What caught my eye this week.

Seekers after financial freedom like us don’t posture about the car we drive or plonk our new handbag or iPhone down in the middle of the table when we meet our friends.

But you do still see one-upmanship in this community:

• “Call this a bear market? I don’t even look at my portfolio unless at least one major High Street bank has gone bust.”

• “Call 15% a savings rate? That’s more like a rounding error compared to what I sock away by living in my tent in the Rhondda valley.”

• “You call shopping at Oxfam frugal? I get Oxfam to donate its clothes to me!”

Okay, I exaggerate. But it’s with fondness. And only a bit.

To be fair, very few of us throw our net worth around without a few humble disclaimers.

Which is confounding, because I bet most of us would love to know more about how other people are getting on.

Not in a monetary game of phallic wonga-waving, you understand. More to put their words into context. And to get a better sense of our own progress on the journey.

Years ago, I used to spend many hours a day on investing forums. And it would drive me mad when a poster would reveal they’d bought this or that controversial stock, to the admiration – or the condemnation – of the peanut gallery.

You can have an opinion of the odds of a particular investment working out, of course.

Yet most posters were happy to ascribe bravery, stupidity, foolishness, heroism, and the like to the action, too.

Very rarely did we know what the investment represented to the person in question. They could be a multi-millionaire investing beer money, or a student investing their entire loan. Which matters.

Because unless you know somebody’s full financial picture – and the magnitude of the investment – you can’t say much about the dangers or prudence of their actions.

It’s similar in online Financial Independence circles.

Somebody will say, for instance, that they can get by on £18,000 a year.

They’ll be labelled delusional by people who don’t know how old they are, where in the country they live, whether they own their own home, whether they have dependents, and so on.

The flip-side is equally true, too. £50,000 a year doesn’t go half as far in London as in Hull.

ISA-sizer

So I’m sure many readers will be very glad to read through the latest ISA statistics to be published by HMRC.

If you’re anything like me you’ll immediately compare yourself to your cohort and ask yourself some serious questions about your life pat yourself on the back.

Maybe it hasn’t all been for nothing!

Only time will tell. But certainly it’s interesting to see how much others are saving, or how your total pot compares to others your age or earning the same as you.

And hey presto…

Average annual ISA subscription:

Pot size by age:

Pot size by income cohort:

Want more? You can download the full report from HMRC’s website as a PDF.

I hope you find what you’re looking for!

[continue reading…]

Passive investing champion Lars Kroijer is back with another trio of answers to your investing questions. Once again this is a collaboration between Monevator and Lars’ popular YouTube channel.

This time we sent Lars some queries we’ve received in the Covid-19 era. As before, his answers are in both video and edited transcript form below.

Note: embedded videos are not always displayed by email browsers. If you’re a subscriber over email and you can’t see the three videos below, head to the Monevator website to view this Q&A with Lars Kroijer.

Should we try to avoid the obvious losers from Covid-19?

Our first question comes from Rachel, who asks whether the pandemic is a reason to avoid certain sectors that are going to be ‘obvious losers’ – or to hire a manager to do so?

Index trackers might be best for normal times, agrees Rachel, but these are not normal times?

Lars replies:

As I’m answering this question in June 2020, virus cases might be down but there is still a lot going on – lockdowns, severe travel restrictions, and rumors of remedies and treatments.

However there is not yet a vaccine and in fact, there is a threat of a second wave of infections.

The future is still highly uncertain. Economies face huge declines and certain sectors like travel and hospitality are facing massive impacts in the future.

So, the first questions really is, would you be able to pick a stock market sector to be an obvious underperformer? And my argument is you cannot. Shares in a lot of these sectors have fared incredibly poorly – but that is not something you know will happen from this point on.

Let us say you have one sector that has already gone from a hundred in value to twenty in value. Will that decline happen again? Not from hundred – but from twenty?

That is actually an incredibly bold statement, to say that you know this sector better than the trillions and trillions of dollars already invested and the very, very well-informed investors all over the world.

So no, I do not think you can pick these sectors to yourself. I recommend you stick with the broadest, cheapest, index tracking fund you can get your hands on.

What if you find a smart investment manager to avoid the bad sectors? Someone with access to all the right information, people, and so forth?

Well, in normal times, one or two active managers out of ten perform ahead of the relevant index over ten year periods, after all the fees and expenses they incur on top of what they charge you. You can argue that these are not normal times, but is it really likely that the 10-20% outperformers will become more than 50%? I do not think so.

Can you then pick one of the few investment managers who will outperform the market? Again, that is very unlikely. Past performance is not of an indication of future performance, so you can’t just pick the ones that have done well in the past, unfortunately!

So again, I think save yourself of all the fees and expenses and buy the broadest, cheapest, global index tracker.

Of course what is going to happen is once this plague is over, one way or another, some investment managers will have done very well. You should expect to see big billboards, and books written about them saying how they knew this or that what happen. But that is the winner’s argument. We are not going to see billboards, talk shows, and so forth highlighting all those that have not done well.

I appreciate the desire to do something in these turbulent times. You probably have a lot of other stuff going on economically. I’d strongly encourage you to look more closely at your personal financial circumstances.

We also know that equity markets are probably a lot more risky than they were before the coronavirus. This is a far more volatile market. If you want to reconsider your asset allocations, there are other videos in this series that address this issue.

What do low or negative rates imply for 60/40 portfolios?

The question in this video comes from Dave, who asks: if central bank interest rates go negative, what implications does that have for the 60/40 portfolio?

Lars replies:

First of all, the 60/40 portfolio refers to the idea of having 60% of your money in equities and 40% in bonds. The idea is this is a reasonable level of risk for a lot of investors. You have the upside in equities but you also have the 40% bond allocation to temper the risk.

My view is it’s great to keep things simple but risk is really quite an individual thing. It depends on the stage of your life, your non-investment assets and the correlation of these, and also just how you feel about risk, your job, and so forth.

So, the 60/40 might suit you – but do not assume it is for everyone. If you are interested, there are product providers like Vanguard and others with funds where you automatically get this – or a similar fixed – allocation.

Back to the question, and the answer, unfortunately, is not really clear. If you assume that the risk of the government is fixed, which is a big assumption, and that the equity risk premium does not change as a result of interest rate changes, then it is clear your expected investment return will be lower as a result of lower interest rates.

What does that mean in practical terms? It means you will expect to have lower investment income in the future if you keep the 60/40 investment portfolio. For those looking to retire, this means you will either have to save more, consume less, or work longer, which is obviously not great.

Of course you can exchange or expand your portfolio composition from 60/40 to invest more in equities. But all else equal, this will be a higher-risk portfolio. So you have got to make sure that you have the risk tolerance to do that.

In reality, it is not that simple. Central banks set their interest rates in response to the status and the prospects for the economy. It is a great tool to get the economy going. Their decisions on interest rates filter through to bond yields for investors, and obviously with lower interest rates there is an incentive to borrow more money and invest in the economy.

But can you assume that government risk is a constant? You cannot really assume that. You also cannot assume that the equity risk premium is a constant. It is also not really knowable.

The equity risk premium is generally deemed to be 4-5% above inflation. But it really changes dramatically with the changing of the risk of the equity markets. And it is also perhaps not a terrible assumption to say that in a lower interest rate environment where governments are actively trying to boost the economy that the equity risk premium may go up.

I should mention we are discussing here real interest rates, so that’s after-inflation. So if you have high inflation country, even with a 10% nominal interest rate and 9.5% inflation, that still means the real interest rate is only 0.5%. So there is no free lunch there.

But going back to the 60/40 portfolio, this video is shot in the middle of the pandemic and one thing is very clear – the risk and the equity market’s expected future volatility has varied dramatically and shot up massively.

So if you have kept a 60/40 portfolio, well the overall risk of that portfolio has changed a lot. In a sense it is quite an active choice to simply say you want to keep 60/40. So, just be sure you can stomach that higher risk.

Of course with higher volatility, it is not unreasonable to expect higher future returns. But that’s at the cost of the higher risk.

I would also say that the answer to this question would be clearer if you had a 100% bond portfolio. In that case, it is pretty clear there is no potential compensating factor from equities and you will simply earn less and have lower real returns for your portfolio, and you would have to adjust for or simply live with that fact.

In summary, I’m sorry the answer is not clear but I still hope my commentary was somewhat useful!

Do widespread dividend cuts mean equities are less attractive?

Finally, a question from Sandeep who asks whether the widespread dividend cuts we’ve seen affects my view on the attractiveness of equities as an asset class?

Lars replies:

This video is shot amid the Corona pandemic and a lot of companies have cut dividends because of the highly uncertain economic future.

But this does not really change my view of the attractiveness of equities as an asset class.

I’m not aware of any studies that suggest that a lower dividend yield will automatically lead to lower overall returns for equities going forward. And even if that were the case in the past, it is not clear that it would be the case in the future.

Now, ‘overall returns’ means both dividends and the capital gains from owning these stocks. And obviously, changes in the dividend are often seen as a sign from management as to how things really are. An unexpected lowering of a dividend will very often lead to a massive price drop. It is essentially management saying we do not have the cash to pay the dividends that we thought we did. That signal is very bad.

But it is also a very good assumption to say that market prices adjust quickly to these new circumstances. Therefore it is a very bold statement to say that you can outperform the market after dividend cut announcements by assuming it says something about the prospects for the wider markets.

Now, just talking briefly about dividend cuts in the Corona pandemic and what happened when the virus spread globally, quickly. What we saw was the market reacted much faster than companies around the world were announcing dividend cuts. So, those dividend cut announcements did not lead perhaps to the same magnitude of price movements you’d expect, because the market was already expecting these dividend cuts.

Of course, they were still surprises, both positive and negative, from the signal and effect of the changes to the dividends but nothing [to exploit as an edge] – certainly not for regular retail investors.

More broadly speaking, I would say some people like receiving dividends and others do not. For me that often has a lot to do with tax. Your specific tax situation, the jurisdiction you are in, and whether you want dividend or capital gains

Let us say you had a €100 stock that is paying €2 in dividends – after the dividend date, that stock should go €98. If you have a parallel situation where the stock did not pay dividends, you’d stay at €100. What is better for you depends on your tax situation, so that is worth keeping in mind.

Until next time

Please do feel free to add to or follow-up Lars’ answers in the comments below.

Watch more videos in this series. You can also check out Lars’ previous Monevator pieces and his book, Investing Demystified.

How much will bond prices fall if and when interest rates go up? With many government bond yields straying into negative territory or teetering on the brink, surely this asset class now only offers the prospect of painful loss in the years ahead? Or maybe not?

You can get an intuitive feel for how big bond losses – or potential gains – can be using a bond price calculator.

And some of the results may seem a bit, well, weird…1

Let’s run through a few simulated examples of how a range of hypothetical bonds could move in response to changes in market rates.

A note on confusing bond terminology
Just to clear a few things up before we start.
Interest rates
When people talk about bond prices falling due to rising interest rates, they’re not talking about central bank interest rates like the Bank Of England’s Bank Rate. They’re talking about the market interest rate for a bond. Each and every bond is subject to a market interest rate that is the sum of supply and demand for that particular bond. The market interest rate is the return investors demand for tying up their wealth in that bond, and it fluctuates in line with the market’s view of factors such as inflation, the bond’s credit rating and maturity date, other macro-economic forces and, yes, the influence of central bank interest rates.
Bond yields
There are many different types of bond yields. Commentators often bandy about the term ‘yield’ as if it’s a unified concept that everybody understands. When I talk about yield in this piece, I’m referring to the yield to maturity (YTM), also known as the redemption yield. This is the annualised return you’d expect to receive if you invest in a bond and hold it to maturity (accounting for its market price and the remaining interest payments, which are assumed to be reinvested at the same rate). It’s the go-to yield to use when comparing similar bonds (for example gilts) that vary by price, maturity date, and coupon rate.

Scenario #1: Interest rates rise by 1%

Say we own a newly minted 30-year government bond and interest rates shoot up by 1%, with our bond’s yield rising in turn to 2%. We can use a bond price calculator to survey the damage using the following specs:

30-year bond

• Face value: £100
• Coupon rate2: 1%
• Market rate: 2%
• Years to maturity: 30

Dial that scenario into the calculator and it tells us the bond price falls from £100 to £77.52.

Capital loss: -22.5%

From our perspective here in June 2020, 30-year gilt yields have come down 1% in a year, so it doesn’t seem beyond the realms of possibility that they could rebound back, given time.

(Note: the size of your loss also varies depending on the speed of the interest rate change – we’ll come back to that.)

Now let’s replay the interest rate rise but this time with a 5-year bond:

5-year bond

• Face value: £100
• Coupon rate: 1%
• Market rate: 2%
• Years to maturity: 5
• Price falls to: £95.26

Capital loss: -4.7%

Okay, that’s a much less harrowing number. It also explains why many investors have moved to shorter-dated bonds as interest rates tumbled over the years.

The trade-off is that shorter-dated bonds offer ever less downside protection as interest rates continue their journey to the centre of the Earth. (We’ll come back to that, too.)

Let’s look at the middle ground with a 10-year bond:

10-year bond

• Face value: £100
• Coupon rate: 1%
• Market rate: 2%
• Years to maturity: 10
• Price falls to: £90.98

Capital loss: -9.0%

Tough but not awful. Stick in an instant 2% interest rate rise though (not likely, but bear with me) and the capital loss is -17.2%.

Cheaper prices = higher yields = recovery mode

Lower bond prices aren’t all bad news. Sure a chunk of your portfolio will get taken to the woodshed for a whalloping. But at least in you’ll be able to buy new bonds at higher yields.

In time, reinvesting your income into those now-cheaper bonds will offset some of the pain of that initial bond market beating.

You can use a duration calculator to see how long it would take you to make good the capital loss by reinvesting your interest payments into higher-yielding bonds after a rate rise.

Turns out the 10-year bond in my example scenario gets back to breakeven after about 9.5 years. After that point, your higher-yielding holdings would put you in profit, relative to the old bond and assuming interest rates remained stable.

The five-year bond takes just 4.9 years to breakeven.

It’s a long 25 years for the 30-year bond.

Scenario #2: Interest rates fall by 1%

So far, so traumatic. But what if interest rates are forced down even further as central banks suck up bonds with their QE 2020 giga-Dyson?

30-year bond

• Face value: £100
• Coupon rate: 1%
• Market rate: 0%
• Years to maturity: 30
• Price rises to: £130

Wait for it…

Capital gain: 30%

That’s an equity-like gain in the puff of a recession – and enough to offset a lot of stock market pain if you’re packing a large slug of long bonds.

This is why many investors hold long bonds and they aren’t mad to do so. They don’t see historic lows as an unbreakable floor. They think interest rates can fall further. Long bonds will make big gains if they do.

Notice how the 30% gain is larger than the equivalent -22.5% capital loss from the 1% rate rise scenario. Long bonds become more potent at ultra-low and negative rates. That’s what makes them so tempting even in the face of interest rate risk in the other direction.

A rapid 2% yield drop would mean a 70% gain for our 30-year bond. You could buy a lot of cheap equities for that, if you could stomach rebalancing into a tanking market.

Before you drool your way to your broker’s screen, note though that interest rates don’t tend to move that hard and fast for long bonds. During the coronavirus crash, for instance, the SPDR 15+ Year Gilt ETF (average maturity 29 years) spiked just 12% as equities dive-bombed.

Is a -1% yield possible for long bonds over time? Well, long-dated inflation-linked UK bonds have drilled down to near -3% yields.

Finally, the 30-year bond is again less lethal if rates rebound in the opposite direction. You’d take a -39.4% loss if interest rates rocketed by 2%.

What happens if we go for a short bond?

5-year bond

• Face value: £100
• Coupon rate: 1%
• Market rate: 0%
• Years to maturity: 5
• Price rises to: £105

Capital gain: 5%

That shallow 5% gain demonstrates that short bonds won’t do much to stabilise your portfolio if equities plummet and central banks keep firing their bazookas. The upside for short bonds is limited, especially at this end of the interest rate spectrum.

10-year bond

• Face value: £100
• Coupon rate: 1%
• Market rate: 0%
• Years to maturity: 10
• Price rises to: £110

Capital gain: 10%

Our compromise 10-year bond puts in a decent but not pyrotechnic show. If rates fell 2% it would gain 21.1%.

Again, the downside drop is amplified for intermediate bonds relative to its losses when interest rates rise, but the effect is muted in comparison with 30-year bonds.

Scenario #3: Ultra-low interest rates

The long bond effect is magnified in a low interest world (where this post certainly belongs).

Let’s cut the coupon rate down to 0% and model a 1% fall into negative yield country.

30-year bond

• Face value: £100
• Coupon rate: 0%
• Market rate: -1%
• Years to maturity: 30
• Price rises to: £135.09

Capital gain: 35%

That 35% capital gain compares with a 30% gain for the higher-yielding 30-year bond in our earlier interest rate drop scenario.

The lower-yielding long bond gains 82.8% on a -2% drop in rates, versus 70% previously.

So don’t believe bonds are necessarily firing blanks.

But what happens if we point this thing in the other direction?

You guessed it. A lower-yielding bond is more dangerous than its higher-yielding cousin when rates rise.

Imagine a 30-year bond with a 0% coupon rate, issued at the nadir of a zero-rate world that was on the turn…

30-year bond

• Face value: £100
• Coupon rate: 0%
• Market rate: 1%
• Years to maturity: 30
• Price falls to: £74.14

Capital gain: -25.9% (vs 22.5% previously)

Worse, a 2% rise would expose you to a -45% loss (vs -39% previously).

It now takes 30 years to breakeven according to the duration calculator, because with no coupons the impact upon return is driven solely by capital gains – with a 0% coupon you don’t have any interest payments to invest into higher-yielding bonds to accelerate you to breakeven.

That’s also why our 0% coupon long bond makes a big 35% capital gain when rates drop – it doesn’t receive any coupon payments that cause it to start reinvesting into lower yielding bonds after the interest rate fall.

The upshot is that lower yielding bonds are more sensitive to interest rate changes. They’ll show bigger losses and gains as we enter the negative yield underworld and the effect is particularly pronounced with long bonds.

For more on the counterintuitive impacts of interest rate changes on bonds, read this excellent piece on bond convexity from Portfolio Charts.

Scenario #4: Rate rise impacts are affected by time

What if the 1% interest rate rise happens after you’ve held our example bond for one year?

30-year bond

• Face value: £100
• Coupon rate: 1%
• Market rate: 2%
• Years to maturity: 29 (previously we calculated the rise to maturity 30 years away)
• Price falls to: £78.08

Capital loss: -22% (vs 22.5% previously)

Hahaha… -22%? Why, tis but a scratch! While we’re hopping about on one financial leg, just note that interest rate rises are less scary the longer it takes for them to gently waft upwards.

How quickly do market interest rates move?

All my examples have shown an instantaneous drop in interest rates. That isn’t very likely. Rates fluctuate daily. They will drift up or down over months and years.

What we fear most though is big interest rate rises, so let’s conclude with some of the nastiest examples I can unearth using the UK government bond data I can access.

• The worst year for gilt losses in the low interest rate world (i.e. post-Great Recession) was 2013. 15-year gilts took a -9.6% real return loss that calendar year, according to the Barclays Gilt Equity study (BEG).

• 10-year gilt yields rose around 1% that calendar year according to this aggregation of Bank of England data by Data Hub.

• 30-year gilt yields rose about 0.5% that year according to the Debt Management Office’s records.

• 1994’s -13.8% was the worst calendar year return for 15-year gilts since the BEG study started tracking them in 1990.

• The 10-year gilt yield rose just over 2% from 1 January to 30 September that year (Data Hub again).

The worst post-war year for gilts came with the -29% loss suffered by 20-year gilts when stagflation was all the rage in 1974 (BEG). Using a bond price calculator and an 11% guesstimate for the coupon rate on 20-year bonds in 1974, that implies a rough(ly) 4.75% increase in market interest rates that year.

If somebody out there has access to more accurate data, I’d love to hear more.

Unbroken bonds

Interest rate rises as violent as those I’ve simulated are possible. Shorter-dated government bonds will shrug off those hikes better than long government bonds.

But the capacity of bonds to protect diversified portfolios against a crash is far from exhausted at low interest rates, except in as much as short bonds run increasingly out of puff the lower we go.

The extreme volatility of long bonds in this environment suggests we may need to think about them in a new way.

Would you be interested in an asset that’s negatively correlated to equities that could help offset a market crash – but which entails big-kahuna level risks of its own?

If long bonds are too risky to properly belong in the defensive part of the portfolio, then what if a 5%-10% allocation was carved out of the equity side?

That is how the Permanent Portfolio works. With cash acting similarly to short bonds, long bonds provide the best protection against a deflationary recession, while equities are for growth and gold for when nothing else does it.

A risk-portfolio allocation to long bonds could also make sense for somebody whose holdings are dominated by extremely risky equities (think risk factors, emerging markets, and sector bets) or even a young adventurer who would-be all-in on 100% equities but would also be happy to have the best dry powder to hand when the market crashes again.

Personally, I’m happy to keep holding intermediate gilts as a muddy compromise between knowing that interest rates could go either way and needing some decent crash protection for my portfolio.

I recommend playing with a bond price calculator for yourself though, as an easy way of visualising more ‘What If?’ scenarios.

Take it steady,

The Accumulator

Bonus appendix: Bond funds, duration and bond price calculators

It’s simplest to use duration as an approximate guide to your bond fund’s prospects when its market interest rate changes.

As a rule of thumb, a bond fund (or bond) with a duration of 7 will:

• Lose 7% for every 1% rise in its yield.
• Gain 7% for every 1% fall in yield.

Whatever your bond fund’s duration number, that’s roughly how big a gain or loss you can expect for every 1% change in its yield. The duration number should be published on the fund’s home page.

However, duration is a moving target. Duration increases as yields fall (and vice versa) which means losses and gains are amplified the lower we go. Again, as we saw earlier that super-charges the volatility of long bonds in particular, and the same goes for long bond funds.

Still, this stuff only really sunk in for me once I started running my bond fund numbers through the calculator.

First go to your bond fund’s home page. Look up its average coupon and average maturity metrics.

Vanguard UK Gilt ETF – interest rate falls by 1%

• Face value: £100
• Coupon rate: 3.1% (fund’s average coupon)
• Market rate: 2.1%
• Years to maturity: 19.7 (fund’s average maturity)
• Price rises to: £116

Capital gain: 16%

This happy 16% gain is a little more than implied by the fund’s average duration of 15 (we’d expect a 15% lift) but this brings me to a good point about all the calculations I’ve used in this piece.

They cough up results to however many decimal places but the equations whirring away in the background use a ‘best fit’ process. They ‘guess’ at the final value and then modify it until further iterations don’t make much difference.

The bottom line is that these calculations aren’t precise answers but they are close enough.

Inputs matter, too. If I change the ETF’s coupon rate to 3.05% then the calculator hands me a 15% gain. So perhaps Vanguard rounded the average coupon number up and that threw the calculator off.

Similarly, a newly minted bond with a 1% coupon won’t behave quite the same as its secondary market equivalent with a 2% coupon.

Nevertheless the calculators help illustrate what we’re in for – even though they have to use a little guesswork.

1. If you want to understand the maths behind the calculator a tiny bit better, see these musings by The Investor on a potential bond market crash from… gulp… 2012! (You see why we keep warning that people have feared a bond market correction for donkey’s years? [↩]
2. Assume a semi-annual interest payout in every example. [↩]