What caught my eye this week.

How are you feeling? Pretty comfortable? Enjoying the stock market recovery? Ready for a relaxing weekend?

Well I’m here like the Angel of Bad Breath to cause a stink with the following miserable graph, which comes courtesy of The Retirement Field Guide via Abnormal Returns:

The graph shows how after the age of 60, financial literacy decreases by about 1.5% a year.

As author Ashby Daniels says:

Nobody likes to think about getting older. Even less so, nobody likes to think about the decline of their mental health.

But the harsh truth is that as we get older, our cognitive abilities decline. This is especially true with regard to personal finances.

In an era when we’re being charged with taking control of our finances as never before – from how we save for retirement to how we invest our pensions – this seems to me a wrinkled grey elephant in the room.

Older and not wiser

Even worse of course is that we don’t want to admit to any decline. Just as we’re all better-than-average drivers, so we’re destined to believe we’re on top of our finances long after we’re not.

And let’s face it, older people aren’t exactly receptive to being reminded of these issues. My mother already thinks young people have it in for her generation by questioning its stance on Brexit.1 It’s easy to guess how they’d take to being told they don’t know best what to do with their own money.

I’m saying “they” but I appreciate not a few of you are in this older age group. Besides, I know what I’d say if confronted for the first time at 75 by someone saying they needed to take control of my investments (er, “f…lounce off!”) so we’re all in this together.

Clearly there needs to be more discussion – not least on our own site – as to how to guard against the potential downsides of poor decision-making in our later years. Children should be involved before they’re needed if they’re around, capable, and willing. If they’re not all three, there’s a role for trusted friends or professionals.

Many of us may aspire to remain mentally agile Warren Buffett types at 90 – that’s long been my goal – but it’s not in our gift to make it so, however many crosswords we do and new languages we try to learn.

“I’m mismanaging my own money”

Incidentally, this decline also has a potential impact on asset allocation decisions and other aspects of portfolio management that you rarely see referenced in the literature.

At the least it’s a tick in the box for underwriting your minimum income requirements with a simple annuity.

I also wonder if I should better incorporate it into my arsenal in my on-running guerrilla war against the “Screw income, total return is all that matters, sell capital each year!” passive orthodoxy.2

I’ve noted in previous skirmishes that calculating how much to withdraw and selling down your capital each year might seem a fine plan at 45, but it could be terrifying prospect for a mentally slipping and frightened 80-year old.

Monevator contributor The Greybeard has pondered this quandary, too.

Perhaps relying on a portfolio of income generating funds dumping cash into a current account (i.e. not even bucketing) would also be beyond me in that state but it seems intuitively to be a lower hurdle.

Again, what a shame (most) financial professionals don’t have the same reputation as say doctors. There’s an obvious need here. But not an all-encompassing obvious solution.

Enjoy the weekend, whatever age you are!

*A drag on your returns. Geddit grandpa? What, you’re only 26? Oh, it’s sort of a pun.

p.s. I’ve closed the poll in our great debate about whether to include your house in your net worth number. In the end 54% of you voted yes and 46% said no, with nearly 1,200 readers voting. The comments on that article were excellent, too – well worth a read if you’ve only seen the post over email. Thanks to everyone who chipped in!

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1. No, not every young person. No, not every old person. But a valid generalisation. See: https://twitter.com/SkyData/status/746700869656256512 [↩]
2. Which includes my own co-blogger, who I have immense respect for so obviously I’m teasing a bit with my language here. Also as I’ve said many times, living off income is a richer retiree’s game, and it leaves a lot of cash on the table when you die. [↩]

Immerse yourself in the Monevator archives (hey, it’s what Saturday nights were made for), and you’ll notice we talk a lot about investing in shares. Much less so about bonds.

Bonds – aka fixed income – are the unglamorous siblings to equities1. Yet whilst shares hog the limelight like a first child, you’ll be hard-pressed to find anyone – outside of the gold, guns and baked beans brigade – who say bonds have no part to play in a diversified investment portfolio.

Clearly bonds deserve more love – or at least another lengthy and excessively detailed Monevator article!

In this post we’ll dive into the nuances of the different bond funds out there, to help you find the right one for you.

Characteristics of bonds

Just like their equity equivalents, bond funds have their own special characteristics. As ever with investing, understanding these differences means more jargon to get to grips with.

Types

We can boil down bond funds into four types:

• Government (‘Conventionals’, Gilts, Treasuries)
• Inflation-linked (‘Linkers’)
• Corporate bonds
• Aggregates

Conventionals and Linkers hold government issued bonds. Corporate bond funds contain bonds issued by companies.

Aggregate bond funds contain a mix of both government and corporate bonds. (Inflation-linked bonds are usually excluded from aggregate bond funds, and from all but dedicated inflation-linked bond funds).

Duration

Duration is the measure of sensitivity of the price of a bond to a change in interest rates.

Longer-term bonds have greater interest rate risk. That is, if interest rates go up their price falls, and vice versa.

Bonds are typically separated into Ultra-Short (no, not a bond superhero, but bonds with maturities less than a year), Short (a few years), Intermediates (around two to ten years) and Long (10 to 15 years or more).

Lars Kroijer has already covered the importance of duration and short vs long-term bonds in a previous Monevator piece. Check it out to get the low-down.

Credit Risk

Another key characteristic of bond funds is credit risk: How likely is the issuer to not pay you?

We can use credit ratings from the credit rating agencies as a proxy for credit risk.

Bond funds mostly invest in bonds divvied up into four main tranches of credit risk:

• AAA-only – These are the safest fixed income investments.2

• Investment grade – BBB or better, investment grade bonds are considered unlikely to default and so are held in large amounts by institutional investors and pension funds.

• Sub-investment grade – Bonds issued by countries or companies that are looking a little ropey and could go pop. Excuse the technical jargon.

• Mixed – An assortment of investment and sub-investment grade bonds.

Geography

Bond funds can also be split by geography. These range from Country-specific funds (such as UK or US) through regions (Europe, Asia) to Global funds.

Yield

Some bond funds specifically target high-yielding securities. Such bonds will typically be a mixture of high credit risk and/or long duration issues.

Goin’ shopping

Enough of the preamble. Let’s look at how we can passively invest in bonds.

To do so, we need to know what indices contain which types of bonds. As we go through some of the common indices, we will point out some examples of bond index funds that track them.

Aggregate indices

Let’s start off with Aggregate indices. The big cheese of the Aggregates is the Bloomberg Barclays Aggregate Bond Index (or affectionately known as the ‘Agg’).3

The Agg is a conventional government and corporate bond index. It does not include inflation-linked bonds. The underlying bonds must also be investment grade, which rules out low credit quality bonds.

There are different Aggs at the Global, Regional, and Country level.

At the Global level is the Bloomberg Barclays Global Aggregate Bond Index. This index has over 20,000 bonds. To put this into perspective, the equity-equivalent FTSE All-World index has merely 8,000 or so stocks. An example of a fund that tracks the Global Agg is the Vanguard Global Bond Index Fund.4

The Global index has a number of sub-indices, which track different maturities, credit ratings or particular characteristics (such as ESG-weighted).

As mentioned above, there are also Aggregate indices for specific regions and countries. The most prominent example is the US Aggregate Index. An example of a fund that tracks this index is the iShares US Aggregate Bond ETF (Ticker: IUAA).

As far as I’m aware there aren’t any index trackers that follow the UK Aggregate Index.5

Government bond indices

Next up are the government bond indices. Again at the Global level we have offerings from Bloomberg Barclays. We also have a few other indices that track different geographies.

For example, Citibank produce indices that track Developed and G7 markets6. The latter index is tracked by iShares Global Government Bond ETF (Ticker: SGLO).

We also have indices for the gilts market. For example, there is the Bloomberg Barclays Gilt Index – tracked by the Vanguard UK Government Bond ETF (Ticker: VGOV) – and the FTSE Actuaries UK Conventional All stocks. An example fund tracking this index is the iShares Core UK Gilts ETF (Ticker: IGLT).

As with the Aggregate indices, there are also sub-indices that focus on different levels of maturities and credit risks.

Corporate bond indices

Similar to their sovereign counterparts, there are the full range of Bloomberg Barclays Corporate bond indices. These range from Global through to Country-specific level.

Two example trackers are Vanguard’s Global Corporate Bond Index Fund, which tracks Global corporate bonds, and the Vanguard UK Investment Grade Bond Index Fund, which tracks UK investment grade corporate bonds.

There are a few other corporate bond index providers out there. Chief among them is iBoxx, which a number of iShares ETFs and the L&G Sterling Corporate Bond Index Fund track.7

Inflation-linked indices

At the global level there is – surprise surprise – a Bloomberg Barclays Inflation-linked index. This is tracked by Xtrackers’ Global Inflation-linked Bond ETF (Ticker: XGIG).

At the UK level there is the Bloomberg Barclays UK Inflation-linked Gilt index. This is followed by a Vanguard fund of the same name.8

As with conventional gilts, there’s also a FTSE Actuaries Inflation-linked Index. This is tracked by the Lyxor FTSE Actuaries UK Gilts Inflation-linked ETF (Ticker: GILI).

Emerging market indices

Interested in the emerging markets? You’ll find a number of different bond indices, from Bloomberg Barclays, FTSE, Bank of America, Merrill Lynch, and JP Morgan.

As with emerging markets equity funds, it’s particularly important to look under the tin of emerging market bond funds to see what they hold. That’s because the definition of what is an ‘emerging market’ differs significantly from provider to provider.

Fund managers offering emerging market bond trackers include the usual suspects: Vanguard, iShares, State Street (SPDR), Legal & General, and Xtrackers.

High Yield indices

Finally, there are a range of High Yield indices that specifically cover high yielding bonds. Such bonds tend to have lower credit ratings (usually sub-investment grade) and potentially offer the opportunity of higher returns, at the cost of higher risk and volatility.

Get ’em cheap

Very handily, Monevator scribe The Accumulator maintains a list of low-cost index trackers, including bond trackers. Have a peruse at your leisure. If you know of any good ones he’s not covered, please tell us about them in the comments.

Other factors to consider when choosing a bond fund

Before we jump the gun and start throwing our money into the market there are a few other factors to consider when choosing the right bond fund.

Currency hedging

When buying foreign denominated bonds without hedging you are taking on additional currency risk. Currency volatility can swamp the returns and volatility of bonds.

We can see this in the following two charts from Vanguard:

Source: Vanguard

Source: Vanguard

As we can see in the charts above, currency hedging reduces the volatility of bond returns. In addition, it has the effect of leveling the returns of bonds from different countries.

It is important to consider what risks we want take on when investing in bonds. If our aim is to get specific exposure to the potential risks and rewards of bonds – typically to diversify our portfolios, and to dampen volatility – then it is wise to strip out the extra risk from movements in currencies.

If you want to invest in international bonds, it is therefore worth thinking about whether you want to hedge your portfolio against swings in the global currency markets.

Market exposures

Each index and associated tracker exposes you to different markets, in different ways. It’s not going to be easy as an amateur investor to have a very informed view on such exposures, which is one reason why it’s usually best to stick to broad bond markets (and arguably just to government and perhaps investment grade bonds from the UK if you live in Britain). Remember bonds are mostly there in your portfolio for security, not return.

By way of example, let’s think about the Global Aggregate index and compare it to a similar index of shares.

• When you invest in a fund that tracks a global market-weighted equity index, you are buying exposure to shares of the world’s most valuable companies (such as Amazon, Google and Apple).

• In contrast, with market-weighted bond funds, you buy the most bonds from the most indebted countries (or, if you prefer the sound of it, the biggest issuers). This means loading up on bonds from countries like Japan, Italy, and Spain. It also means you get more corporate bonds from more indebted companies.

You can avoid being overweight a particular country or issuer by plumping for a ‘capped’ index. This is where the weight of any one issuer (or issue) is capped at a set amount.

Credit and duration risk

A third factor to bear in mind is the substantial differences in credit and duration risk between the different sub-classes of bond indices.

For example, UK gilts tend to have very long duration compared to government bonds of other countries. This means that they come with higher interest rate risk.

Similarly, many indices are investment grade only. They exclude bonds from high credit risk issuers, which should reduce volatility but could also exclude you from earning higher returns.

Float-adjusted indices

You might need to consider whether you should plump for a float-adjusted index. These indices account for the fact that central banks are often the largest buyer of government bonds.

For instance, a float-adjusted US Aggregate index excludes bonds held in the vaults of the Federal Reserve.9

Given the impact of Quantitative Easing over the past few years – which has seen central banks invest enormous sums in government bonds – the difference can be quite substantial.

Taking Vanguard as an example, most of its index funds and ETFs track float-adjusted indices. This has the effect of increasing the proportion of corporate bonds relative to government bonds in the Vanguard funds.

Heresy! Consider an active fund

I’ll whisper this bit in case The Accumulator hears me. With bond investing it can sometimes pay to go active.10

Sometimes the bond fund that seems right for you might have a specific profile that’s not achievable through an index fund. You might want to avoid certain countries or duration, or you may be looking to target high yield bonds. A combination of these requirements might make an actively-managed fund more suitable.

It’s worth keeping in mind that most of the returns on bond portfolios are explained by duration and credit risk.

Where there is more leeway (in the broader global indices) managers can tailor their exposure to these risks. For example a manager might underweight Japanese Government bonds or overweight short duration bonds.

As with investing in other assets, it’s important to work out what you need from your bond allocation first and then find the product that best fits.

Don’t neglect to consider costs! In today’s lower return world, the fees of an active bond manager could well gobble up a large percentage of your bond fund’s expected return.

Rounding up

Bonds are an important asset class. We tend not to talk or think about them enough.

Bonds can act as a diversifier and a de-risker to an investment portfolio, so it’s worth considering whether an allocation to bonds can help you meet your investment goals.

Hopefully this article has set out some of the factors to think about when investing in bond index funds and pointed you towards the options available.

If you have any tips of your own when it comes to passive bond investing, please do share them in the comments below!

Read all The Detail Man’s posts on Monevator, and check out his own blog at Young FI Guy where he talks about life as a financially free twenty-something.

1. ‘Equities’ is just a fancier word for shares. [↩]
2. Unless they are sub-prime mortgage backed securities in 2007! [↩]
3. The Aggs date back many decades and were originally run by Lehman Brothers. In 2008 something bad happened to Lehman and Barclays took over. In 2016 Bloomberg started looking after the indices. [↩]
4. To be precise it tracks the float-adjusted index variant. More on that further on in this article. [↩]
5. If any of our savvy readers can correct me, please do! [↩]
6. Canada, France, Germany, Italy, Japan, United Kingdom, and United States. [↩]
7. These track the iBoxx Sterling Non-Gilts ex-BBB Index. [↩]
8. Specifically, it tracks the float-adjusted index variant. [↩]
9. I know they’re not actually held in vaults, but it’s boring to say ‘held in their electronic accounts’ [↩]
10. Actually The Accumulator has also considered active funds before in the bond space. [↩]

What caught my eye this week.

Figures from HMRC, as reported on in the Financial Times [search result] show the tax take from capital gains tax and inheritance tax rising fast in recent years:

Much of the increase is apparently due to growing tax receipts from property sales. The FT quotes Sean McCann, a chartered financial planner at NFU Mutual:

“Landlords are being caught in a very effective pincer movement from the taxman. From one side the higher rate tax relief on mortgage interest is gradually being phased out and making letting properties less profitable. From the other side, landlords looking to sell buy-to-let properties are being squeezed with an extra 8 per cent capital gains tax.”

I suspect most Monevator readers won’t be too sad to see buy-to-let being squeezed after a 20-year boom. I’m not against the rental sector on principle. But I did think the game had tilted too much in favour of landlords, and I was glad to see measures to address that.

Of course I myself swooped to buy my own home barely a year or so into the resultant correction. My stellar record of making a fist of the erstwhile millionaire-maker that is the London property market continues!

Tax take

I don’t think property is the whole story, though. It doesn’t take a charting genius to notice the previous peak in capital gains tax receipts was just before the last bear market. So after a decade of strong stock markets, at least some of the latest surge is surely also coming from investors coughing up on selling unsheltered investments.

Always use your ISAs and SIPPs as much as you can! Don’t be a klutz like me 15 or so years ago, when I was tardy in sheltering my investments.

I am still defusing capital gains tax liabilities from back then – as well as some built up when I’d filled ISAs but hadn’t started on a SIPP – and expect to be doing so in a decade.

You might say it’s a high-class tiny violin problem to have; perhaps but it was also an unforced error.

Back then I thought tax on investments was only a concern for moguls. Not only was I wrong, but in the eyes of The Man anyone pursuing the sort of high six-figure portfolios required for financial independence pretty much is a mini-mogul.

Now I’ve got rid of nearly all the dividend payers it’s not such a pressing issue as it was (at least not until the rules change again) but it is a pain.

Paying investment taxes can savage your returns, for no risk/reward upside. Use tax mitigation strategies wherever legal and practical.

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