Across the Monevator comments and beyond, a cry has gone up: “Bonds are bad! Down with fixed income! Duration is for dummies! Stick your equity cushion where the sun don’t shine!”

It’s not hard to see where the hate comes from.

2022 has been a terrible year for bonds.

I don’t mean terrible ‘for bonds’ in the sense that bad years for bonds are less common than for shares, meaning you’re disappointed with, say, a minus 5% annual return.

It has not been a bad year for bonds like Oswald Mosley wasn’t that bad for a Nazi.

No, it’s been a bad year in the sense that some bonds and bond funds – those of lengthier duration – have done even worse than the risky US Nasdaq index – which itself has had a rotten year:

Clued-up investors know equity declines come with the territory. Fair enough.

However we own bonds mostly because we hope they’ll do better than shares when that happens.

That’s why 2022 stings so much. It’s not just that bonds have fallen a lot. It’s that they’ve fallen when shares are down too.

Bad for bonds is worse for LifeStrategy

Because long duration bonds have done so much worse than shares – especially US shares, juiced by currency gains for UK investors – we see surprising and ghastly results like this:

Source: Trustnet

The chart shows how Vanguard’s popular LifeStrategy funds have put in a Bizarro World performance this year.

• The supposedly lowest-risk LifeStrategy option – the 20/80 fund, with just 20% in shares and 80% in bonds – has done the worst.

• The best LifeStrategy fund to own in 2022 was 100% in shares.

This is the opposite of what we’ve come to expect from balanced funds like LifeStrategy.

And let’s be honest – it sucks.

It’s one thing to lose money in the hurly-burly of the stock market.

High risk, high reward, right?

It somehow feels far worse when your pension is battered by boring old bonds.

The trouble is the same unwelcome double act has done for both bonds and shares this year – high inflation and rising interest rates – with lofty starting valuations for both asset classes having a supporting role.

Hence in 2022 bonds and shares have moved down together.

So are the newly-converted bond-o-phobics right? Have bonds been unmasked as wolves in sheep’s clothing? Ripping your face off just when you could really use some comfy woolens?

Should we junk our bonds faster than Tories getting rid of a Prime Minister?

Not so fast.

Not such a bolt from the blue

The potential for bad years for bonds was always in the small print – and the history books.

Moreover the risk of a bad spell for bonds only rose as prices climbed and yields fell.

Of course, we human beings tend to think the opposite way. The longer something bad doesn’t happen, the more we dismiss the risk.

(This is also why every outdoor activity with children eventually ends in tears…)

And after a 40-year bull market for bonds – longer than many City careers – complacency was at an all-time high.

But the risks were still there, if you wanted to see them.

Way back in 2012 I explained how bonds looked more vulnerable as Central Banks lowered rates:

What makes bonds particularly risky at the moment is the low yields you get for holding them.

As we’ve seen, this increases duration, and so makes them much more vulnerable to interest rate shocks.

I held no government bonds myself, preferring cash. As I wrote then, gilts “gave me the willies”.

This was my stance for a decade. Seems a good call now – but the fact is until this year it was a losing trade to prefer cash over bonds for safety.

In my 2012 piece I also said I couldn’t imagine yields on a ten-year bond would go much lower than the prevailing 2%.

But they eventually went to near-zero, boosting returns for bond owners.

Moderation in all things. Even bonds…

My co-blogger The Accumulator has also flagged the issue many times before this annus horribilis:

• Why UK inflation-linked bonds might not protect you from inflation
• Negative yields on bonds: what do they mean?
• What the warning signs about the 60/40 portfolio are telling us
• Defensive asset allocation and model portfolios
• How much will you lose if bond prices fall?

Like me in 2012, he also suggested holding more cash as one response to very low yields. But being the grown-up in the room, The Accumulator also urged readers not to dump bonds entirely.

Instead he stressed you could choose lower duration bonds to make your portfolio less vulnerable to an interest rate shock.

Why didn’t we bail on bonds?

What none of our articles did was declare in 72pt bold font:

SELL YOUR BONDS – NEXT YEAR WILL BE TERRIBLE.

Indeed you’ll wait a long time to read an article like that on Monevator.

That’s not because we keep such secrets to ourselves. Rather it’s because we have no idea exactly when crashes of any kind will happen.

For The Accumulator, knowing your limits is a key plank of the passive way.

For me, a naughty active investor, it’s a perspective hard-won from years of trying to second-guess the market.

But this is not a cue for you to read a different website – let alone turn to TikTok – instead of sticking with us.

Because I don’t believe anyone can tell you exactly when to get in and out of markets, consistently.

Sure, you will find thousands of people making comically precise market predictions all over the Internet. Some of these people are quite popular. But that doesn’t mean they’re any good at it.

Everyone has a hunch now and then. And after a drink, I’ll tell you I think I do better than average.

For example here’s a bottom. And here’s a top.

I think I do okay, by the standards of a scurrilous game. But the fact is it’s hard to distinguish skill from luck – or more importantly to bank on it.

I don’t urge you to avoid making wholesale moves in and out of different asset classes (as opposed to judicious tweaks or re-balancing) not because I don’t trade my portfolio. But because I do.

Mugged by the market

Since 2010, some commentators – including me, as we’ve seen above – were saying bonds were over-priced and bound to crash when yields rose.

But as it turned out, bonds delivered solid returns for many years to come. Culminating in a final flourish in the 2020 Covid crash.

How many people held themselves – or their preferred pundits – accountable for getting those predictions of a bond crash wrong, year after year?

Of course you might argue it didn’t matter exactly when the bond crash happened. It’s been so deep you could have bailed on bonds in 2015, say, and still dodged a lot of pain.

True – but that statement is neck-deep in hindsight bias.

Once you’d sold your bonds, you had to put the money somewhere.

Maybe into low-to-zero yield cash?

It’s taken a crash of 2022 proportions for that bet to come good. There was no certainty it would.

Equities?

Sure, if you chose US or global equities then these have beaten bonds over the past decade.

But (a) you were and are always likely to get a higher return from equities than bonds, and (b) the risk is you don’t. Equities are far more volatile than bonds.

In some parallel universe, we saw a huge equity crash in 2016 that we’re only now limping out of. For the past six years in that alternate reality, even low-yield bonds did better than shares.

Or maybe there’s a universe where we’re still looking for a Covid vaccine, and the world is mired in a 1930s-style depression.

I don’t want to think about what our portfolios would look like in that reality. But I’m confident that bonds would be doing better than shares.

Investing: probably, likely, could, might, may, should

The trouble is we’re not good – as humans – in thinking about probabilities as a basket.

Something with a one in 50 chance of happening will happen, given enough throws of the dice.

Whereas people try to mentally transform risk like this:

Relatively lower risk = lower risk = low risk = no risk

That’s totally wrong. Bonds being relatively lower risk than shares never meant there was no risk.

It’s better to think of a diversified portfolio as a basket of relatively higher and lower risks, where something is definitely going to happen. But you don’t know what will happen in advance.

So 2022 should not be teaching you that bonds are bad, just because they’ve had a terrible year.

That would be like avoiding shares after the Dotcom bust of 2000, or never buying your own home after the early 1990s property crash.

The better lesson we should take from 2022 is very bad things can happen to our portfolios.

And that if a lot of things can happen, then some of them will.

This year it was bonds that blew up. But plenty of other historically rare but perfectly possible things are waiting to derail us in the future.

And in some of those situations, high-quality government bonds will be your best friends – especially now they have a meaningful yield again.

When you’ll be glad you own bonds

Here are a few plausible scenarios where you’d probably be glad you kept some bonds:

Deflation – Strictly a regime of falling prices, deflation tends to be associated with higher unemployment, lower economic growth, stagnant or falling wages, and weak or negative stock market returns. But the best paper assets – government bonds and cash – can hold their value as the rest of your portfolio tanks. If yields fall then bonds can give you a capital gain to offset losses elsewhere. Whereas cash is likely to be yielding nothing.

A big and prolonged equity market crash – I’m not talking about a wobble like late 2018 or early 2020. Even 2022 hasn’t been particularly painful compared to the worst stock market crashes of all-time. Rather, imagine if your shares drop 70% and stay down for years. Bonds will probably do much better, at least in nominal terms. (However some very bad bear markets for shares coincided with big inflation-adjusted declines for bonds. You’ve been warned!)

A short sharp meltdown – Think the Global Financial Crisis or another deadly pandemic. This overlaps a bit with the previous entry. But the distinction is that a meltdown or confidence ‘flash crash’ is short-lived. Bonds may give you speedy gains upfront. You can then re-balance into rebuilding your battered equity exposure for the long-term.

You’ve retired – If you quit work to live off a 20/80 portfolio, pregnant with bonds, I excuse you a hollow laugh. 2022 has been awful. But over longer spans of time, bond returns are much less volatile than shares. When you’ve no new money coming into your portfolio and less time to sit out the declines, that’s valuable.

We’ve written extensively about the role of bonds, so I won’t repeat it all here:

• Are bonds a good investment?
• Should you hold cash instead of bonds?
• A brief guide to the point of bonds
• Best bond funds and bond ETFs

Read those and our other articles about bonds for a reminder about the merits of this asset class.

And try to do so without wearing your blood-tinted glasses of 2022.

Yes the long-awaited bond crash has finally happened. But we’re probably through the worst. If anything, it’s less likely to happen again anytime soon. At least not to the same awful extent.

One very bad year doesn’t entirely destroy the logic of owning some bonds, no more than the sinking of the Titanic killed the need for global travel.

Better days ahead for bonds

As we’ve explained before, falling bond prices have a silver lining. When bond prices fall, yields rise. And that bodes well for future returns.

As of early October, Vanguard’s models suggested that between 30 June 2021 and 30 June 2022:

… projected 10-year annualised returns for UK aggregate bonds have risen from 0.6%-1.6%  to 2.4%-3.4%, while return expectations for global bonds ex-UK (hedged) have increased from 0.5%-1.5% to 2.3%-3.3%.

Again, low returns had been baked-in. Now they look a lot better.

On a related note, the fund behemoth has also modeled how future expected returns from a 60/40 portfolio improved from the end of 2021 compared to late September 2022:

According to the latest forecasts from the Vanguard Capital Markets Model, the projected 10-year average annualised return for a 60/40 portfolio has increased considerably since the start of the year, from 3.3% to 6.8% – a rise of 350 basis points.

I will triple underline these are expected returns. They are not guarantees!

However the mathematics of fixed interest means that models can be more confident about future returns from bonds, compared to shares.

And those future returns look brighter.

If history is any guide it probably won’t be too long before even the battered 20/80 LifeStrategy fund is back in the black:

Again, you can’t be certain with a forecast. But at the least it shows you why I’m so wary of all the pessimism about bonds right now.

If anything, I’d be buying them. (In fact I am).

Bonds are not bad, but prices can be

I would be a hypocrite if I said you should always own bonds. I didn’t own them for a decade and perhaps in the future I’ll be out of them again.

But equally I’m not a supposedly passive investor now bailing on bonds after a very bad year.

If that’s you, then ask yourself:

• What do you know better than the multi-trillion dollar bond market?
• If the answer is ‘nothing’, then aren’t you just responding emotionally to recent losses?

This isn’t a call to excessively load up on long-duration bonds. Interest rates could go still higher. If they do then after a recent mini-recovery, bonds could decline once more.

There’s even an argument that bonds tend to move in long secular cycles. If that’s the case then we might be in for decades of rising yields and mediocre returns.

It’s also perfectly possible for bonds and equities to both keep doing badly for years – especially in real1 terms.

Again, no guarantees.

But let’s learn the right lessons from 2022. By all means diversify your lower-risk assets with cash and gold. Stick to intermediate or lower-duration bonds if you’re concerned about interest rate risk.

Or even be a naughty active investor like me. Own what you like, but be ready to sell on a whim!

(Just know you’ll probably do far worse for trying, and you’ll definitely be more stressed.)

But you should probably own some bonds

Frankly, if you’re someone who now thinks bonds are bad – full stop – then you’re probably the sort of person who most needs bonds in their portfolio.

Ideally tucked inside an all-in-one fund where you can’t see how the sausage is made. Because something is always doing badly in a well-diversified portfolio.

I don’t mean this unkindly. The opposite. I know it’s been a rotten year.

However I’m worried some people are going to load up on equities, only to sell out at the bottom when the next deep stock market crash comes and they have no safety cushion at all.

Shares are riskier than bonds. Not this year, but most years.

And there are pros and cons for every asset class.

You think bonds are bad? That’s a shame, because they haven’t looked this good for ages.

Never say never again

1. Inflation-adjusted. [↩]

You might be surprised to learn you are not the legal owner of the assets held in your investing platform account. That’s because brokers funnel most of their customers into nominee accounts.

Legally that means you are the beneficiary of the assets you buy – but you are not the registered owner.

It’s a convoluted arrangement that benefits your platform, but that can have unfortunate side-effects for ordinary investors if things go wrong.

Given your broker probably hasn’t clearly flagged the risks, read on to find out what they neglected to mention about nominee accounts. (At least, outside of disquieting small print in a dark and dingy T&Cs PDF.)

What is a nominee account?

A nominee account is a legal structure that enables your assets to be held in trust for you by a custodian.

In the case of a broker, it appoints a nominee company to act on your behalf, and that company is charged with the safekeeping of your investments.

The nominee company is the legal owner of the assets. You are the beneficial owner and are thus entitled to the economic benefits – namely income payments and proceeds of sales.

The custodian should be a separate entity from the broker. This is important because that legally segregates your assets from the broker’s. Thus creditors aren’t allowed to lay their greasy paws on your investments if the broker runs into trouble.

So far, so not terrible. In reality, the arrangement isn’t nearly so neat and that’s why it’s worth understanding the deal you’re making when your friendly investing platform ushers you into a nominee account with a “don’t worry” pat on the head.

Why are nominee accounts the rule?

Nominee accounts are the ultimate in low-cost convenience – especially for your broker.

With them, your broker can trade and move securities on your behalf without generating more paperwork than Wernham Hogg.

Your broker doesn’t, for example, have to contact the administrator of a company’s share register when you sell your stake. The company has never heard of you!

It’s the nominee company’s name that appears on the share register. That saves a lot of paper-trail hassle.

In practice, you don’t even get your own nominee account. Most brokers lob everyone’s securities into one pot – known as a pooled nominee account (or an omnibus account).

If ten customers wish to sell 1,000 Apple shares each, then the broker can just fish out any old 10,000 shares from the tank, rather than worry about administrating ten separate accounts.

Records on who owns what are kept by your broker, but the system is far from perfect…

Are nominee accounts safe?

The primary weakness of nominee accounts is they are open to abuse and mistakes.

Brokers know this which is why their Terms and Conditions document typically contains a clause like this (bolding is mine):

Any investments held on your behalf may be pooled with those investments of other customers. This means that your entitlement may not be individually identifiable on the relevant company register, by separate certificates or electronic records (other than ours, where they will be identifiable) and, in the event of an unreconciled shortfall caused by the default of a custodian, you may share proportionately in that shortfall

In other words, if the records don’t match the funds available then all customers will be liable, whether the reason be fraud, mismanagement, or anything else.

You can check your own broker’s T&Cs for similar small print by searching for words like ‘pooled’, ‘nominee’, ‘omnibus’, and ‘custody’.

The concern is that the ring-fence around your nominee account is only as good as the broker’s records.

And those records can be too easily altered or swatted aside if – for example – management are tempted to solve a cashflow problem by dipping into customer accounts.

Or perhaps employees neglect to keep the books updated as a company slides into crisis? Due diligence can be an early casualty on a sinking ship.

Can the worst happen?

It’s relatively rare, but yes it can. A US brokerage firm called MF Global is the poster child for this kind of mess. The firm went bankrupt after executives – ahem – ‘borrowed’ customers’ funds to cover company overdrafts.

In the UK, Beaufort Securities collapsed in 2018 after an FBI sting operation.

And SVS Securities was brought down in 2019 by an FCA probe into the broker’s dubious high-risk, high-fee investment products.

In Beaufort’s case, it was actually the insolvency administrator, PwC, who went after customers’ cash in order to settle its bill of £55 million.

Thankfully the UK’s Financial Services Compensation Scheme (FSCS) stepped in to prevent most of Beaufort’s clients losing out.

What protection do I have?

UK investors should be protected against broker fraud and insolvency by the FSCS Scheme mentioned above. Check your investment platform is covered.

But even if you are eligible for compensation, you’re only shielded against losses up to £85,000.

Consider diversifying your investment platforms if you hold substantially more than that amount with a single broker.

Also note that the FSCS scheme may not apply if your broker is based overseas, or if you hold non-UK securities.

For example, your holdings may be lodged with an overseas custodian. If so, then that custodian may be held to lower standards when the grit hits the fan.

My own broker sums up the situation in this hair-raising clause:

There may be different settlement, legal and regulatory requirements and different practices for the separate identification of investments from those applying in the UK […] We will not be liable for the insolvency, acts or omissions of any third-party referred to in this sub-clause except where we have acted negligently, fraudulently or in wilful default in relation to the appointment of the third party.

This clause could apply to you if you hold international shares or funds domiciled outside the UK.

It gets worse. A later clause cheerfully explains that my nominee investments may be recorded in the name of my broker or its custodian in certain overseas markets. And if this happens then (bold emphasis is mine):

the Nominee investments may not be segregated and separately identifiable from the designated investments of the person in whose name they are registered; and as a consequence, in the event of a failure, the Nominee investment may not be as well protected from claims made on behalf of our general creditors.

This suggests that my overseas securities could be used to settle the claims of creditors if my broker failed. That wouldn’t happen to UK securities.

Nominee accounts and shareholder rights

Because your name isn’t linked to your share holdings, you don’t gain the automatic right to vote at annual general meetings, or even to attend. Nor will you automatically be sent company reports and notifications.

If these rights are important to you then ask your broker to pass them back. Many brokers will, although they may charge a fee, and be more or less enthusiastic in how they facilitate your request.

If you love a company report then they’re generally available on a firm’s corporate website.

Are there any alternatives to nominee accounts?

Yes, but the perfect solution does not exist:

Certificates – In the old days your broker would send you a rectangle made from a now-obsolete material called ‘paper’. The kids would never believe it, but it would confirm your ownership of the securities and you could use it to sell through any broker you liked. Even today you can use this arcane papery system, but it’s slow and expensive.

Designated or sole nominee accounts – Your securities are registered in the name of the nominee but this time your assets are walled off in your own account rather than thrown into the pooled nominee pit. Only a minority of brokers offer this service and they don’t like to shout about it. Enquire if you’re interested.

CREST personal accounts – Theoretically CREST1 is the best of both worlds for shareholders. Your name is recorded on the company register, you retain your voting rights, your shares aren’t mixed up with everyone else’s, and you can still deal electronically without any paper certificate faff. In reality, it costs quite a lot extra, few brokers support the system, and CREST personal membership isn’t compatible with ISAs or SIPPs.

Unlike the last two alternatives, paper certificates do protect you from fraud and negligence because no naughty nominee or rogue record-keeper can spirit away your holdings.

Sadly though, paper is susceptible to fire, theft, the vagaries of the postal service, and being mislaid in the same place where the orphaned socks go.

The digital tech barons of the future also keep threatening to consign paper to history. Beware your share certificates going the way of the cheque book.

Nomin-AIEE!

Any system that enables us to buy and sell at the press of a button is inevitably open to some element of error or abuse. That’s the price of speed.

In an age of conspiracy theories it’s all too easy to overstate the danger so I should be plain: I’m not losing any sleep about my own nominee accounts.

But I am shocked that brokers don’t think they should explain how the system works – warts ‘n’ all.

Sadly, transparent customer service is too often seen as a competitive disadvantage. Explanations of the nominee account system are generally buried in arcane small print or glossed over in brochure-speak accompanied by big ticks and smiley faces.

Best practice:

• Diversify your holdings among two or three brokers to reduce your risk once you’re over the £85,000 FSCS compensation threshold.
• Understand your right to compensation.
• Review whether the safeguards apply to your overseas investments. There may be UK equivalents that help you to sleep more soundly.
• Keep your own records. Download a portfolio valuation from your accounts regularly. At least once a month.

Then, move on with your life.

Take it steady,

The Accumulator

1. The central securities depository and settlement system. [↩]

What caught my eye this week.

Last week the major US exchanges went bananas on a strong signal that US inflation might be turning.

And that was very good news.

You know that old adage about it being important to remain invested at all times – because if you miss a handful of days you will miss most of the return?

Here’s what that looks like in practice:

These look like somewhat mediocre returns for a whole year. But they happened in 16 hours of trading.

Admittedly, I have a love/hate relationship with the old “don’t miss the best days” schtick. As a very active investor who watches the markets like most people follow their favourite football team, I feel the rollercoaster ride of a year like 2022 in my guts.

So I sometimes ponder how missing out on the best days might be worth it if you miss the worst days too. The optimal – but to be clear, hugely inadvisable – thing to do this year was to sit out the whole shebang out in cash.

(Inadvisable, sadly, because the books about successful investors who have consistently got in and out of markets wholesale for a profit would be welcome on any ultra-minimalist’s bookcase.)

Begone foul pestilence

Anyway, the inflation news is a big deal. Much bigger for markets than the US mid-term elections, which dominated the US media for fortnight.

From CNBC:

The consumer price index rose less than expected in October, an indication that while inflation is still a threat to the U.S. economy, pressures could be starting to cool. The index, a broad-based measure of goods and services costs, increased 0.4% for the month and 7.7% from a year ago, according to a Bureau of Labor Statistics release Thursday.

Respective estimates from Dow Jones were for rises of 0.6% and 7.9%.

Excluding volatile food and energy costs, so-called core CPI increased 0.3% for the month and 6.3% on an annual basis, compared with respective estimates of 0.5% and 6.5%.

Regular readers will recall I’ve been expecting inflation to ease for months. It didn’t happen. Indeed rates have gone higher than almost anyone predicted this time last year, as market expectations have been repeatedly confounded.

The result has been a brutal 12 months for pretty much everything. Stock-picking has been brutal. Some of the car crash US growth shares already down 80%-90% this year found it in themselves to drop another 10% in a day earlier this week. The proximate cause was yet another crypto crash (see the links below). But it is inflation and rates that have driven most of the de-rating in shares and the crushing of bonds this year.

And so if – and we still can’t be sure – US inflation really has turned, then we could have seen the bottom of this bear market.

US rates lever the (un)attractiveness of US markets. That sets the tone for markets around the world. The rapid pace of US rate rises also sent the dollar to lofty levels, dragging up rates around the world. All this could unwind if the threat of ever-higher inflation has been defeated.

Markets – which look forward – could move more than you’d think in response.

Leave your chickens uncounted

None of this means the interest rate rises are over – in the US or anywhere else.

Market interest rates moved far faster than official rates, as traders bet on the direction of travel. Higher rates from central banks still playing catch-up are baked-in, over there and over here.

But again, the top for rate expectations would be in if inflation is rolling over.

Mortgage rates – much higher than I believe central bankers would prefer – should start to ease too.

On the other hand something dumb1 could happen again and throw this all off course. Or the CPI numbers could get revised. It’s an unpredictable world, and investing is all about uncertainty.

Which is why, despite everything, it’s best to stay mostly invested.

Have a great weekend all.

[continue reading…]

1. Like the war in Europe. [↩]