieme,
Not strictly value but healthy dividend yield https://www.ishares.com/uk/individual/en/products/251766/ishares-emerging-markets-dividend-ucits-etf
Am I misunderstanding the Vanguard article about bonds? It seems wrong, but perhaps I’m missing something.
My understanding is that the main concern with bonds at the moment is the virtual inevitability that interest rates will rise at some point, which will cause bond prices to plummet.
Let’s take Vanguard UK Gov Bond Index Fund as an example. As at 31 March 2017, it had an average coupon on its investments of 3.3%. The coupon is the fixed rate of interest paid on the face value (the amount that will be paid on maturity of the bonds) of the bond. Current interest rates on UK gov borrowing are about 1.1%, so the value of the underlying investments has, on average, increased way above face value , resulting in a rise in the value of the bond fund.
The maths is roughly as follows. If face value of investments is 100 and they have a 3.3% coupon, there’s 3.3 of interest paid on the bonds. But as interest rates have fallen to around 1.1%, investors were willing to pay more than face value for that 3.3 of income, so the price of the bonds has risen. The current price is 300, because 3.3 of income is equal to 1.1% on the 300 price.
When interest rates rise, this price premium will reverse. If interest rates return to 3.3% (which is not a high rate, historically), a 300 investment in this bond fund will fall in value to 100, wiping out 67% of the capital. If interest rates reach 5%, the capital loss will be 80%. These are massive losses, even though I’m talking about interest rates that are not unusually high. Of course, such interest rate rises might be spread over several years, but an 80% loss is catastrophic, even if it happens slowly over several years.
I don’t know when they will rise this high, but I think there’s an extremely high probability that they will do, at some point. For 290 out of the last 300 years interest rates have been higher than at present, so I think the chances of them reverting to the mean are pretty strong.
As I understand it, this inverse relationship of interest rates and bond values is a certainty. If rates rise, bond values will fall. I may be missing some fine detail of the calculations, but if the rates rise to 3% or 5% the falls will be roughly of the magnitude that I’m talking about.
(I realise I’m probably simplifying a bit, because the redemption value of the bond does not change, so as bonds get closer to maturity the redemption value becomes more important than the effect of interest rate changes. But unless you only buy very short term bonds, isn’t it still true that if (or rather when) interest rates return to normal, bonds will suffer catastrophic capital losses?)
If I understand the Vanguard article right, it is saying don’t worry about potential capital losses, because interest rates will have increased and over time the extra income will offset the capital loss. But does that make any sense? Surely you still hold the same bonds and their coupon is the same. So, the income is the same. All that has changed is that the capital value has fallen, to compensate for higher ongoing interest rates.
Furthermore, even if there is some extra income (eg, on new investments), it will take many decades for a bit of extra income to recoup capital losses of 67% or 80%. And, if interest rates have risen to 3% or 5%, it will almost certainly mean that inflation has risen a similar amount, so although gross returns might have increased, real returns may not have done.
I realise the ethos of this site is that one is unlikely to be wiser than the market and I agree with it. So, I would normally accept that if the market is buying bonds, so should I. But it is also well accepted that the market sometimes behaves irrationally. Isn’t this one of those times?
If it is rational to hold bonds at the moment, this must be because either:
(a) My understanding about interest rate rises inevitably leading to falls in the value of bonds is wrong;
or
(b) Investors think interest rates will stay at 1% for ever;
or
(c) Investors think they can time the market and get out just before everyone else realises that it is time to sell bonds;
or
(d) Investors are willing to accept a high probability of losing most of the capital they have invested in bonds, because they think the potential losses – and the probability of those losses – are even worse for equities (and other alternative asset classes).
Can anyone explain to me which of these explanations is the right one? As (b), (c) and (d) all seem very unlikely, (a) must be the explanation. So what am I missing? Or is there an (e)?
@ivanopinion
Losses will be violent if rates rise suddenly, but not to the extent you think, I.e if a 30y gilt yield goes from 1% to 3% it doesnt lose two thirds of its value, but more like 30%, still a lot but remember that most bond portfolios have a lower average duration (maturity) than 30y.
also, rates aren’t expected to be as low in the future as a naive look at the yields might suggest. For example inthe Us, rates are expected to be 2.5% in 10y time (in the UK 1.75%) which given inflation targets of ~2% does not seem totally unreasonable even if it is on the low side, especially once the chance of a Japan-esque scenario is factored in. And given the level of mortgage debt in the UK now can anyone realistically see rates at 5% in the next 10 years without one hell of a boom first.
@ivanopinion
The nuance that you’re missing from your calculations is maturity or for bond funds effective duration so your 100/300 calculation isn’t really telling you what happens when rates move.
The dance that you’re doing is comparing the yield to maturity (ie the return including capital repayment to the end of the life of the bond) and the prevailing interest rate. In fact the yield to maturity is the prevailing interest rate if the bond is risk-free.
As a rule of thumb the duration is the gearing on the sensitivity of price to movements in interest rates. A one year bond will move about 1% for a 1% change in interest rates. A ten year bond will move about 10% for the same change in interest rates. So moving from 1.1% to 3.3% will move ten year bonds prices down by about 22%. It will move 30 year bonds down a lot more!
You can buy ultra short bonds — I reported my dabbling in comments previously — these obviously have considerably less exposure to interest rate movements. Effective duration is about 3 months so the price is pretty stable subject to dividend policy. The rate is small, but non-zero. However when the correction came that meant I wanted to buy, the liquidity dried up and the spreads widened so far as to make it expensive ot sell to make the equity purchases. If bonds are a place to store wealth while you wait for equities to get cheap (my restatement of modern portfolio theory), then the ultra-short ETF isn’t a good vehicle. Cash – if you can get a government guarantee on your deposit – is very similar return and much more liquid. YMMV.
@ivanopinion. It’s worth remembering that the bond market does incorporate some expectation for BoE rates tightening from the current 0.25%. The current 3m rate, 5y forward is 1.34% and 3m rate, 10y forward is 1.83% (using swap rates, rather than bonds). So the breakeven expectation has 100bp and 150bp of tightening over 5 and 10 years, respectively. The last actual tightening cycle started 14 years ago ( July 2003, at 3.50%, ending with the last hike on July 2007, 5.75%). So it took 4 years to hike 225bp. So perhaps 100bp over 5 years is not totally unreasonable. In probability weighted terms it’s equivalent to a 20% chance of 50bp in cuts, 30% chance of no hikes and 50% chance of 225bp in hikes. Given how mature this economic expansion is getting (9 years now since the last crisis in 2008), there has to be some expectation that we could have a recession in the next 5 years.
Personally, I’m not a fan of UK gilts here (I was 50bp higher). I’m especially not keen on the advice to own short-duration bond funds, say sub 5-year, since I think an equivalent duration barbell of cash and 30-year has much better properties in most scenarios. Nonetheless, we all need to acknowledging people have being getting the bond market wrong for seven years. Bond yields can still go both ways from here; zero is not a floor anymore. So some allocation is still prudent.
@James, Mathmo, ZXS
Thanks. Your comments all make sense. I’ll take your word about the effect of an interest rate rise being a smaller fall in bond prices than I thought.
If I understand right, none of your comments seem to provide any support for Vanguard’s rationale for holding bonds, ie that any capital losses will be recouped by way of extra income, over a few years. Or is there some validity in that, too?
Very interesting article in the FT today (actually in the FTfm supplement) in which ‘former hedge fund trader Victor Haghani explains why he has abandoned active strategies and converted to passive investing’. Seems that his conversion to passive came after he was involved in the collapse of LTCM and then had time to think very carefully about how he should manage his own money! He now runs Elm Partners which uses index trackers and aims for the lowest possible costs. This is the Google link: https://www.ft.com/content/32c32462-2f3e-11e7-9555-23ef563ecf9a
@ivanopinion — It’s completely valid. I suggest re-reading the articles, as well as the ones in this site as you don’t need to take people’s word for it — it’s maths. 🙂
Look at the redemption yields on a range of UK gilts here:
http://www.fixedincomeinvestor.co.uk/x/bondtable.html?groupid=3
You’ll notice they are all positive. Slightly simplifying (because yield to maturity maths makes assumptions in order to be calculated) buy those bonds, hold to maturity while reinvesting the coupon, and you’ll get that return over the life of your investment. A positive return.
Bond *funds* are trickier to get head around because they buy/sell bonds as they age to maintain their exposure. But they’re not different to the extent you originally supposed. 🙂
I think it’s important to understand what Vanguard /others are saying. It is not “bond funds cannot go down in value”. It’s “over the longer term bond funds will do what you bought them for”.
Currently you would buy them to buffer equities and a very small nominal return.
In contrast you could buy shares and have less than you started with in nominal terms 20 years from now. Highly highly unlikely but quite possible theoretically.
For private investors prepared to faff, at today’s low yields FSCS covered cash is I believe an acceptable substitute for bonds. But it probably won’t be forever, so good to get ones head around bonds in advance.
Again I’d suggest people properly read these articles as even clearly savvy people come to this asset class with misconceptions and errors. 🙂
I may try and do a beginners article illustrating the capital / income *cashflow* perspective soon. This is the bit I think trips many up.
P.S. Here’s a grossly oversimplified example to illustrate the capital / income relationship.
I am going to use a higher interest rate environment as it makes the numbers easier to see. Also I’m typing on a phone on a train so can only do head maths, so nothing precise here, just to illustrate.
Let’s say you own a gilt originally issued at £100 with a 10% coupon. You buy it when there’s 10 years left to run.
Let’s say low interest rates etc have pushed the price up to £200 when you buy.
At this point your return is calculated as £10 a year (10% coupon) hypothetically reinvested at around 5% (10/200) and the capital value that starts at £200 and over 10 years reverts back to £100.
Let’s now say at the moment you buy interest rates surge to the extent that the bond falls in value to £100.
You’ve immediately taken a 50% loss! However you’re now in an environment where you are reinvesting at 10% (£10/100) over the next ten years of the bonds life, instead of 5%. As you can see in crude terms (ignoring issues such as yield curves, yields to maturity etc) you’re able to buy a higher future cashflow with your reinvested coupon then before, for the remaining life of the bond.
From the above you can see that (a) yield to maturity at purchase is basically what determines your return (provided you hold to maturity) since the capital gain/loss and cashflow are baked in for risk free bonds on day one and (b) lower prices equal higher future cashflows.
As someone like @zx could explain better than me, real life is more complicated. But that’s the gist (unless I’ve mistyped — can’t check before posting really on this phones editor! 🙂 )
@TI
Ah, the example really helps. Upon buying the gilt, I was counting on receiving cashflows of £10 for the next 10 years and then £100 when the gilt matures. As long as I hold to maturity, that’s the cashflow I get, regardless of any fluctuation of the value of the gilt in the meantime. So, the initial unrealised capital loss must gradually reverse over the life of the gilt. I don’t think Vanguard explained it well, but I now see what they meant.
“Reverse” is probably the wrong word. The capital loss will be balanced out by the subsequent flows on the gilt.
@ Investor. You invest £200 and over 10 years you get back £200 in your example (assuming you pocket the yield every year and not reinvest it) . Now lets say interest rates went down to 2.5% after you bought the bond then the value would £400, however if you held to maturity you would still receive £200 back. Now imagine another investor buys the bond at £400 they would also receive £200 back if held to maturity. Am I correct in my analysis.
@Grislybear. No.
If you invest £200 and get back £200 after 10 years, then what is your yield to maturity? It must be zero.
For someone to be willing to pay £400 but only receive £200 after 10 years, there would have to be extreme negative interest rates, not a 2.5% rate. Theoreticaly feasible, but I don’t think that is what you are suggesting.
I’ve been looking into GBP-hedged US bond funds. E.g Vanguard have one with a 1.9% YTM with intermediate duration of about 6 years https://www.vanguard.co.uk/uk/portal/detail/mf/overview?portId=9161&assetCode=BOND##overview
I keep thinking “but what is the catch?”
Now I’d rather find an ETF alternative to dodge Hargreaves Lansdown fund charges, if anyone has any ideas?
Pocketing, say a 1.5% yield to maturity on a (credit) risk-free asset with currency risk hedged and a low enough duration to not lose sleep over interest rate rises – more tempting than gilts?
Especially as I’d be unlikely to start buying until next year anyway, by which time a couple of rate hikes will be baked in and tge yield higher still.
@Grislybear @Andy — I think two things are perhaps being conflated here: Whether the bond price would rise to £400, and what the cash return is from buying that bond at £400.
If you paid £400 for the bond in my example, then you would indeed end up with £200 after ten years. (i.e. (£10*10)+£100 on redemption).
However as Andy says the bond wouldn’t rise to £400 on the interest rate move example given for precisely that reason (a locked-in £200 loss) unless market interest rates were so low / deflation was so deep / fear was so unbelievably rampant that investors were prepared to lock in a huge negative return.
(Again, look at the yields to maturity in the Fixed Income Investor link I gave earlier for UK gilts. They are all positive, if tiny. This tells you that at least some people are overdoing the ‘catastrophic losses from UK government bonds’ potential. Volatility, yes, and short-to-medium term modest capital losses in funds, yes. But not huge permanent destruction of capital in *nominal* terms. As I said above, inflation is the real bond return killer).
There might be some confusion here because as I said at the start of my example, I was *grossly oversimplifying*, to illustrate the relationship between coupon payments and capital in a very easy to see way.
In reality, the reinvestment (and consequences for yields to maturity) is more complicated, because of the uncertainty of the bond’s pricing at year 2,3,4 etc when you begin the calculation. In fact, you (or a yield calculator) has to guess until you get the right answer.
I gave a simple explanation of this here:
http://monevator.com/how-to-calculate-bond-yields/
Here’s a more complicated and detailed explanation at Investopedia:
http://www.investopedia.com/terms/y/yieldtomaturity.asp
@Semipassive — I don’t think there’s a catch as such. You’re taking on US interest rate risk, and it looks like you’re paying about 10 basis points for the hedging, going on a quick Google of Vanguard UK’s gilt funds as a comparison. (i.e. Not an exhaustive search!)
One reason US *market* interest rates (i.e. the yield curve) is perhaps a bit lower than one would expect with the Fed saying it’s going to keep raising rates is for exactly this reason. (Investors from lower-yielding countries buying US bonds for higher yields, and thus driving up the price and reducing that yield).
@prav — Sorry, meant to say thanks for the heads up. Not sure what’s going on there, but it’s worth me figuring it out with so much traffic now on mobile. Cheers for reading for two years! 🙂
@semipassive. You probably understand this but just to check. When you currency hedge, in addition to any transaction costs, you will pay away the implied yield differential between the two currencies at the tenor of the fx forward used to hedge. So when you compare say a 10-year Gilt at 1.20% and a UST at 2.40%, there is a yield pickup of 1.2%, currency hedged. Once currency hedged (lets say using 1m GBP/USD fx forwards), however, the effective yield pickup will drop to around 0.45% because the 1m GBP/USD fx forward used to hedge is effectively borrowing USD at 1% and lending GBP at 0.25% i.e a yield differential of 75bp. Essentially, once currency hedged, the actual yield pickup earned becomes a function of the relative shape of the two yield curves, rather than their outright levels.
Thanks for the explanation zxspectrum, so the net gain in yield is less than it first appears. No free lunch then.