Some Monevator readers question why they should bother owning bonds in their portfolio when they can earn higher yields with cash. They make a good point.
A competitive three-year fixed rate savings account bags you a 1.3% interest rate right now. Whup-whup!
Think that’s overenthusiastic? Well, a rate of 1.3% is positively Epicurean compared to the shoeing you can expect for offering your money to the bond market:
- The yield on a three-year gilt is currently -0.1% according to the FT’s Bond Yields table. Robber barons!
- The equivalent short-term gilt ETF will also steal your cash like an identity thief in the night. The SPDR 1-5 Year Gilt ETF is currently tempting punters with a -0.1% yield to maturity (YTM). They might as well offer to set your wallet on fire. Or send you on holiday to a wet market.
- It’s no coincidence that this duration 3 gilt ETF has the same YTM as a three-year individual gilt.
If you compare the duration of any gilt ETF against the same length maturity on the FT’s Bond Yields table, you’ll see that the ETF’s YTM approximately matches the yield shown on the table.
Capiche? A gilt ETF is no more than the sum of its underlying gilts, after all.
That leaves our three-year cash option 1.4% ahead of its gilt equivalents. In cash terms, you’ll earn an extra £1,400 in interest per year for every £100,000 you have tucked away at that interest rate.
Meanwhile, taking on more interest rate risk does not look worth it – even 30-year gilts yield only 0.68%. As carrots go that reward is shaped like a particularly hideous load of old genitals.
And if you’re worried about inflation then the market is saying: “Don’t bother your head.”
What happens if interest rates rise?
Let’s say interest rates rise by 1%. That doesn’t seem likely any decade soon but bear with me.
Your old gilts immediately drop in price. That’s because their scrawny interest rates are forced to compete with the pumped-up coupons of shiny new bonds, which parade around the market like bodybuilders on Venice beach.
Our three-year gilt and short-term gilt ETF would fall about 3% in price to remain attractive to buyers. (As per the duration of 3 mentioned earlier).1
The three-year savings account would also drop its pants by about 3%, if there was an open market in fixed-rate savings bonds. You can instinctively tell that, by imagining how much interest you’d lose if rates rose by 1% the day after you opened the account.
A 24-hour delay would have netted you an extra £1 in interest per £100 saved for the next three years. Whipping out our compound interest microscope we can see:
£107.06 would be ours after saving £100 for three years at 2.3% interest per year –versus a paltry £103.95 in an alternative universe where we only earned 1.3% interest.
103.95 / 107.06 x 100 = 97.1%, or a 2.9% loss if you were condemned to life in that wrong universe.
Pop this battle royale into a duration calculator and you get a duration of 2.9 – confirming the 2.9% loss for the 1% rise in interest rate.
If you’re as anal as I am then you can put the very same particulars into a bond pricing calculator. The value of your £100 drops to £97.13 due to the 1% interest rise. High five! (C’mon, don’t leave me hanging…)
The savings ‘bond’ is essentially the same as the outmoded gilt. You’ll take a 3% loss if you stick with it. Except that on the bond market you’ve already taken that capital loss quicker than you can say, ‘Bond Apocalypse’. Whereas all you need do with the cash is foist the unwanted savings account back on to the bank. It’s like financial wardrobing.
If the switch costs you less than 3% (in this case) then that’s another win for cash over similar maturity gilts.
Suppose that busting out of your savings account incurs a penalty of 180 days interest.
180 / 365 x 100 = 49.3% (the percentage of your interest rate that you’ll lose that year).
0.493 x 1.3 (the account’s annual rate of interest) = 0.64% (loss of interest that year).
You’re paying a 0.64% cost to ditch the savings account versus a 3% loss on the gilts.
This calculator shows you the interest rate you’ll actually get on a fixed rate savings account if you take an early withdrawal charge.
And this early withdrawal calculator from the excellent Finance Buff goes a stage further if you can’t decide whether to stay or go.
The comparison between cash and gilt losses only worsens as maturities lengthen. If you’re the Nostradamus of interest rate forecasts then you know what to do…
Bonds in a crisis
Where gilts tend to excel – especially over the last two decades – is spiking in price when equities are jumping off a cliff.
Coronavirus crash: gilts vs cash vs equities
Source: JustETF.com
The chart shows gilt ETFs peaking in unison on 9 March 2020. The longer their maturity, the higher they surge:
- Long gilts: +11.9% (red line)
- Intermediate gilts: +7.2% (orange line)
- Short gilts: +0.99% (blue line)
- Money market (cash equivalent): +0.03% (yellow line)
When global equities hit bottom on March 23, a 60:40 portfolio (blue line) was in much better shape than a 100% equities portfolio (green line):
60:40 Global equities : Money market (cash)
The 60:40 portfolio was down 16% while equities face-planted -26%. Of course, -16% isn’t great, but you can see the ride is gentler and that can make the difference between panicking and holding on.
60:40 Global equities : Intermediate gilts
The 60:40 intermediate gilt portfolio performed better than its cash cousin but not by much.
At the height of the crisis, this portfolio was down 14%. I was very glad I held gilts on 23 March but I doubt I’d have freaked out at -16% either. With that said, everybody has a tipping point…
Still, this is only one data point. Intermediate gilts did much better during the Global Financial Crisis when they rose 19% while global equities tanked -38%.
You could argue that the spike in gilts gives you more firepower when you rebalance. That’s true, although many studies have shown the rebalancing bonus to be small to non-existent. You also have to actually be able to rebalance into the teeth of the storm.
It’s worth noting that if your cash is in variable rate accounts then yields will most likely tumble during a recession (witness the rate slashing of the last few months). Your gilts can still make capital gains, which may be usefully rebalanced when you regain your poise.
Avoid binary thinking
It’s easy to forget in our polarised age that there is an alternative to ‘For’ versus ‘Against’.
Do we have to choose cash or bonds? The very point of diversification is that we place our chips on both.
120 years of UK asset returns shows that you were better off holding some cash in your portfolio 62% of the time when equities scored an annual loss. (Although cash has taken a beating every year since 2008 versus gilts and equities).
History also tells us that cash has been nothing but a drag on sustainable withdrawal rates if you want your retirement portfolio to last longer than 25 years.
I’m not attracted to this time is different theories but we are living through strange times. As yields fall below zero, cash and short-term gilts act like clapped out O-rings and lose their ability to contain losses. But long bonds (a proportion of which are held in intermediate gilt funds) can still make huge countervailing gains in sub-zero conditions.
It’s interest rate risk that looms largest in most people’s minds when they think about bonds, though. I know I didn’t want it holding me back when I first started investing. As a result, the defensive side of my portfolio was all in cash that doubled up as an emergency fund. Not best practice.
Back in those days I ignored two major risks:
- I had no idea what my risk tolerance really was beyond some vague notion of ‘backing myself’ in a crisis. The reality is I didn’t know how I’d react.
- The second problem is that at some point – without realising it – you’re no longer the devil-may-care desperado of old. You wake up one day with something to lose, but you never pass a road sign saying: ‘You’ve Made It. Caution Ahead.’
Without a plan to ease off the brakes, there’s every chance you could careen off the road during a future pile-up.
To that end, government bonds still provide the best stopping power you can buy.
And I’ll keep making room in my portfolio for gilts and cash because, well, diversification.
Take it steady,
The Accumulator
Bonus appendix: miscellaneous ‘cash vs bonds’ tie-breakers
Protection
As everyone in the UK is aware since that incident with Northern Rock, banks can go bust. Up to £85,000 worth of your cash is protected per ‘authorised institution’ thanks to the FSCS compensation scheme.
That sounds pretty sweet until you find out that 100% of your readies are protected when you hand them over to the British Government in exchange for an IOU – aka a gilt. Her Majesty’s Treasury will definitely pay you back.2
That in turn sounds pretty sweet until you check out the investor compensation scheme and realise that your 100% protected gilt holdings could disappear in a puff of mismanagement if your fund or platform provider went down in mysterious circumstances.
Then you’re back to £85,000 compensation, or less if the FSCS scheme turns out not to apply. A disaster like this is not likely but it could happen and it casts new shade on the whole ‘backstopped by the UK’ promise.
The sweet spot is cash parked in the National Savings & Investments (NS&I) bank. NS&I savings are guaranteed by the government and there’s no other weak link in the chain forcing me to write several lines of warning.
Better still, NS&I savings products are hot right now especially as the government has a huge hole to plug in the public finances.
Even better than that, you can pop eligible NS&I products into your SIPP. Although it looks like only owners of expensive ‘full’ SIPPs and SSAS vehicles need apply. ‘Simple’ SIPPs – as offered by most platforms – don’t look like they co-operate.
But I’m not expecting NS&I index-linked certificates to come back any time soon. These amazing inflation shields – perfectly tailored for the little guy – are subject to a value-for-money test by the Treasury. That pits them against the cost to the public purse of raising funds in the wholesale markets using equivalent gilts.
As the government has been able to issue index-linked3 gilts at negative real yields for several years, I don’t think they’re likely to come to the likes of you and me for a few billion, even if we agreed to an interest rate of CPI +0%.
Taxes and other cost considerations
Cash in a savings account doesn’t incur dealing fees or OCF charges but that’s neither here nor there when you’re making strategic asset allocation decisions. Most passive investors can hold gilt index trackers extremely cheaply.
Individual gilts are not liable to capital gains whereas gilt funds are.
Interest paid by bonds and bond funds benefits from your tax-exempt Personal Savings Allowance and Starting Rate for Savings, just as cash does.
- The duration number tells us approximately how much a bond or bond fund will gain or fall in value for every 1% change in interest rates. [↩]
- Although they do reserve the right to inflate away the national debt like a Chinese Sky Lantern if things ever get a bit much. [↩]
- That is, a return that keeps the value of your investment unchanged in real terms after a particular measure of inflation. [↩]
I for one hope you may be wrong about the re-introduction of NS&I ILSC’s.
I have held these for a good few years now and whilst some years back a lot of people viewed them as fairly poor value for money, I am very happy that I held on to them – renewing them as required. And I am even prepared to swallow the change from RPI to CPI indexing; not that I have any practical alternative.
Yes … I have been feeling some of this for a long while now. Bonds have very little up side and they do have risks and downsides for the long term. Equities in some markets look a bit pricey maybe, but they are at least a two way bet.
Negligible bond yields may push people towards alternatives (including buy to let and second homes, for those with large portfolios – which really does not help the housing market!).
For me (late 50s) I should probably be 70 global equities 30 bonds right now.
With bonds looking so ropey I should be 70 equities 20 property 10 cash, but being a bit reluctant re property, it’s more like 90 equities 10 cash. not ideal but I can’t see the point of bonds right now.
I’m looking at those charts and they are a bit misleading as they cut-off on 10 April.
If they were extended to the current date I think the 100% equity portfolios would be showing a very small loss pretty much equivalent to the mixed equity/bond/cash portfolios’ performances.
(I’m not sure about the long term wisdom of governments’ constantly bailing out investors though…)
@DavidR
‘I can’t see the point of bonds right now’
They generally perform the opposite to equities and generate some real return unlike say, lottery tickets. If there is a second wave of Covid-19, which no one knows, you could well see the point of bonds again.
It is a conundrum. I tend to overbalance in rungs from my coasting 60/40 equity/bond mix. The pot recently returned to its pre-Covid value sitting at 80/20 so I have shifted back to 60 per cent equities, but I cannot bring myself to put the proceeds back into bonds so close to their high. So for now its 60/20/20 and hoping for a good money market ETF to come along. It doesn’t feel right but at least it’s set up for another dip.
If you hope that interest rates will drop/ a rebalancing bonus that is essentially speculation (If cash is an option to you). You really have to ask if you think that’s worth it – it is market timing and not really a safe option
Premium bonds should average the 1.4% prize rate over the long term at current rates (or 1.2% if you only counted £25 prizes), and its not tied up. A fixed savings/ bond can guarantee your pittence in interest – you will never recieve less and also never more. Getting 1m in premium bonds IS a total crapshot (or a smaller prize) but it also IS genuinely possible – how much do you really need to guarantee your pittence in interest at these rates?
Any advice for someone with a (needed towards retirement income, in the next 5 years or so) pot of Vanguard LS 60 ? Would that 40% bonds be much better off somewhere else ?
Just for interest I have held for many years a Vanguard Global Bond Index Fund hedged to the Pound (VIGBBD) as my sole Bond investment
Performance-currently 3.41% ytd
Since inception averaged 4.54% pa(Vanguard website)
Bonds do the reduction of volatility thing for me ,maintaining value of portfolio in downturns
The interest is a bonus
May be different going forward-who knows?
xxd09
xxdo9: Where an ETF is preferred, Vanguard have an identically-performing GBP-hedged Global Bond Index fund VAGS, though curiously only the distributing version VAGP is available in Vanguard’s own ISA and SIPP. VAGP is my main bond holding. It does seem to be a good all-rounder and I expect many switched to it from their gilts Fund/ETF for the lower risk rating.
Hi,
Are you still happy to hold the Royal London short duration Global Index linked Bond fund at the same percentage holding as of now in the “slow and steady” passive portfolio? or do you plan to drop the percentage held?
Thanks
@xxd09 – bear in mind that some of that performance is from corporate bonds – equity lite? If you find the right balance between cash&equities only could you achieve essentially the same level of risk?- with a better return from swapping quality bonds for cash and corporate bonds for equities & maybe tweak the allocation to keep risk level the same?
Helpful and unhelpful article!.
cash isa maturing , cash bond maturing , Need to make some decisions…Always had too much in cash , always been stuck on bonds
what damn fund???
current idea is vanguard 20 equities 80 bonds as a bond proxy.
or xxdogs global bond hedged
I did read somewhere its mistake to exclude an asset class, a mistake i made..
I also like Jim collins total bond index idea of just buy all maturies in one fund.
Whats the UK version of US total bond index?
Thanks Matthew
Yes I was aware there were some corporate bonds there
I am OK with that
xxd09
Andrew-I started at the time when there were no ETFs available-funds only
John Bogle of Vanguard didn’t like them anyway-why would an investor want to day trade a bond (or equity) index fund investment?
I must say I rather agree with him
Index investing is for buy and hold -forever
Worked for me-so far!
xxd09(aged 74-17 years retd)
I found this article from Portfolio Charts very helpful in thinking about my long term strategy. Not only the defensive values of bonds but also how well a portfolio can recover from a big impact seems key. https://portfoliocharts.com/2020/06/08/welcome-to-the-big-bounce/
xxdo9: For me the small advantage of the ETF is knowing the price when I rebalance which can sometimes be useful. I am not a day trader but it has been useful to confidently rebalance during the market’s recent gyrations and has resulted in an earlier recovery for me. Jack’s Vanguard recommends rebalancing. If, like founder Jack, you never sell to rebalance, another excellent policy to adopt, I can see that the fund can help one avoid temptation and stick to buy and hold.
@ Neverland – the point of the portfolio vs 100% equities charts was to show what bonds can do in the heart of a crisis. We all know that over a longer time frame, 100% equities can be *expected* to outperform but the bonds are there to cushion you when the economy is going south. As you point out in comment #4.
@ Dawn and others torn about what to do – we’re on the horns of a dilemma. Bond returns look pretty unpalatable, but there’s still no substitute when another crash comes. Personally, given I know that bonds helped me stay sane in March, I’m looking past returns to some extent, holding my nose and maintaining bonds. But I’m also holding more cash than I might have once expected instead of a larger percentage in bonds.
If I was much younger, or psychologically immune to the effects of watching my portfolio halve in value, then I would cut bonds to the bone. I’m neither of those things but I ease the pain by thinking of my portfolio as a strategic whole, rather than worrying about the parts in isolation from each other.
Total bonds – iShares Core Global Aggregate Bond ETF and Vanguard Global Bond Index come to mind.
@ Raymond – the percentage of global index-linked bonds in the Slow & Steady portfolio will creep up over time as the time horizon shortens. Linkers are the case par excellence of a diversifying asset where small negative real returns look baked in for years but, if the inflation monster gets loose, they could be a lifesaver.
@ Matthew – looks like 1.4% average rate for premium bonds is a misnomer according to this deep dive: https://www.moneysavingexpert.com/savings/premium-bonds/
@TA – well 1.2% is more realistic (from £25 prizes only) and you only get an average amount by having a few thou over a few years, but I think MSE uses a bit of unfair bias in general in favour of fixed savings/ mortgage repayments – ie you never never never see Martin recomend the world of investments (barely even mentioning that the option exists – you’d think cash/mortgage was the only option) – his articles say things like mortgage overpayment is a “no brainer”, he places much importance on guaranteeing returns (even at these rates), he underrates the danger of inflation in fixed savings accounts but makes much more of a point of it in premium bonds, he makes much of a point about what you can expect in 1 year but not 10 years. The upside you can get with premium bonds is only ever mentioned in that article and never in any other savings accounts articles, premium bonds are never in Martin’s comparison lists.
It presents true facts in a way that would bias an unsuspecting reader into thinking the world was only about fixed rate savings
@Accumulator
‘Bond returns look pretty unpalatable, but there’s still no substitute when another crash comes.’
Mental resilience/not looking at your portfolio seem to work equally well.
More info from the battlefront
It was interesting to watch a low 7 figures portfolio drop 14% from Feb figures to return to “normal” and a few thousand more by July-with no action by me
Same in 2002 and 2008-getting to be a habit!
My portfolio is 30/65/5- equity/bond/cash-made a big enough pile
3 funds only-a Global Equities Index Tracker ex UK(26%),a FTSE AllShare Index Tracker (4%)and aforementioned Bond fund(65%)
5% cash is 2 years living expenses
Very counterintuitive for investors to do nothing in a crisis but it works
Concentrate on getting “your ducks in a row” or Asset Allocation in the quiet times
Write your Plan down and the go and play golf!
xxd09
I would note too that at low yields gilts (as a safe haven) are effectively like a more capital protected version of gold – gold being more inflation protected instead – since gold therefore overlaps some function with equities (inflation protection) you could potentially afford to keep more in total “safe havens” that way, although the capital protection of gilts would be better for drawdown.
That’s a thought provoking article followed up by your excellent comments Accumulator and others.
As you have discussed above cash is very different to bonds and so I do not think comparing the interest rate of cash to the interest rate of bonds is a complete approach. One effectively has ‘zero’ duration (Fixed income specialists do say if I am wrong) being cash the other has duration depending on the nature of the bond. The problem being convexity (sensitivity to changes in bond yields) increases as yield to maturity (YTM) approaches zero. In plain english, now that your bond fund has a YTM that is much lower than before it is more sensitive to increases in interest rates than it was previously hence why people are somewhat nervous.
The real life example here is my national insurance index linked gilts (sort of like cash) vs my $TIPS over the pandemic. The first did nothing during the pandemic (neither went down or up) whilst the second provided a substantial hedge against falls in equities given their duration (although much less of a hedge than an ultra long bond fund). You are looking at two different asset classes and so as the Accumulator says you should hold both not one or the other imo. Cash does not provide a counter weight against falls in equities
Of course bonds may not always be inversely correlated against equities and may not deliver this hedge. The scenario would be in a world of unexpectedly rising interest rates, which seems very unlikely today but may not be 1 , 5, 10, 20 years time.
What should this pandemic should have done is remind us that we don’t have a clue what the future holds. Therefore deciding not to hold bonds because I don’t believe they will deliver a return in the future is suggesting you can forecast the future, which I would suggest we can’t unless you predicted the financial crisis, brexit and the cv pandemic in which case do let us know what’s coming next. It doesn’t mean you can’t have a view – I certainly do but I don’t let that cloud my asset allocation. Deciding not to hold bonds because historically an all equity portfolio has generated higher returns with accompanying higher volatility is a legitimate course of action depending on your personal situation.
I like XX D09 comment because he uses the word worked not works. The performance of that bond fund into the future can only be replicated through increasing price rises, i.e. expectation of future lower (negative) rates as the YTM of that fund will not on its own support that return. Again in plain english that’s why its understandable to be nervous to hold bonds.
As it happens, I hold US $TIPS, which are less expensive than index linked gilts – their YTM is circa zero vs negative for index linked gilts and are a hedge against unexpected inflation – none of which can be seen on the horizon for now. With a duration of 8 they also provide some exposure if equities fall and people buy fixed income assets. Definitely some cognitive dissonance in that because I would have done better to hold a global bond fund over the last few years.
If I was retired with a mean expected life span of say 30 years and possibly 40 – 45 years then I would likely hold more bonds and unfortunately reflect that in a lower withdrawal rate. As I’m not and willing to bear the volatility of equities I’m largely in equities whilst continuing to noodle on the fact that whilst I have been fine in the pandemic a ten year bear market in real terms would be a bit dull.
This paper on the effect of aging populations on the equity risk premium quoted in the FT caught my interest. Not least I liked the title ‘Murder-suicide of the Rentier’
https://www.josephkopecky.com/Papers/KopeckyTaylor.pdf
The world previously didn’t have many old people looking for a stable retirement income outside Japan, now its about to have rather a lot. All wanting bonds.
Maybe this time really is different because the world is different?
@accumlator
Thanks that’s helpful and reassuring.
Half of my fixed assets are index linked ,the royal london index linked fund, a linker, and the valuable, not on sale ns&I inflation bond. The other half is cash. I’m 55 yrs and was fine in the crash, as you said, my fixed intrest allocation steadied my nerves and made me feel safe and not over exposed to what might have been a slow climb back up with equities. I’m still work part time but at any point from now I could start living off portfolio.so like you, I dont have years ahead of me otherwise I think I’d be 100% equities.
Thanks for article and I love reading everyone’s comments.
A method by which to visualize the choice between cash and bonds is to calculate the forward breakeven yield (FBY). This is the yield the bond needs to reach, over your horizon period, to breakeven in P&L terms vs. the borrowing rate for that bond. Now, retail investors are not borrowing money to buy the bond but the depo rate you can achieve on cash is effectively that borrowing rate; it’s the opportunity cost.
So imagine we have Gilts 2y, 5y, 10y and 30y at yields of -0.10%, -0.10%, 0.10% and 0.60%, respectively. Lets also imagine their durations are 2, 5, 9 and 25. So a “back-of-the envelope” approximation of the forward breakeven yield change (ΔFBY) is
ΔFBY = Time (years) x (Bond yield in bp – Depo Rate in bp) / (Duration at horizon date)
So if we have a 10-year Gilt, yield -0.1%, duration 9, and the depo rate is 1.2%, and the horizon date is 1 year from now, then ΔFBY = 1 x (-10 – 120)/(9-1) = -14bp
So the 10-year Gilt needs to fall around -14bp over the next year to breakeven vs. cash at 1.2%. Note I deduct 1 from the duration of the Gilt to take account of the fact that the Gilt duration will be 1 year less in 1 years time. If the time horizon was 6 months rather than 1-year, then ΔFBY = 0.5 x (-10 -120)(9-0.5) = -6bp
So far this year 10-year Gilt yields have moves 70bp lower and typically 10-year Gilts move around 3-4bp per day. So the FBY is fairly small in negative carry terms vs. the yield volatility.
By comparison, it should be clear that currently short duration bonds need a large ΔFBY to breakeven vs. depo rates. So for a 2-year Gilt, the ΔFBY is around -130bp over 1 year or -45p over 6 months. For comparison, the 2-year Gilt is about 70bp lower so far this year. So for 2-year Gilts to outperform retail depos is hard. The typically daily move in 2-year yields is about 1bp. Even if they move another 70bp lower over the next six months, you’d only make the bond duration x the difference vs. the FBY, or about 27bp, which in return terms is about 0.5%. Effectively, you need a very large amount of yield volatility to outperform cash and that can only come from large policy rate cuts.
For retirees, I find the floor and upside approach provides a useful framework for resolving – at least in my mind – the cash/bonds dilemma.
First some definitions:
a) flooring products guarantee to pay at least X per period for Y periods,
b) whereas the upside is a risky sub-portfolio that is generally close in spirit and construction to an accumulation portfolio.
This tends to imply government bonds or government bond strips (inflation linked or otherwise) held to maturity can be used as flooring. All other types of bonds should generally be considered as part of the upside, i.e. risky, sub-portfolio.
Cash/cash-like products – with due consideration for inflation – should be diversified to take account of FSCS limits and are for flooring and/or for reserves, i.e. emergencies.
Neverland. thanks, interesting paper. Taking one extract:
“Looking to the future, the model predicts a continued fall in the risk free rate to –278
bps by 2050 with the ERP roughly stable at 498 bps. The expected return to equity therefore continues to fall to just 220 bps as demographic shifts continue to relentlessly boost the demand for all assets, but especially safe assets”.
This would seem to provide a scenario where continuing to hold bonds would make sense. Noting that I don’t know what will happen.
Moving off topic, this would also seem to support those who suggest (which is also me in the short term and also I note recently capital economics) that it is the lesser of two evils for the UK govt to finance fiscal deficits caused by the pandemic through borrowing as opposed to tax rises.
@xxdog
Thanks for your contributions. It’s always good to hear from those well into living off thier portfolio.
@SeekingFire
‘… the lesser of two evils for the UK govt to finance fiscal deficits caused by the pandemic through borrowing as opposed to tax rises…’
I don’t personally think this works for the UK because of balance of trade deficit
You only have to look at the recent history of the Turkish Lira versus USD to see how that one resolves itself
Time will tell but I get a terrible feeling the government just burnt through c. £300bn trying to shore up an economic model which won’t work in the future, but who knows
I do use vanguard lifestrategy 20 as a bond proxy as it’s highly diversified. I also use what I consider to be the UK versions of US total bond index:
iShares Core Global Aggregate Bond ETF GBP Hedged | AGBP
Vanguard Global Aggregate Bond ETF GBP Hedged Income | VAGP
@zx – thats assuming yields keep falling, I worry that they won’t (more significantly than credit risk), and theres fees too in that calculation.
Cash I would say is more inflation safe since it’s capital value wont drop if the mood on inflation changes
Also I do think there’s such a big institutional market that quality bonds are not necessarily priced for retail needs – one price does not fit all
@matthew. I’m not assuming anything. The forward breakeven yield (FBY) just tells you what the bond yield must be at the horizon point to generate zero P&L vs. your funding rate (or, in this case, the opportunity cost of cash). You can then compare it with the current spot yield to decide if you believe such a move is likely.
Clearly as the yield curve is inverted vs. the depo rate, all forward breakeven yields will be below the current spot yield. Again no assumption, just basic math. If the bond yields were higher than the depo rate, then the forward yield would be above the current yield. Thinking in terms of forward rates, rather than spot rates is key to all fixed income analysis.
The point is that short duration bonds will need to rally considerably in yield terms to hit their FBY vs. depo cash. It will require substantial policy easy. Even then you may not make a profit vs. cash. You need to call both the directional of yields and the magnitude of the move.
By comparison, long-duration bonds, say 10y, do not need to move that much lower in yield – just 14bp over 1 year. That’s not a large move compared to a daily volatility of 4bp or a monthly vol of say 15-20bp. So with long duration bonds vs. cash the only real question is whether yields go up or down, not how much they move.
@john
Thanks
Dawn
@ZX – how does a bond fund (which I guess most here will hold) differ in respect to breakeven compared to individual bonds? As in the underlying bonds held by the fund will change over time due to influx/outflux of capital plus I guess a manager is selling and buying bonds based on where he sees current and future value. I have to say, I have little idea how a bond fund is managed at all.
@Richard,
Some clues (and maybe even answers), admittedly from a US perspective, are given at:
http://www.theretirementcafe.com/2015/09/all-stock-investors-are-above-average.html
More details on individual bonds vs funds are available if you follow the links within Dirk’s 2015 post.
@ ZX – thank you for that formula. I think even I can follow that.
@ Nobody in particular – there’s a lot of worry being expressed in this thread that the future could turn out one way or the other and perhaps we’ll be on the wrong side of the argument. Getting things catastrophically wrong can only happen if you make a big bet on one outcome that does not come to pass. The alternative to trying to predict the future (fun though that is) is to get comfortable with uncertainty, hope to win some but know you’re going to lose some. On balance you’ll probably come out OK as long as you give yourself a margin of safety and follow a strategy that doesn’t rely on you being precisely right.
“So if we have a 10-year Gilt, yield -0.1%, duration 9, and the depo rate is 1.2%, and the horizon date is 1 year from now, then ΔFBY = 1 x (-10 – 120)/(9-1) = -14bp”
Purely based on a back of the envelope calculation, really just in the head calculation as I only have my mobile to go on, this looks wrong. A 10y gilt yielding 0.6% will need to rise by 0.6% in price to deliver 1.2% over a year, so the yield drop cannot be more than 7bps.
Sorry, should have said “A 10y gilt, TRADING AT PAR, ..”. None are of course, but that’s beside the point.
@Naeclue. 10y Gilts yield about 10bp not 60bp (currently 11.6bp). Oh for the heady days when 10y Gilts yielded as much as 60bp! So 10-120 = 110. Duration say 8 at the horizon (that depends on specific Gilt though). So a 13.75bp fall is required using back of envelope.
Precise calculation for UKT 4.75% 7Dec30 (current 10y benchmark) is -12bp (so a FBY = -2bp, if spot yield is 10bp). Over a 1 year horizon, you get 2 Gilt coupons, and on a bond that has such a high coupon vs. the YTM, the reinvestment assumption is substantial so this makes the back-of-the-envelope approach less accurate.
@Naeclue. Also I should really just use a duration of 10 for a generic par 10y Gilt (it’s almost a zero coupon bond). Then its (10-120)/(10-1)=-12.2bp fopr 1y year horizon. I was trying not to use duration=maturity since that assumption is not normally correct for every bond market. It’s just happens to work quite well for 2y, 5y, 10y (but not 30y or 50y) par Gilts right now. I’ll give up now since this is why I hate approximations. It’s just easier to do it precisely but you can’t upload spreadsheets or paste images.
The point that is being lost and I was trying to make (clearly really badly) is that there is a risk here that retail investors think “Gilts are expensive” but also “I need to hold some Gilts for diversification/protection”. The result could be they choose a short duration Gilt fund. The problem I’m highlighting is that the breakeven yield move vs. term depos of short Gilts is large. You would need substantial policy cuts just to breakeven vs term depos and, to make any substantial money, quite a bit more.
@ xxd09, always interested in your posts as I am about to retire at 57 with a public service pension. I am fortunate in that I only need to protect from inflation,, at the moment I have invested in Vanguard L/S 40/60 e/B after finding this great resource. Also have lump sum cash just sitting. What now?
Apologies, forgot to mention I am very cash heavy at a split of 50/50.
“10y Gilts yield about 10bp not 60bp”. Yes that will be it . what short memory I have. 1.1% capital gain needed on a par gilt then, so yes 12 to 14 bps yield drop.
@Richard. Don’t concern yourself with the fund manager activities. Assume it’s a passive fund that tracks the index composition and even if it’s an active fund most of the time you’ll still be about 90%+ correct, probably much more.
At any instant in time, the forward yield of a bond fund is just the weighted sum of the individual bonds. The issue is that the fund composition changes over time and you have reinvestment.
If the composition changes very little over time (overall fund duration doesn’t really change), the amount of reinvestment is small (from principal and coupons), the yield curve is flat, and the volatility of yields is low then you can approximate the fund as a “constant maturity bond” i.e. a bond that doesn’t decay in maturity.
In reality it’s going to be a path dependent problem. For example, if yields trend lower, then your principal/coupons would be reinvested in lower yielding bonds, and your FBY for those bonds would be lower. Conversely, if yields rise. That reinvestment amount could be large or small over one year. If it was a Gilt 1-3y fund, you’d expect about 50% of the fund to be reinvested per annum. So it’s hard to generalize. But then again you have exactly the same issue in an equity fund vs. a single equity.
David
If your pension is enough to fund your day to day living -some suggestions
Put 2 years living expenses in cash in an easy access account-National Savings-I currently get 1.5% with a Tesco Bank Internet Saver
Invest the rest
If you are happy with Vanguard 40/60 LS -use that -hopefully in an ISA anon a suitable platform(see Monevator.com)
Keep your living expenses fund topped up from your 60/40 LS as required
That’s it
xxd09
One other thing to consider is if you are holding a bond fund outside a tax shelter, the tax you will pay is likely to be larger than your expected return. That’s because of the historic high coupons on many bonds. VGOV for example has a running yield of 2.9%, so that’s 0.58% gone in tax for basic rate taxpayers. The expected return cannot be more than 0.4% with the flat yield curve we have now.
@David, what is right for you may not be right for someone else, even if they start off from the exact same place.
Are you aiming to maximise your spending, or are you happy to spend less and increase your expected legacy and/or reduce risk of investments lasting?
How comfortable are you living off variable income?
Do you have other assets you could countenance selling if need be? eg how would you feel about downsizing if you get poor returns?
How do you feel about giving assets to beneficiaries during your lifetime?
Answers to questions like these will help shape your asset allocation.
@ xxd09, thanks for your reply, all in a Isa with iweb as I don’t intend to meddle, lessons learnt as a novice after finding Moneyvator. signposting numerous Health Service colleagues to the page as we chatted over coffee and it was clear we were all of the same financial mind “Clueless”. Your suggestion was my plan until I read posts from Dawn above and that got me thinking. Always dangerous.
Hi Naeclue, just read your post, thanks for your reply I appreciate it. No dependants, happy to keep up with inflation and spend accordingly.
Could we say cash is a zero duration bond with the same credit risk as the bank(/fscs) itself?
Zero duration means the coupon cannot be different to the yield – and therefore doesnt have any skin in the game betting on fear at all
A fixed savings account is a bond without fees, you could even cash it in early for a penalty if it gained value in a deflationary crash if you wanted to rebalance.
To add duration duration even for cash savings is to bet on falling/stagnant/subdued rates, and for little gain seems a strange thing to be doing from this point in time if it has the potential to turn catastrophically wrong
Likewise to fix a mortgage deal is to bond-ise the debt
@TA – well 1.2% is more realistic (from £25 prizes only) and you only get an average amount by having a few thou over a few years, but I think MSE uses a bit of unfair bias in general in favour of fixed savings/ mortgage repayments – ie you never never never see Martin recomend the world of investments
I’ll admit upfront that I’m a Martin Lewis fanboy. The amount he has done to help people is incredible, and he seems to have a strong ethic about giving honest advice.
I wouldn’t describe his bias as unfair. I think he wants their advice to be beneficial to an extremely broad and financially ‘naive’ audience. In the same way that Monevator benefits from having a relatively clear passive focus, MSE benefits from being accessible money advice for the masses.
I’m a higher rate tax payer in a stable financial situation who uses their ISA allowance and has interest beyond their tax free savings allowance; this means that for me premium bonds are a great option; but I’m not Martin’s target audience, I don’t need his help as badly as millions of others, and trying to provide advice that covers all bases would make it less effective for everyone.
It will be interesting to see if he does start to advocate PBs more widely in the next few months if interest available on alternatives remains so poor or even gets worse; because I would agree that at the moment I think the case for PBs even for people with modest savings is pretty good.
@johng – I suppose my main worry about Martin Lewis is that he’s reinforcing a bunker mentality of zero risk, guarantee everything – you’ll get people overpaying their mortgage ‘cos Martin told them when they really should focus on pension (and as a result they never have enough savings to get signposted by their bank to investing), or likewise a poor person potentially has the most to hypothetically gain from premium bonds. I think its mostly a “dont sue me” problem but he IS giving finacial advice and that does not account for inflation, it won’t be appropriate for, lets say… the young
Current invester education is going to great lengths to get people out of this bunker mentality. It can be hard when one family member wants to invest but the spouse is too worried about “the stock market” to ever allow it, or people start Buy to letting, because its the only investing they know, or put solar panels on their roof in England because they dont realise that renewable energy funds exist that could do it on scale where there is sun.
There was a time when we’d look to Martin for the best accounts but he’s not the only comparison site nowadays, so to speak, and not the only place that’d alert you to tax breaks. If people really want to find out how to save money, they would find a way. Helping the average consumer could limit consuption when the economy – and their own jobs – need it to continue
@matthew I’d suggest monevator readers are not Martin’s key audience… although though they might be related to people who are: I know I am. I see him as educating those whose monthly spend includes £100 on Sky; £50 on latest phone; £120 on variable energy tariff; £10 for ‘premium’ banking; £?? minimum payment for credit card; plus renewing home and car insurance and then complain about not having any money. For these people, paying off the mortgage, along with the other zero-risk suggestions, will make a big short-term difference and build into a long-term one.
Leveraging your shelter to invest in the market is fairly advanced stuff and only for people with a plan… most people I meet don’t have one. Few have nest eggs requiring jumps through tax-efficient hoops.
Firstly, great site, article and discussion.
I’m 51 with an Interactive Investor SIPP and ISA and I’d like to be able to semi-retire at 55.
I feel like the equity market has become overheated without time to properly adjust since the 2008 credit crunch and therefore want to get some bonds as a diversifier. Also to get a feel for substituting them for a portion of cash and to maybe rebalance them for stocks during a bear market.
I’m active with my buying and selling so feel like there would be too much “inertia” with something like a Vanguard 20 fund.
Therefore I was thinking about buying individual Bond trackers that constitute that Vanguard 20 fund now and again, depending on which one had currently dipped the most.
For example, The UK and US govt bond trackers are currently the most dipped, so I will buy a little bit of those for my monthly buy (as well as my, ahem, dodgy risky stuff of course).
I’m not trying to catch a falling knife with bonds, but I think that is a better way to do it so when I want to sell, I’ll simply take profit the ones that have done the best as there will be a wider selection.
Does anyone else think like this, or am I overthinking it?
Aged 74 retd 17 years
Vanguard Global Bond Index Tracker Fund hedged to the Pound (VIGBBD)-only Bond I hold
Held for many years-done and still doing it for me
A rough guide for amount of bonds to hold-your age minus 10
xxd09
@xxd09, many thanks and I shall put VIGBBD on my watch list.
However, my first concern is that it is currently at its very peak, when stock markets also seem to be at their peak.
If using bonds as a hedge, is it not better to watch a selection of more specific bond funds and buy the one that is most dipped (we are obviously talking about sums large enough to make the trading fee more insignificant)? Hopefully later in times of need you take profit from the ones that are most peaked.
Obviously, this takes a bit more time and thought- and time is indeed money – but then we’ve got enough time to read this very excellent website and make comments on here 🙂