Bonds, huh! Yeah. What are they good for? Absolutely nuth– hang on, that’s not quite right.
Despite the exciting Bond Crash Apocalypse Now scenarios available from your local financial media outlet or multiplex cinema, bonds still have a place in the portfolio of any investor whose risk profile questionnaire doesn’t bear the name “Indiana Jones”.
Below I’m going to trot through the main kinds of bonds and quickly sketch out the part they each have to play in a diversified portfolio.1
But before I do, it’s worth remembering that bonds are meant to be the counter-weight to shares in a portfolio. They are the stabilising influence that tempers the turbulence. Equities are from Mars and bonds are from Venus, if you will.
- The key to (most) bonds is they aim to pay you a fixed income until a certain date, at which point you get your initial money back.2
- That is very different to equities, which offer no such certainty of income or capital returns.
- When equities crash we look to bonds to limit our losses.
- When equities underperform, we hope that bond returns can pick up the slack.
- When equity valuations are in the dumpster we rebalance from bonds to take advantage of cheap share prices.
- Bonds reduce volatility and increase our chances of getting the outcome we want.
The cost of these benefits of bonds is a much lower expected return than equities (though things don’t always turn out that way) and, in most cases, a vulnerability to inflation.
Here’s a couple of other bond basics that will help make sense of what’s to come in the rest of this article:
Maturity refers to the length of time (usually years) before the issuer must pay back the loan that the bond represents.
The longer a bond’s maturity, the more risky it is. That’s because there’s a greater chance it will fall prey to rising interest rates and inflation.
The duration of a bond tells us two things:
1. The impact of changing interest rates on a bond. For example, a bond with a duration of seven years will lose around 7% of its market value for every 1% rise in interest rates. Equally if rates fell by 1% then the bond would gain 7%.
2. How long it will take for a bond to recover its original value as its interest payments are reinvested at a higher rate. If you hold a duration seven bond for seven years then you won’t lose your original stake.
Bonds or bond funds? Most of the characteristics described below apply equally well to individual bonds or bond funds. If in doubt, assume I’m talking about bond tracker funds and ETFs, as they are the simplest, most cost-effective way for most investors to hold fixed income assets.
Here’s a handy new-fangled infographic that lays out the bond landscape:
Short-term gilts
If you are haunted by fears of spiraling interest rates then short-term gilts are the place to be.
Short-term gilt funds hold conventional3 UK government bonds that are due to mature in 0-5 years, which means:
- They are high quality assets. The risk of the UK Government defaulting on its debts is very remote.
- Volatility is low because the maturity date of each holding is short. In other words, if interest rates rise, it won’t be long before the old bonds mature and the money is reinvested in fresh bonds that reflect the new rate.
- Returns are very low because you’re taking about as much risk as a royal nanny popping Prince George into a bubble-wrap onesie.
- Currency risk is off the table, assuming you’re an investor who spends most of their dosh in the UK4.
Who for: If you’re vulnerable to interest rate hikes, have a high fixed-income allocation, and have little need for growth then short-term gilt funds are for you (although please remember as always we’re advocating a portfolio approach with your bonds and other asset classes, not all or nothing).
Intermediate-term gilts
This is the regular coke choice of government bond funds. It holds conventional gilts: short, long and everything in between to end up in the risk/reward sweet spot for fixed income.
Intermediates are a good choice because:
- They should be better rewarded than short-term funds. That’s because they earn a risk premium for accepting increased exposure to interest rates and inflation.
- You’ll suffer less volatility than if you were in a long-maturity fund but you’ll still grab much of the return.
- The standard advantage of guarding against stock market trauma at the cost of accepting lower returns still applies. And again, no currency risk.
How to recognise: An intermediate fund won’t call itself intermediate. It will have a very plain name: UK Gilts fund or UK Government Bond fund with no mention of any kind of timescale. Look out for an average duration of nine to 10 years in the fund factsheet.
Long-term gilts
You’re into long-maturity gilt funds because you fear deflation. Long bond funds are chock full of conventional gilts with maturities of 20 years and well beyond.
Key features are:
- They can be ravaged by spiking interest rates and inflation. If new bonds are issued that pay out at a higher rate than older existing bonds, then a 30-year bond becomes outmoded faster than last year’s smartphone. Yet it hangs about like mercury in the water supply.
- When a financial earthquake lets rip, long bonds are likely to be a safe haven. As equities, interest rates, and inflation collapse, it’s gangway for high quality, long-dated, liquid assets.
- Volatility and expected return are much higher than for their shorter bond brethren. However as bond maturities lengthen, so volatility rises faster than returns in comparison to intermediate bonds.
Who for: Young investors with 80% plus equity allocations and reasonably stable jobs have the most reason to fear deflation. The increased volatility of long bonds is barely relevant in such an aggressive portfolio.
However, long bonds are currently considered to be extremely risky given the widespread expectation that interest rates will eventually bob back to their historic norms. Under the circumstances, intermediate bonds can fulfill much the same role but will take less of a beating if rates do rise.
Perpetual bonds
Economic Cassandras sometimes snicker that Western governments have no intention of ever paying off their mountainous debts. The existence of perpetual bonds is this cynicism incarnate.
‘Consols’ are a special kind of gilt issued in the distant past by the UK government that look set to pay a fixed amount of income forever. Other similar bonds include “War Loan”, which was issued in 1917 to encourage patriotic citizens to help pay for World War 1.
In theory these bonds are redeemable by a determined administration, but in practice nobody expects this to happen any time soon – where “soon” means in our lifetimes, or your grand children’s lifetime for that matter.
The origins of consols dates back to the 1700s. Their value – and hence what the government owes on them in real terms – has been utterly destroyed by the higher inflation of the 20th Century, and they now amount to a tiny proportion of the nation’s loan stock.
So while buying something that pays you an income for the rest of your life might seem akin to a perpetual motion machine, there are snags – principally caused by inflation and the time value of money.
- Perpetual bonds are essentially long-dated bonds turned up to 11. Whereas even a 40-year bond has the anchor of distant redemption date, there’s no such capital return guaranteed for a consol. This means they are entirely at the mercy of inflation and interest rate risk.
- When I say “at the mercy” I really mean it. In the late 1970s, the running yield on “2.5% consols” (and which were issued with a 2.5% coupon) flirted with 18%! This means that loyal holders who held from the 1920s saw the spending power of their consols utterly destroyed.
- On the other hand, anyone who picked up those same consols from despairing octogenarians throwing them overboard in the ’70s did very well. Since then the yield steadily fell to less than 4% by the middle of 2013, resulting in a huge capital gain over the period, as well as enormous annual income payments on their buying price.
- You can buy consols and other perpetual bonds via a stock broker, but beware their big spreads.
Who for: Doomster deflationists. Arguably they could in some other reality have a role for ordinary investors in providing steady income, but we think not at anything like today’s prices – we’d have to turn Japanese and see decades of deflation for them to be attractive. A long-dated gilt fund does a better and cheaper job at protecting against that risk for passive investors.
Index-linked gilts
Want inflation-proofed government bonds? Then you want index-linked gilts (other wise known as linkers).
Here both the principal and the interest component of the bond rises and falls in line with the retail price index (RPI) measure of inflation. Plus you get a smidge more yield on top.
Inflation is the great nemesis of bonds, which makes linkers extremely useful. Indeed they are so popular in the current environment that some are priced to deliver a negative yield. In other words, you’ll pay through the nose for the safety features.
Why else should you not commit your entire bond allocation to linkers? There are a few reasons:
- Conventional (or nominal) gilts will beat linkers when inflation falls short of market expectations. Part of a nominal bond’s yield is an inflation premium. That’s why linker yields seem lower than conventional bonds. If a 10-year nominal bond yields 3% and a 10-year linker yields 0.5%, it means the market expects inflation to be 2.5%. If inflation is higher than that the linker wins. If inflation is lower then the conventional bond wins.
- If RPI inflation falls over the lifetime of the linker then you are not guaranteed a positive return from the bond.
- Hence, investors are likely to swim towards nominal gilts during crisis scenarios, not linkers.
- Linkers benefit from the same low risk traits as conventional gilts. The shorter the maturity of the bond, the smoother the ride. However, linker funds tend to be quite volatile as they have long durations – around the 18-19 year mark.
Who for? Everybody! But it’s not a good idea to place all your fixed income bets on linkers. Rampant inflation is not the only fruit.
Corporate bond funds
Corporate bonds are debt issued by companies instead of governments. They yield more than gilts because companies have an unfortunate propensity to go bust and not pay back their debt. Hence corporates offer a risk premium to compensate for the possibility of this happening, compared to the low odds of the UK government not paying up.
They’ve become popular of late as investors – who mistakenly think of bonds as blanket “safe” – scratch around for anything that seems similar to a gilt yet mysteriously offers a higher return. (The London Stock Exchange has even launched a special market to cater for retail bond investors like us).
Things to know:
- Corporate bonds are typically split into investment grade and high-yield (or junk) varieties.
- Investment grade bonds are rated AA+ to BBB- . BB+ to C is junk. Anything below that is in default.
- The fortunes of high-grade corporate bonds largely rise and fall with interest rates and inflation. Default is still a risk though.
- What’s more, many corporate bonds embed features that enable firms to repay the debt when it suits them rather than the investor.
- The higher rates of default on low-grade bonds means that they are likely to pay out less than their high yields imply.
- The volatility of corporate bonds can be deceptive. At times they appear to be as benign as government bonds. But when the markets cut up rough, corporate bonds behave more like equities, especially at the lower grades, as investors become more fearful of company defaults.
- At the very moment your bonds should be cushioning the impact of plunging equities, your corporate bonds are likely to be tanking in tandem.
- Like all bonds, interest paid by corporate bonds is taxed at higher income tax rates, not dividend income rates.
Debating point: There’s an argument that an international corporate bond fund further diversifies your portfolio, enabling you to increase expected returns without increasing risk. Many American passive investors are in ‘total bond market’ funds that include a 20-25% corporate bond slice.
But personally, 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.
International government bonds
Adding a touch more diversification is also the reason to consider international government bonds.
However, there seems little point in devoting a portion of your bond allocation to AAA–AA rated countries that are in the same low yield boat as the UK. You’d be taking on a fair chunk of currency risk in the part of your portfolio that’s meant to offer stability.
Instead, you might consider emerging market government bond trackers that take you into the realm of sub-AA countries. If you go down this route, make sure you diversify as much as possible across countries, maturities, and currencies.
As with corporate bonds, you can expect a choppier ride from emerging market bonds. It’s probably best to carve their allocation from the equity wedge of your portfolio, rather than the low risk, fixed interest side.
Heavy bonding session
So there we have it. If you can handle equities see-sawing like Chucky after a rejection letter then bonds may be optional for you.
If not, then they have a place in your diversified portfolio regardless of the widespread conviction that interest rates must rise and that bonds will take a shoeing for a time.
Fancy grabbing some? Here’s Monevator’s take of the cheapest trackers around, including some cost-effective ways to get exposure to bonds.
Take it steady,
The Accumulator
*Editor’s note: I think this is called “irony”, but check with Alanis Morissette.
- Please note: It’s not all or nothing! Many comments miss this point, and say bonds are “sure” to go down so why hold them. But we diversify because nothing is so sure. If government bonds do decline a little in price, it’s very likely that your equities will be more than making up the difference. And if equities crash, you’ll be glad you own some bond ballast, and of the income they pay out, too. [↩]
- Getting your money back assumes you bought when the bonds were first issued. If you (or your bond fund) buys them in the after-market, then you may get more or less back depending on the price you paid for them. [↩]
- That is, they are not linked to an inflation index. [↩]
- This is true of all domestic bond funds. [↩]
Comments on this entry are closed.
High street banks cash accounts are probably a better option with the FSA guarantee. Currently an instant access account is ~1.5% which is the same as a 5 year government bond. The very slight increase in default risk is more than offset by the superior term. There is the annoyance of yearly account switches though.
What are the precedents for apportioning or dividing state debt when a country splits (like Scotland might just secede sometime in the lifetime of some UK gilts)? What happened with the Irish Free State? Czechia and Slovakia? Even Yugoslavia (a non-agreeable separation)?
If Scotland takes a portion of outstandng UK debt, denominated in pounds sterling, then it has a different risk of default than the residual country which controls issuance of that currency. Scottish debt would be like sovereign debt in Euroland — impossible to devalue away when one needs to.
Excellent post – factually dense and a good summary of the reasons for holding bonds in a diversified portfolio. One to bookmark for the next time I rebalance or review my portfolio.
Now aim to keep asset allocations fixed in percentage terms but always looking for best investment vehicles with a view to reducing costs and volatility. I have this notion that keeping the low volatility elements of my portfolio as low in volatility as possible should, in theory, maximise the benefits from rebalancing.
@mucgoo,
True but you can’t hold high street cash accounts within an ISA or SIPP and I’d guess most UK-based readers of this blog have their portfolios within ISAs and/or SIPPs. Yes, you’re right that the annual account switches are a pain. I’ve some instant access cash ISAs for emergency cash and switching them when bonus periods expire is tiresome, especially when proof of identity and address is required.
A well timed piece, as ever. As a result of a fixed term cash offer (12 months @ 2%) expiring, and cashing out of a corporate bond with the intention of buying Royal Mail shares I’m now sitting on a fair bit of cash in my SIPP.
So I have just increased equity allocation from 60% to near 70%. I already had about 20% in an index linked gilt fund.
That leaves 11% of my SIPP still in cash. The non-bond alternative that sprung into mind was to split that between physical gold and platinum ETFs.
And then to balance this riskier SIPP allocation I could de-risk my ISA portfolio over the next couple of years to
increase the % in Cash ISAs. But that is from a bond-hater perspective, and ignoring the good advice above.
http://www.moneysupermarket.com/savings/cash-isas/
However you can’t move money from stock and shares into a cash isa although you can do the reverse. Potentially if you’ve got a larger portfolio in a period of good stock performance your going to exceed the yearly (~£5500) limit so can supplement with a bond ETF or funds.
It’s the good advice that you just didn’t take.
I’m intrigued by this article. I’ve built up a fair of of cash in my cash ISA (i was lucky to squirrel away a large chunk @ 4%, fixed till next year).
I’ll be starting a passive portfolio come next April (contributing full ISA allowance) and always assumed bonds would make up a large percentage of that total. But after reading this article, thinking it’s probably not worth it.
Looking at some morningstar ratings, I see returns of 6% etc on some govt bond funds – how on earth is this possible? I’d be interested in hearing from someone who has experience with holding bonds/bond funds, anyone kind enough to advise on realistic returns?
> True but you can’t hold high street cash accounts within an ISA
Eh? I still have two years’ worth of cash ISA that every so often I figure I should jump to my equity ISA but I forlornly hope one day cash will hold it’s day like it’s said to on here rather than slowly die in the gutter like dogs which has been my experience of cash to date. So you can hold cash in an ISA – just not the same one as your equity holdings 😉
@Ermine, @BeatTheSeasons
As you guessed, I was of course referring to Stocks and Shares ISAs but omitted to say so.
It’s a pity that you can’t move money from Stocks and Shares ISAs into cash ISAs. In fact, it would have been much better and simpler if there were a single annual ISA allowance covering both cash and shares.
It really would. The only reason I can think of that this isn’t allowed is that the Treasury doesn’t want people socking away even more cash beyond the reach of the taxman, by utilizing what would be effectively doubled cash allowances.
Anyone thinking about holding bonds in an ISA should remember/note that they need to have at least five years to run when you buy them. (You can hold them as they run towards maturity, but can’t buy if, say, there’s only three years left to run). Something like a medium term bond ETF should be fine (and it does the rolling over and reinvesting for you). Some brokers/platforms may allow short-term bond ETFs, too — possibly by accident.
Regarding cash as a bond substitute, I think that’s okay right now for private investors like us and in fact it’s what I do in the main. We didn’t want to clutter up this article with opinions about the direction for bonds, or indeed cash for that matter, though. We wanted to give you guys the information about bonds to make your own minds up! 🙂 They are a weirdly misunderstood asset class in the UK.
One thing to note though is cash is less useful as a cushion in a market crash than bonds. That’s because bond prices will typically rise in a bear market, whereas cash, by definition, stays the same value! So you’re extra yield from cash right now isn’t entirely “free”, as it doesn’t have that attractive quality.
Do total market bond funds in the US cover all these types of bonds – that’s what i thought? Its a shame we don’t have them here unless there is anything new out there. The vanguard 20% Equity, so 80% bond fund seems like the only alternative if you don’t want to get messy with different funds, although of course its not pure bonds.
Its good to be told again that really the only true diversifier is a mixed duration gilt fund. I think i will have to start dripping into one, as like many here, can’t bring myself to buy lots of bonds at current prices/valuations. I think i read somewhere gilts are on a equivalent PE of 40? Is that right? Anyway don’t want to get a good learning article bogged down with speculation TI was avoiding – sorry.
Very interesting article, thanks for this. It did clarify quite a lot of things I believed but wasn’t 100% on. I have to say I have found it reassuring that even in the short period I have been investing the gilts fund in my portfolio did a lot to smooth out the equities volatility over the last few months.
Good introductory article apart from this bit “The impact of changing interest rates on a bond. For example, a bond with a duration of seven years will lose around 7% of its market value for every 1% rise in interest rates. Equally if rates fell by 1% then the bond would gain 7%”. Talking about duration in terms of interest rates like this is likely to cause people unfamiliar with bonds to jump to the wrong conclusions. As soon as you say “interest rates” without qualifying what you mean, many people seem to automatically assume you are talking about the Bank of England base rate. It is not at all true that a rise of 1% in the base rate would result in a 7% drop in the price of a bond with a 7 year duration. That would only happen if there was an upward shift of 1% across the whole yield curve up to the maturity date of the bond. Perhaps it would be better to say something like “The impact of changing interest rates on a bond. For example, a bond with a duration of seven years will lose around 7% of its market value for every 1% rise in the gross redemption yield of the bond. Equally…” and to then explain what gross redemption yield is. You are a better writer than me though, so I am sure you can explain the point I am struggling to make here.
Another point – Bond investors are not stupid and they will not be caught out by a change in base rates unless the change really does come out of the blue. Anticipated changes to the base rate are already in the gilt yield curve and a rise in base rates exactly when the market is expecting it will have naff all affect on longer dated bond prices. Rising base rates may even bring down long dated gilt yields as this can show determination by a central bank to act against rising inflation.
@the investor
You do lose the capital gains qualities but it works both ways. If you do want that effect then augment cash with a small ultra-long (50 years, Consols even) bond holding.
>◾When equities underperform, we hope that bond returns can pick up the slack.
Hope is rather the operative word at the moment. Do you have any data on Gilt/Equity price correlation? It seems to me that over the past four years, Gilts and equities have positively correlated, perhaps to an abnormal degree, but how do we this is not the new normal?
Thanks a great summary of what for me has been, and still is, the hardest part of my portfolio to really understand. Great article.
SG: yes was thinking the same.
I suppose the economic theory here is that;
In a strong economy, equities are high, and the govt / BOE set interest rates high to curb inflation. Therefore, bonds perform badly.
In a weak economy, equities are low, so govt / BOR sets a low interest rate to stimulate the economy. Therefore bonds perform well.
However, as you rightly point out bonds and equities have both performed well in the past few years. This isn’t because of a change to the rule of interest rate to bond relationships; more to the rule of high stock market values in the middle of economic down times.
That’s my view anyway! I’m sure my argument will get smashed to pieces but I’ll learn something along the way if so.
Nice article – many thanks.
I have a mix of corporates, conventional gilts and linkers but I’m puzzled regarding the latter. Given that RPI inflation almost always rises over any significant time period one would expect that linker coupons would also rise (as well as capital seeing uplifts). I find it hard to understand why every single one of the last ten 6-monthly income distributions from my linker fund has been cut – the last to the point where the AMC gobbles it up completely.
Is this the result of new money (or re-invested maturities) diluting the yield? If so, the impact of that has been far greater than I would have anticipated.
@ Geo – the only total bond tracker I know of is SPDR Barclays Sterling Aggregate Bond UCITS ETF (Don’t you just love those snappy names?)
http://www.spdrseurope.com/product/fund.seam?ticker=SYBP%20GY
Or you could hold a gilt tracker and corporate tracker in the appropriate blend.
@ K man – Surprised you came away thinking bonds aren’t worth it. The historical experience of UK government bonds is a real return of 1.5% or thereabouts. You don’t hold ’em for the long-term return.
@ NaeClue – good point about the distinction in interest rates. A duration 7 bond will move 7% in price response to a 1% change in market rates (the return demanded by investors) which is not the same as the Bank of England base rate (though there is a strong relationship).
@ SG – The memory can be deceptive 😉 It’s worth taking a look at the groovy asset class returns table here: https://www.vanguard.co.uk/uk/portal/indv/investing-truths.jsp#the-truth-about-risk
2011 Shares – 3.46%, gilts +13.47%
2008 Shares – 29.93, gilts + 4.43%
Though of course you can find periods where bonds did not zig when shares zagged. The historical correlation is low, not negative. But looking at the Vanguard data for the last 30 years, there was only one year (1994) when bonds and shares were both negative.
@ Trium – those linkers will have been bought at a premium so as they mature the fund takes a capital loss. The yields on most linkers are negative right now. That’s the price investors are willing to pay for inflation protection during the world’s greatest money-printing experiment!
Excellent article – as are they all.
I am just about to press go on my first passive portfolio based largely on this site. I am going for a 75/25% equity bond split which I will lifestyle over the next 20 years. I am fairly comfortable with the decisions I have made on the equities side (although still wondering if investing in emerging markets is a good idea)…but I would really value some advice on the bonds section. Currently I am aiming to go for a split as follows:
Vanguard Uk Gov Bond Index 10%
Vanguard short term investment grade bond 10%
Vanguard UK inflation linked gilt 5%
The thinking is to have a small amount of protection against inflation with the linkers and to opt for what looks like the best available short duration tracker.
Does the above look sensible? or is it needlessly overcomplicated for what is likely to be a small but growing isa portfolio?
Would be interested in people’s views?
Hi Floatboy,
You’ve got a reasonably nice diversification there among your bond options and there’s nothing wrong with your choice. The following is food for thought only:
You could easily start off with the gov bond index and then diversify into linkers and then the corporate bonds later if you want to keep things simple. Many people never go beyond a 50:50 split between nominal bonds and inflation linked.
Given your time horizon is 20 years and a 75% equity portfolio will be volatile, I’d question the role of the short term corporate bond fund. Choosing the short-term fund won’t make much difference to the volatility of an aggressive portfolio like yours which will be dominated by the pitch and yaw of the equities. You could choose a intermediate fund which can be expected to give you more return with little perceptible difference to your overall volatility.
Hi Accumulator,
I’d appreciate your views on whether you consider the article you wrote in 2013 i.e. ‘A brief* guide to the point of bonds’ is as relevant today as it was when you wrote it in 2013,given all the doom and gloom surrounding bond bubbles and low returns.
I’m five years off retirement, with a portfolio roughly divided 55 % bonds 45% stocks and have to decide whether to add this year’s ISA allowance in to more bonds, or simply put the money in a cash ISA.
Thanks for a great website.
Hi Ron,
Yes, I think it’s still relevant. But given you’re already 55% bonds I don’t think it would hurt at all to put a slug into cash.
The expected return on bonds (not necessarily the return you will get) is their current interest rate, so with UK 10 year gilts currently yielding 2% you can expect to match this with a cash ISA right now.
And having some cash in hand will prevent you from having to sell your bonds or equities at the wrong time.
I’ve got some further reading for you 😉
http://www.obliviousinvestor.com/asset-allocation-for-retirement-portfolios/
A brief explanation of holding cash, bonds and equities in a bucket retirement strategy.
http://monevator.com/sell-government-bond-funds/
Links to some excellent Vanguard research that sketches out how quickly you can expect bonds to recover during rising interest rate scenarios.
http://monevator.com/cash-and-your-portfolio/
A really nice piece from The Investor on why cash is a good option for small investors.
http://monevator.com/maximise-savings-rates/
A somewhat arch piece from me on setting up a ridiculously elaborate system of bank accounts that maximises your interest rate from cash.
I hope some of this helps you in your decision.
Easy question. There are two 2018 gilts listed at Hargreaves Lansdown. One has a running yield of 1.227%. The other has a running yield of 4.594%. Can you explain why one would ever *not* buy the latter instead of the former?
Answering my own question, I got confused between running yield and yield to maturity. Sigh. No free lunch, as always.
Is it permitted to revive this thread?
October 2018. Brexit. Trump trade wars. Bull markets which have been steadily rising for 10 years (or is it 30 years, I forget), although a sizeable correction just this month. And the prospect of rising inflation and rates everywhere.
I am a UK resident. I have virtually no money invested in £ stocks or cash at the moment. I am not going to change this until a Brexit deal is actually signed and endorsed by all parties.
I have been floundering around for months now trying to find what possibilities are open to me for putting some investments in $ or € fixed-rate investments. It is very hard work indeed: for one thing, recommendations often turn out to be for funds which are available only to US investors. Secondly, even if you find an interesting looking prospect the chances are quite high that my platforms (Lloyds, Hargreaves L, Cavendish) won’t in fact sell it. Thirdly, even after reading this very good article, I still don’t understand bonds, or bond funds, at all. You look at something like Jupiter Dynamic Bond, and it has been declining in value (total return as well as price) for about two years, and yet it is still rated quite highly.
Even understanding the performance of bond funds can be very hard work: is this a graph of the *price*, of of the *total return*.
When it comes to ETFs, I often have difficulty finding out whether these are physical or synthetic (which I would never buy ever).
Dear Mr Monevator: can you recommend a good investment-grade bond fund or 2 (or physical ETFs) which are either 1) global 2) USD or 3) EUR, which are index trackers and which are likely not to be totally disastrous if the Fed continues to raise rates? (And which a UK investor can purchase?)
… and one other thing: £-hedging. A lot of the non-UK Vanguard passive bond funds shown here, https://www.vanguardinvestor.co.uk/what-we-offer/index-active-products, for example, turn out to be hedged against the £. I don’t really want this: in the event of a Brexit No Deal this would limit my “gains” in £ terms. If a deal is reached, on the other hand, my London flat, priced in £, might actually be worth more than £35.
Mike, I’m a bit worried. You say you don’t really understand bonds yet you’re making investment decisions based on your best guess of future international currency moves. It strikes me that you’re making short term bets rather than a long term plan and I fear that’s liable to backfire. Here’s some extra reading on bonds which I hope will illustrate how hard it is to predict outcomes.
https://obliviousinvestor.com/what-happens-to-bond-funds-when-rates-go-up/
https://canadiancouchpotato.com/2012/07/03/how-will-rising-rates-affect-bonds/
https://canadiancouchpotato.com/2018/07/19/bonds-behaving-badly/
https://canadiancouchpotato.com/2018/07/23/when-bond-yields-throw-you-a-curve/
https://personal.vanguard.com/pdf/ISGGLBD.pdf
If you insist on pursuing your present course then take a look at the International government bonds section here:
http://monevator.com/low-cost-index-trackers/
Or use the ETF screener here: https://www.justetf.com
You’ll soon find what you’re looking for but we can’t make recommendations and certainly aren’t qualified to predict performance / interest rate rises / currency moves.
Thanks. Those links look very good… I shall study them. The real thing I’ve noticed about bond funds is how very badly most have performed over the past 2 years or so, e.g. the first recommendation on that page, iShares Overseas Government Bond Index Fund D (GB00B849C803) … You’re absolutely right, I don’t understand them. But I feel that given my age, 57, I am probably too equity-heavy.
As for the £ and Brexit, yes, even thinking about this is no doubt very much counter to the philosophy of this site. Equanimity in the face of Brexit, particularly the possibility of No Deal, is something I also don’t understand! My understanding is that the markets have “priced in” a deal being reached, meaning that the £ is unlikely to rise much if a deal is indeed reached.
For me, the role bonds play in my portfolio to protect against downside volatility. I hope they will rise as a counter-weight to tumbling equities during a market crash. That’s their job and expectation of a return beyond inflation is a luxury extra in the medium term. Because I need bonds to dampen volatility and I pay my bills in £, the best option is high-quality UK Government bonds or high-quality global gov bonds hedged to the £. If I try to get too clever then I’m likely to end up with bonds that don’t perform when I need them to: in a crisis. So equities for offence (i.e. portfolio growth), bonds for defence.
The market has a view on Brexit. If the deal is worse than expected then the £ could fall. If deal better then £ could rise. But all kinds of other factors will be playing into the strength of sterling too. And the strength of other global currencies. And what will happen to the £ in 6-months? Or 1-year? Or 5? It’s better to admit that we don’t know and can’t capitalise on it any more than we can capitalise on the spin of a roulette wheel. When you invest in line with a sound philosophy then you free yourself to do the right thing. You buy high-quality government bonds because that’s your best redoubt in a crisis. You buy ’em in £ (or hedged to £) because then you can always pay your bills and don’t have to worry about currency risk.
Thanks again… I really appreciate you giving me the benefit of your insight.
The trouble is that most bond funds appear to have been generally worse than keeping one’s money in cash over recent times (e.g. past two years). Doesn’t there come a time when that starts to irritate you? Take something like Jupiter Strategic Bond (£ hedged): https://www.hl.co.uk/funds/fund-discounts,-prices–and–factsheets/search-results/j/jupiter-strategic-bond-class-i-income/charts. It doesn’t appear to have gone up with the October equities “correction”. That’s an active fund of course, but passive ones don’t seem very different.
I have a lot in cash at the moment, in Euros in a Euro account in Ireland. But some in £ as well. Money in £ for outgoings (in the event that the £ shoots up over the coming year): yes, well worth thinking about.
And what about a raising interest rates environment? My very paltry understanding is that a bond fund needs to buy short-term bonds in that case.
The truth: I’m paralysed with indecision: the anti-volatility case would work if the general trend of bonds could genuinely be expected to be up (i.e. higher than 0%). But that “trend”, if such it be, seems to have vanished!
Mike, I’m about the same age as you,I used to fret about my asset allocation and worry that bonds could become a burden should interest rates go up, but I realised that worrying won’t make a damn bit of difference. So to give you an idea of my simple allocation I own 100 minus my (age 58) in a low-cost world equity fund, which in my case equates to 42% , 29% in a Vanguard intermediate bond fund, and 29% in building society (cash) accounts and that’s it.I’m not saying it’s a perfect allocation, but it’s fine for me, and over the years I’ve not made a fortune but I’ve done reasonably well and ‘touch wood’ not lost a fortune either. I stopped checking it and micro-managing it, I just let it do it’s thing ; adding cash when I can and then I (bed and Isa) once a year. onhttps://www.smartinvestor.barclays.co.uk/invest/moving-investments/more-about-bed-and-isa.html
@ Mike – it seems like a desire for guarantees or making the right call is playing on your mind. But the greatest gift you can gain from expanding your knowledge is freedom from certainty. It doesn’t exist. Bonds could underperform cash for 20 years. So could equities. Cash or equities could underperform bonds. Diversification is the answer. 2 years is nothing over your investment lifetime. Neither is 5. Any asset you pick could weigh you down for a decade and the rest. Diversification is the answer.
The anti-volatility case relies on bonds being less volatile than equities. And having less of a downside than equities during a downturn. You can expect but not guarantee those two things.
Re: rising rate environment. Some of the links I sent you previously were meant to demonstrate that owning short term bonds in a rising rate environment isn’t the only answer. But it is an answer – as long as you don’t spend your time torturing yourself with other answers that do better. You can always find those. Cash is a fine option if you do the work of shifting in tune with the higher interest rate accounts. Here’s some Monevator posts on cash and short vs long bonds:
http://monevator.com/what-should-a-new-investor-do/
http://monevator.com/cash-and-your-portfolio/
http://monevator.com/should-you-invest-in-short-or-long-term-government-bonds/
@Roconnor, Accumulator.
Thanks very much. These are very valuable pieces of advice.
On the strength of your recommendations I have started to shift a bit… but the trouble is currently that history is in the making (Brexit). I currently have about 1/4 in £ and the rest in € and $. Quite a bit of that is cash (I have two Irish accounts), or ultra-short USD (https://www.ishares.com/uk/individual/en/products/258117/ishares-ultrashort-bond-ucits-etf), which seems to be as close to parking money in a USD as you can have as a UK taxpayer: it even pays a bit of interest. There are other short-term USD bonds as well.
As a long-term strategy I like the “100-age” formula a lot. When the volatility due to the Brexit nonsense/disaster starts to pipe down a bit the £ may be at parity with the $ (if a No Deal) or it may be at €1.20 (if the deal, the only deal, gets through). At some point I plan to move to the “100-age, split the rest between cash and bonds”… and heavy with the index stuff (although the performance of my Berkshire Hathaway, Fundsmith and Lindsell Train holdings are like sin for a monk: tempting away from the true path…).
Thanks, this was a great blog to get you started on bonds. I wanted to know more about them but I had no idea where to start, now I know!