Way back in 2018 regulators dragged another hidden cost beastie into the open. This festering colony of fee rot is collectively known as transaction costs. A swelling so big it’s like waking up to discover you’ve grown a second head. One with a hungry mouth to feed too. 

The ultraviolet light of regulation has revealed that transaction costs can increase a fund’s total charges by a third, half, double, or more. 

These fees aren’t new. We’ve always been paying them. But the industry has been curiously reluctant to come clean – even despite new rules coming into play. 

Currently, it’s like you agree to pay £15 for a streaming TV subscription – only for Disney or Netflix to swipe £30 on direct debit. Perhaps they hope you’ll never notice. 

The new disclosure regulations aimed to expose this subcutaneous fee fat. But you still won’t find transaction costs next to the Total Expense Ratio or Ongoing Charge Figure on a fund’s webpage. Nor in the Key Investor Information Document (KIID) or any factsheet. 

If you’re lucky they may lurk in an obscure PDF stuck in a corner of the provider’s website. 

Worse, many fund providers use loopholes to claim a negative transaction cost that makes their funds look cheaper than they actually are.

Industry insiders privately admit that negative transaction costs are absurd. 

It’s another investment industry mess that makes you realise you can trust them about as far as you can throw them. 

So the intent of today’s piece is to unravel:

• The quickest way to find transaction costs. Only then can you work out how much you’re really paying for funds (including ETFs and investment trusts).

• How to make the best use of those transaction figures coughed up by the industry. 

What are transaction costs? 

Transaction costs are the costs incurred through the buying and selling of a fund’s underlying assets. 

Transaction costs include:

• Explicit costs – broker commissions and transaction taxes
• Implicit costs – bid-offer spreads, market impacts and delays
• Other costs – namely stock lending charges
• Minus anti-dilution benefits

The following graphic lays out the transaction cost equation:

Explicit costs

Explicit costs are so-called because they involve measurable sums that are clearly paid to third-parties. 

Broker commissions are forked over for trade execution. These intermediary charges bundle up costs such as exchange fees, settlement fees, clearing fees, and administrative fees. 

Taxes include stamp duty in the UK plus other levies imposed by governments around the world on securities trading. 

Implicit costs

Implicit costs are indirect losses of value and are better thought of as market friction. They amount to a cost of trading when market prices move against a fund.

In contrast, market moves in a fund’s favour can be logged as negative transaction costs. And this is where the mischief creeps in. (See the ‘negative transaction costs’ section below). 

The bid-offer spread is the difference between the price market participants are willing to buy (bid) and the price they receive for selling (offer) the same security. 

Market impacts refer to the adverse price movements caused by the supply-and-demand effects of a fund’s own bulk trades. For example, a fund places a large order for a particular share. That very act bumps the share price slightly higher by the time the trade completes. 

Market makers are not obliged to make unlimited trades at their currently offered price. They can and do raise prices in the face of a big buy order, or lower them when a fund sells sizable lots. 

Large orders also attract the attention of other market participants. They can crowd the trade like ticket touts at a Rhianna gig. Agile operators may try to front-run the fund – buying the security first and pushing up its price.  

The ponderous fund then arrives like a flood of crazed superfans with wallets akimbo. This surge in demand raises prices further and front-runners make a nice little profit scalping the fund.  

Market delays: The more time it takes a fund to complete its order the further the price can move in the wrong direction.

Because large orders soak up market liquidity and bend the curve of supply and demand against the fund, managers try to lessen their impact by splitting a large trade into a stream of smaller orders. 

The hope is that the combined impact of the smaller trades is lower than one big splash.

This staggered order method takes longer, however. And the sum of trading by other market participants in the meantime can shift prices further against the fund than if the manager had just stormed in.

Yet the impact of market delay works both ways. So conversely, sometimes the price can swing in favour of a fund while its trade completes. For example, if the fund offloads shares while others are clamouring to buy, then each installment of its ‘sell’ order could gain a higher price than the last. 

Market delays are a rich seam of negative transaction costs when they net out in favour of a fund versus expected prices. The trick is to ‘expect’ a price that tilts the odds of booking negative transaction costs. 

Other costs

Stock lending costs are incurred by funds that use a lending agent to manage loans of their securities to short-sellers. 

Anti-dilution benefits reduce transaction costs

Anti-dilution benefits are designed to protect long-term investors from the love ‘em and leave ‘em antics of speculators, day traders, and financial gadflys like The Investor. 

Because fund inflows and outflows incur transaction charges – caused by the buying and selling of the underlying assets – they ‘dilute’ the value of existing / remaining investors’ holdings. 

Thus anti-dilution measures exist to make the traders pay, rather than the loyal investors who hold on through turbulence like a pantsdown politician’s supportive spouse. 

When a fund has separate buy and sell prices (known as dual-pricing) then the the bid-offer spread recoups the transaction costs of the churners.

But what happens when a fund is ‘single-priced’ (as with most OEIC type funds)?

Then the fund manager protects long-term investors via a levy or swing-pricing. 

The swing of things

A levy is a straight fee imposed on joiners and / or leavers. 

Swing-pricing, on the other hand, acts like a crypto-spread hidden beneath a fund’s single-price simplicity. 

• If buyers outnumber sellers then a fund manager can nudge the price of a fund upward. 
  
• Conversely if sellers exceed buyers then the price swings downward. 

The difference between the swing-price charged and the underlying market price of the fund’s assets allows the manager to offset transaction costs. 

Schroders published a nice visual to show how swing-pricing works:

The swing factor is the amount fund managers are allowed to move the price up or down from its mid-market price point. 

The adjusted price takes a bite out of buyers or sellers, depending on which group causes the fund to trade. 

(If inflows match outflows then sellers’ units can just be handed to buyers without incurring transaction costs.)

The anti-dilution gain is then deducted from a fund’s overall transaction costs. 

While the mechanism makes sense, canny managers can exploit anti-dilution calculations to create artificially large negative transaction costs.

What difference do transaction costs make to the price you pay?

Let’s consider some of the best value UK equity index trackers. Below you’ll see that transaction charges can more than double the cost of some:

UK large equity trackers	OCF (%)	Transaction cost (%)	Total cost (%)
Vanguard FTSE UK All Share Index Unit Trust	0.06	0.00	0.06
Fidelity Index UK Fund P	0.06	0.02	0.08
Lyxor Core UK Equity All Cap ETF	0.04	0.06	0.1
HSBC FTSE All Share Index Fund C	0.06	0.06	0.12
iShares UK Equity Index Fund D	0.05	0.11	0.16

Source: Author’s research

Intriguingly Vanguard’s FTSE UK All Share Index Unit Trust is currently showing a negative transaction cost of -0.01% on AJ Bell’s site. But its transaction cost was 0.05% in July, and 0.02% according to Vanguard’s cost and charges document dated February 2022.

I’ve zeroed out the fund’s negative transaction cost in line with FCA guidance. 

The situation is even worse among FTSE 100 ETFs: 

• HSBC FTSE 100 ETF: OCF 0.07% + transaction cost 0.25%
• Vanguard FTSE 100 ETF: OCF 0.09% + transaction cost 0.04%
• Lyxor FTSE 100 ETF: OCF 0.14% + transaction cost 0.69%

As you can see, the transaction costs differ wildly. They swamp the OCF in two cases.

Incidentally this isn’t just a problem for index trackers. Active funds typically have higher transaction costs than passive funds. 

Either way, relying purely on Ongoing Charge Figures is not good enough for dedicated cost cutters like us.

How to find fund transaction costs

The letter of the law enables fund providers to avoid revealing transaction costs in any helpful place – such as the charge’s section of a fund’s webpage. 

Some brokers clearly show transaction costs, however. 

AJ Bell has the most convenient tools I’ve found to quickly compare transaction charges. The links below enable you to rank:

• ETFs
• Funds (e.g. OEICs, Unit Trusts, and ICVCs1)
• Investment trusts 

Dial up the asset class or fund manager you want to assess. 

Tap on the Costs and Charges tab. 

You’ll see the investment’s transaction charge explicitly listed along with other fees that may apply. 

As far as index funds and ETFs are concerned, just tally up the Ongoing Cost figure (OCF) and the transaction fee to find the Total Cost of Ownership (TCO). 

This better estimates the true cost of your investment. Albeit all figures are backwards looking.

After you choose a fund, keep an eye on transaction costs for it and the rest of your shortlist. 

Check in perhaps once a quarter for the next year and take transaction cost readings for the funds you were considering. 

That’ll give you a handle on transaction cost variability and help decide which fund is the best value for money. 

Know thy enemy

What characterises funds that incur higher transaction costs?

They are likely to:

• Trade in illiquid markets
  
• Frequently buy and sell 
  
• Trade during volatile conditions
  
• Undergo large shifts in investment strategy
  
• Trade in securities with high commissions
  
• Rebalance frequently

The best global tracker funds are the antithesis of this. Consequently they sport very low transaction costs. 

Remember to always count negative transaction costs as zero. Don’t subtract them from your overall cost.

If a fund family consistently presents negative transaction costs then something is afoot. So I wouldn’t choose one of their products if zero or negative transaction costs are the decisive factor giving it an edge over its rivals. 

Indeed even the Financial Conduct Authority (FCA) says negative transaction costs are not to be trusted. 

Negative transaction costs

Negative transaction costs emerge when implicit cost calculations and anti-dilution benefits cancel out positive transaction costs and then some. 

Opportunities to game the system abound because the regulations allow fund managers to cherry pick from a range of methodologies that help tip them into negative transaction cost territory. 

That’s not to say that negative transaction costs are utterly bogus.

But they arise due to flaws in the calculus, not because a fund manager has a magic cost eraser.

As fund managers Schroders says: 

The most obvious manifestation of this is a negative transaction cost, which can be misleading as it implies that the manager has made money for the fund from the transaction, which is not the case as it is impossible.

The FCA is aware of the problem:

Incorrectly applying the PRIIPs requirements: some firms are incorrectly using the arrival price methodology when calculating transaction costs for primary issues. As a result, they are effectively crediting investment products with a negative transaction cost each time they subscribe to a new issue. They should instead be adjusting these to have no associated transaction cost, as per the ESMA Q&A. We are concerned that this practice may decrease the perceived cost of investing through an artificially reduced transaction cost figure.

Using the anti-dilution levy incorrectly: this tool should only be used to reduce dilution. However, we identified instances where its use is artificially reducing transaction costs at the expense of customers who subscribe into or redeem out of a product. In some cases, the levy applied is greater than the total explicit plus implicit trading costs. This more than offsets all transaction costs and results in an overall negative transaction cost figure.

Positive thinking

There’s plenty more evidence on why negative transaction costs occur. But I think we can let it rest there.

The FCA is reviewing the situation. Currently it mandates workplace defined contribution pensions should count negative transaction costs as zero. 

I see no reason not to cancel out all negative transaction costs, as even fund managers agree they’re not actually possible.

Transaction costs: cold bucket of reality or firehose of falsehood?

Clearly a well-meaning attempt to regulate the disclosure of transaction costs has been partially fumbled. 

Still, that’s no reason to stop rooting out transaction charges. They’re a performance drag every bit as serious as the other cost icebergs we look out for. 

Even in the ultra-competitive US market the key takeaway on transaction costs is (as identified by Larry Swedroe):

Trading costs of index funds are comparable in magnitude to expense ratios. 

The FCA places the blame squarely on nefarious fund managers who wriggle through loopholes for fun:

Our recently concluded review identifies that while most asset managers calculate transaction costs in accordance with the relevant rules, we found problems with the way some calculate transaction costs and how prominently and clearly they disclose them.

We conclude that asset managers may be communicating with their customers in a manner that is unfair, unclear or misleading and as such, investors can be confused and misled as to how much they are being charged.

Even when all costs are disclosed, they are still confusing: in instances where all related charges are made available, they are often disclosed in a way we believe requires unreasonable levels of effort from customers to both find and understand. They are commonly located in separate pages or documents on a firm’s website. This is especially concerning where these additional charges have a significant impact on the overall cost of investing and therefore a material effect on returns.

I’ll say! Such disinformation tactics would do Mr Putin proud.

The culprits knows that if they make finding the truth hard work then people will give up trying. 

Carrying on the good cost fight

I’m cheering on the FCA’s attempts to bring the miscreants to heel. In the meantime, we’ll update all our articles that rank funds by fees with transaction cost data just as soon as we can. 

In fact we’ve already made a start with our low-cost index funds and ETF piece. 

Take it steady,

The Accumulator

1. Investment Company with Variable Capital. [↩]

What caught my eye this week.

Another week in the new unreality of British political and economic life. Pass me the smelling salts.

I said last week how I long for these commentaries to look away from the ongoing car crash in Westminster. That though requires some break in the succession of disasters jackknifing into each other.

Don’t hold your breath – but feel free to skip to the links below.

The concrete developments from a financial point of view are quickly recounted. As well as dropping the scrapping of the 45% tax rate, the planned hike in corporation tax from 19% to 25% will now go ahead in April.

Offing the 45% tax band would have cost about £2bn. Bringing in the 25% corporation tax rate theoretically generates nearly £19bn.

In theory that’s £21bn towards the £60bn hole in the public finances implied by the Mini Budget.

We’ve been promised from the start that spending cuts – or efficiencies, in politician-speak – would make up the rest of the gap. In her speed date press conference announcing she’d sacked her chancellor, Truss found a few seconds to reiterate this intention.

Next week’s chancellor Jeremy Hunt will apparently reveal all on 31 October. If he’s still around by then.

For now at least the reversal of the recent rise in National Insurance and the 1% cut in basic rate income tax due in April both survive. As far as I can tell the additional rate applied to dividend income is still to be abolished and the recent 1.25% rise in dividend tax rates will also still be reversed.

The changes to stamp duty and getting rid of the banker’s bonus cap linger on.

Damaged goods

How we used to laugh at Italian politics, with its revolving door of new prime ministers, its fickle electorate, and sleaze.

But with three prime ministers in six years and four chancellors in three – and Boris Johnson more than filling in the blanks in the scandal department – no Briton need stand in an Italian’s shadow again.

Italy isn’t just a unwanted template for contemporary Britain, however. Because while it’s tempting for someone like me to see the acceleration of culture and technology colliding with the tribalism of social media to produce our current political maelstrom, the reality is other countries have been at it for years.

We just used to do things differently here. If anything, turning Italian at least offers the chance of turning back again.

So what changed?

In the dread word: Brexit.

As a generalization, the most deluded and out-out-touch Conservative MPs were always on the so-called Eurosceptic wing.

When I was growing up they were the comic relief of British politics. Very few serious people took them seriously.

Now and then one appeared as a sort of forlorn and romantic figure standing up for the memory of a fading Britain of yesteryear. You could spare them a moment’s respect. But it was in the way you stop chattering when you walk past a war memorial. You don’t want to go back there.

Tragically, all that changed when David Cameron’s gambit to rid his party of the Eurosceptics growing influence failed and they bamboozled the British public into voting for Brexit.

A project that had nothing to recommend it bar regaining that wistfully wished-for full sovereignty. Itself a red herring in my opinion, and after our politics since 2016 I’m not sure something you’d wish on your enemies.

If this is what taking back control looks like, I suggest we hand it over to my Roomba

— Monevator (@Monevator) October 14, 2022

Brexit was always a self-harming move from an economic perspective.

And I bemoaned how the methods of the Leave campaign – lies, for want of a better word – had damaged our cultural life, too. The loss of freedoms most of us were born with were also grievous.

But I never really argued with the sovereignty crowd. At least their reasons for wanting us out of the EU was intellectually coherent.

However their Brexit wasn’t the one the country voted for.

Not great men

Brexit – as imagined by most of the 52% who expected £350m a week for the NHS, economic growth, leveling up, more democratic politics and all the rest – was a con job perpetrated on the nation.

Its promises were at best amorphous, at most contradictory.

They wilted under scrutiny.

Yet like most such delusions in history, the perpetrators – and those they’ve hoodwinked – only doubled-down afterwards. It’s always easier to do that then recant.

Those who questioned Brexit were the enemies of the people. Those who wanted anything less than the Hard Brexit were traitors to the supposed vote for a proper Brexit.

I’m recounting all this yet again because it explains why we’re in the mess we’re in.

Economically-speaking, Brexit was a bad idea but as I’ve always said it’s a slow puncture. It creates friction and leaks growth. We have to work harder just to stay where we would have been before.

However politically-speaking, Brexit is a filter for incompetence and wishful thinking. That blow has come quick.

After offing Theresa May – herself the first politician to impale herself in trying to reconcile the fantasies of Brexit with the paltry reality – Boris Johnson purged his ranks of the Remainers who’d led successive revolts against the hard Brexit being railroaded through Parliament.

Those who formed Johnson’s government and that which has followed were thus of two camps.

Either true Brexiteers, or else Remainers prepared to pretend Brexit was a good idea.

Hardcore support for Brexit is like a filter that selects for magical thinking, disdain for experts, and the belief that if you say something enough times it must be true.

No surprise that hasn’t worked out so well in practice.

In filtering for Brexit believers, the Parliamentary Tory party had purged nearly all its most capable – or at least realistic – men and women, or sent them to the back benches. We’ve been government mostly by the dregs since.

As for the reconciled Remainers, I understand those who say we need to move on. But I have not heard one of these people (who include Truss and Hunt, incidentally) say something like: “Brexit was a terrible idea with tough economic consequences, but we have to make the best of it.”

Rather, they too spout the nonsense about Brexit dividends and having our cake and eating it.

Which perpetuates the national feeling that has something has gone very wrong.

Contract

This is all relevant to our current travails because as I say our leaders have been increasingly selected from the least capable Tory MPs – the faction identified by its disdain for experts.

But it also matters because the fantasy of Brexit-thinking has escaped from the fringes and moved into the public consciousness.

We’re possibly not fatally infected yet. Almost everyone – even many of the rich, and not a few Tory MPs – thought scrapping the 45% tax rate was at the least a bad look. Some sense remains.

But listening to people’s reactions to the Mini Budget and its reversals more broadly, we now seem to be an electorate of cake-ists – only we never got the cake, let alone a chance to eat it.

Few want taxes to rise. Even fewer think spending should be cut. Investors I follow on Twitter are writing to their MPs bemoaning how the corporation tax rise will threaten the dividends they live on.

And while I don’t have much sympathy for Liz Truss, I’m not surprised she keeps banging on about the energy price cap. A potentially vastly expensive relief package that within days everybody took for granted.

When the Maxi-Mini Budget dropped I looked for pros as well as cons, much to some reader’s disquiet. And from the start the tension between a loose fiscal policy and the Bank of England’s fight against inflation was clear.

That’s why I called it a Push-Me, Pull-You budget. It looked sure to cause ructions in the months and years ahead.

But I’m not going to claim I foresaw the extent of market tumult that followed.

Guns before butter

At some point we’ll learn how much of the spike in gilt yields was amplified by technical factors related to the unwinding of pension fund leverage.

Now the damage is done I doubt it can be reversed, anyway. But it’s conceivable that the market’s seeming reaction to the unfunded tax cuts laid out by Truss and Kwarteng was overblown.

What would certainly have improved their position with the markets – though not the electorate, which is doubtless why they didn’t do it – would have been if they’d simultaneously explained where they’d cut spending to help pay for their program.

And also if they’d allowed the Office for Budget Responsibility – which they’d all but sidelined – to cost it out.

But like sacking the veteran Secretary to the Treasury Sir Tom Scholar on taking office, ignoring the OBR was just the latest manifestation of the scorning of expertise (/reality) that has benighted British politics since the Referendum.

With a surname like Scholar he never really stood a chance.

Anyway, would Kwarteng’s have been my Budget for the country in its precarious position in 2022? With the world facing inflationary pressure and the cost of government borrowing rising all year? And a war raging on the edge of Europe? In the midst of an expensive energy crisis?

No, it would not.

Maybe in 2019 it might have had more merit. But as that rare Brexit-y MP with the ability to use a spreadsheet Rishi Sunak so presciently warned, now was not the time.

With that said, I am not going to pretend I saw no merit in trying to shake Britain out of its low productivity slumber – or even to row back from an ever-more costly state.

The issues Truss and Kwarteng identified haven’t gone away. The irony is their antics have probably only made them more entrenched.

Return the gift

I can’t tell you if mortgage rates will settle, or how deep the coming recession will be. The markets were underwhelmed by Truss’s latest U-turns but I expect she’ll be gone in a fortnight anyway.

For now the more troubling question for me is what happens when Sir Keir Starmer’s Labour embarks on its near-certain path to victory in the general election in 18 months or so.

Can it tone down the populist temperature? Dare it say that Brexit was folly and transparently outline plans to at least ameliorate the worst affects?

The crisis in care and NHS staffing is one reason to relax immigration, pronto. And while I expect I’ll have a bus pass when the UK inevitably rejoins the EU, moving towards a softer Brexit via one of the other trading relationships would be a start.

Alternatively, will Starmer and Labour also start to unravel within weeks of gaining office?

Labour has the same problems with a membership base that’s far from what was, historically at least, the center ground of British politics.

I’ve no doubt its MPs are equally capable of scandals and gaffes to be rapidly exposed and pilloried on social media too.

I suppose that’s when we’ll discover whether Britain is just the new Italy, or if something deeper and even more troubling is going on that has put us on this rollercoaster.

Have a great weekend all.

[continue reading…]

Bonds and especially gilts have taken a hellavua beating recently. Rising bond yields have inflicted losses shocking enough to put some people off for life. And that’s a shame because bonds and equities share an important characteristic: they’re likely to be more profitable in the future after a sharp price fall than after a gain. To explain why, let’s investigate what happens to bonds when interest rates rise. 

When interest rates rise, two things typically happen to older bonds1:

• The yield on the bonds rise 

• The price of the bonds fall

This means that as interest rates rise, your bond portfolio or fund will probably suffer a capital loss.

And lower prices for bonds mean your fund is worth less, right? 

Right. But counterintuitively, interest rate rises also create the conditions for stronger bond returns in the future. 

That’s because rising bond yields equate to higher future income payments.

Eventually those improved cashflows can reverse your capital losses and then put you further ahead than if the interest rate rise had never happened. 

Rising bond yields: are they good or bad?

Rising bond yields are bad news at first because they trigger capital losses. But the good news is your expected bond returns are actually greater after a rate rise.

This example shows three alternate destinies for the same intermediate bond fund – depending on the future path of interest rates: 

Source: Author’s calculations and Portfolio Charts

This is a necessarily simplified example that doesn’t include daily fluctuations in yield, nor investment costs. We have assumed an upward sloping yield curve that shifts in parallel, and that all interest is reinvested. The underlying bond fund calculations are handled by Portfolio Charts’ excellent bond index calculator.

• The blue timeline shows what unfolds when interest rates hike 2% and then remain stable. Despite an initial double-digit capital loss the fund earns a 4.5% annualised return over 15 years.  

• The green timeline tracks the bond fund’s fate if interest rates stay flat. It earns a 3.8% annualised return in this scenario. 

• Finally, the red timeline charts a cork-popping 22% initial gain triggered by a 2% interest rate drop. But rates then go flat like cheap fizz. The fund limps home with a 3.1% annualised return.

Hence the surprising result is that the rising yield scenario is the most profitable one over the long term. 

It’s like a bond fund morality tale. Good things come to those who wait.

Who said bonds were boring?

Long-term investors reeling from recent reverses in their bond funds could imagine it as a hero’s journey:

• First, the setback as the interest rate rise inflicts calamitous losses. 

• Then the transformation as stronger cashflows bend the arc of fortune upwards.  

• Atonement as the blue bond fund overtakes its lazier selves enjoying the easy life. 

• Finally the triumphant return: 4.5% annualised in this case. 

You’ll notice it takes the rising yield scenario fund more than three years to recover its capital loss. And it’s ten years until it’s more profitable than if yields hadn’t risen.

But it’s returned 22% more than its falling yield ‘alternative reality’ self after 15 years. 

If you owned a shorter-term bond fund it would recover more quickly. The trade-off is its annualised returns would be lower. 

Conversely a longer bond fund takes more time to repair the damage but annualised returns would be higher still. 

Either way the pattern is the same. 

Yet if you asked most people, I’d wager that they’re cursing rising bond yields right now. 

It’s like an adult version of the marshmallow test. Do you want a quick sugary hit or can you wait for a bigger payoff?

What happens to bonds when interest rates rise?

In a nutshell, rising interest rates in 2022 have caused our existing bonds to be marked down in price. Hence the capital losses. 

But our existing bonds get replaced by higher-yielding versions as they reach maturity. And the new bonds pay more income. 

Over time, the replacements produce a stronger stream of cashflows. This erases the earlier losses. 

It’s like a heavy snowfall that covers a pothole. After a while the snow piles up until you’re left with a big mound. The tear in the road is long since forgotten. 

But to properly understand the underlying mechanism we need to clear something up.

The interest rates that directly affect bond prices are not the Bank Of England’s interest rates. Or any other central bank’s rate. 

No, bonds respond like a puppet on a string to market interest rates. 

Market interest rates are the sum of supply and demand for any given bond. 

Which means each bond has its own interest rate. And that rate yo-yos in tune with bond traders’ views on:

• The bond’s specific properties, such as its credit rating and maturity date.

• Broader forces – inflation, the state of the economy, currency moves, animal spirits and, yes, the influence of central bank interest rates. 

Ultimately, the market interest rate is the return that investor’s demand for bearing the risk of holding a particular bond.  

Why do bond prices fall when interest rates rise?

The reason that bond prices fall when interest rates rise is so that older, lower income bonds remain competitive against newer equivalents that pay better rates. 

Why does this happen?

Well, it’s because most newly-issued bonds pay a steady stream of income that match the prevailing interest rate for their type.  

For example, if the market interest rate for a ten-year gilt is 4%, then a freshly printed 10-year gilt must pony up a 4% annual income stream to be competitive. 

If it didn’t then nobody would buy it. (And then the government wouldn’t be able to finance all those national nice-to-haves like roads, schools, hospitals, the army and such like.)

That fixed rate of bond interest is formally called a coupon rate. 

For example, a bond with a 4% coupon pays £4 per year on its principal of £100.2

The £100 principal is the amount loaned to the government in the first place, when the bond is issued. When the bond matures, whoever owns it at that point will get that £100 back.

But what if interest rates for ten-year gilts afterwards rise to 5%? Then now our old 4% job looks like an Austin Allegro in a car park full of Teslas.

You’re worried about being laughed off the bond trader’s floor with your weeny debt instrument. 

You want to get shot of the 4% gilt. But why would anyone buy it when they can get a shiny, new version of the same thing paying 5%?

There can only be one answer: you sell it at a discount. A lower price that recognises that 4% bonds aren’t all that when 5% behemoths roam the bond market. 

The discount price needed to sell this bond is: £92.21

Bazinga! At that new price your 4% ten-year gilt offers exactly the same return as a 5% ten-year gilt worth £100. 

This market reality explains why bond prices fall when interest rates rise.

Brief sci-fi side trip to an alternative universe

If prices didn’t drop, then nobody would be able to offload their less competitive bonds when a factor like inflation spurs everyone to demand higher rates of interest. 

And if prices didn’t adjust like that, then the bond market wouldn’t function properly.

Instead it’d be like a vast hodgepodge of fixed-rate and fixed-term savings accounts. All sporting different interest rates, depending on when they were initiated.

There would be no liquidity. The fixed term would lock you into your ‘savings account’ with a particular tranche of government debt until it matured.

Government financing would be far more expensive. The risk of being locked into lower interest rates would make everyone demand much higher coupons in the first place.

Basically, if today’s government bond market didn’t exist then somebody would have to invent it.

Rates up, price down, rates down, price up

Back in the real world, the same phenomenon of a bond’s price and yield adjusting to prevailing rates works in reverse. 

If market interest rates fell from 4% to 3%, say, then your old gilt with its 4% coupon would look good by comparison. 

Some quick sums reveal you’d be able to sell it for £108.58. (In practice a small investor wouldn’t need to do any maths. The market constantly adjusts pricing across all bonds as rates move).

At the higher price, your 4% ten-year gilt offers exactly the same return as a 3% ten-year gilt priced at £100. 

From this market-clearing mechanism we can derive the iron law of bonds:

• When interest rates rise, the price of a bond falls.

• When interest rates fall, the price of a bond rises.

You can check out the price changes yourself using a bond price calculator.

Rising bond yields: which yield are they talking about? 

Yield-to-maturity (YTM) is the metric that really counts. 

YTM (minus costs) is a bond’s expected annualised return if you hold it to maturity. This yield takes into account the bond’s current price, and assumes all remaining coupon payments are reinvested at the same interest rate.

Yield-to-maturity is the critical metric enabling you to compare the expected return of bonds of a similar type, even though they vary by price, maturity, and coupon.

Whenever we talk about bond yields in this post we’re referring to the yield-to-maturity.

With this metric in play, we can finally get to the heart of why bond prices fall when interest rates rise. 

In the example above, our poor old gilt – saddled with its now-underwhelming 4% coupon – was outgunned by new-fangled gilts spraying about 5% per year. 

Our 4% gilt’s price falls to £92.21, which pushes up its YTM to 5%. Now it offers a 5% annualised return to new buyers and is every bit as appealing as its newer rival. 

Extra yield juice, reinvested, is on top of the £7.79 capital gain a buyer will make if they hold the 4% gilt to maturity. On that date the bondholder receives the £100 principal payment, booking a £7.79 gain over the price they bought it for.  

Hence it’s the discounted price that enables an old bond with an under-powered coupon to trade on equal terms with new entrants on the market.   

Again, the process plays out in reverse when interest rates fall. Which brings us to the second iron law of bonds:

• Yields rise when the price of a bond falls.

• Yields fall when the price of a bond rises.

Higher market interest rates means investors are demanding a higher yield (i.e. a greater return) on their money. 

And as we saw in our sci-fi aside earlier, this price-adjustment mechanism is what prevents the bond market seizing up due to it saddling investors with uncompetitive bonds they need to sell. 

Not so smooth operators

In reality bond investors constantly reevaluate their assumptions just as equity investors do.

Thus market interest rates oscillate like a thrash metal guitar string. Which causes bond yields to rise and fall like empires on fast-forward, and prices to seesaw like frenzied toddlers.  

Thus, while my chart above models the effect of rising bond yields in principle, the real world is far messier. Interest rates are never going to hike on day one then stay flat for the next 15 years.

So how can we apply the rules above to our own investments?

Rising bond yield takeaways

Let’s boil down all this bond banter to some basic principals you can take to the bank.

Rising bond yields are positive for long-term investors who can ride out the capital losses and eventually take advantage of fatter income payments. 

Much of the doom and gloom after the Financial Crisis concerned the fact that low yields meant miserly long-term bond returns. It dragged down the equity risk premium as well.

Now, rising rates and a return to the old normal is leaving that particular threat in the rear-view mirror. 

Higher coupons should lower bond volatility. They plump up your safety cushion against equity losses, too. 

But let’s be clear-eyed about the risks.

Sharply rising bond yields can rain pain upon us for years. This happened to UK government bonds in the 1970s. 

Eventually those vertiginous yields became the source of stellar bond returns in the 1980s and 1990s when high inflation and interest rates fell away. 

But a rising rate environment is no picnic if you’re short on time. You’ll lock in real capital losses if you’re a forced seller, before your bond allocation can take advantage of higher yields. 

If you need to sell to pay the bills then some of your allocation should be in cash and short duration bonds. These refuges are less vulnerable to inflation and less sensitive to interest rate moves. 

The standard advice is to match your bond fund’s duration to your time horizon. 

But this is tricky to do in practice and is no magic bullet anyway. We’ll talk it through in a follow-up post. 

The other important point is that not all interest rate rises are as calamitous as the surges that heaped historic havoc on the UK recently. 

Steep and rapid hikes at the long end of the yield curve can ravage bonds with lengthy lifespans.

Gentle climbs over years are much easier to cope with. 

What you should do about bonds

That brings us finally to the psychological element.

You may be a long-term investor who can afford to wait for rising bond yields to work their charm. 

But if staring at a long bond fund in the red for years on end is going to gnaw at your psyche then the waiting game may not be for you. 

We know that high inflation which escapes its Central Bank gatekeepers is bad for bonds. 

So it’s not hard to imagine a world where bond yields could keep rising from here.

If that higher-than-expected inflation scenario unfolds then we’ll spend much longer eating capital losses before finally enjoying the fruits of growing yields. 

To me, that has suggested trimming bond allocations, looking at diversification options, and reassessing your exposure to long bonds. I argued for that in a reappraisal of the 60/40 portfolio.

But I believe it’s short-sighted to ditch bonds entirely.  

We do not know that interest rates will keep rising. 

In a deep recession they typically fall – buffering your portfolio with bond capital gains even as equities crash like a drunk’s Jenga tower. 

In that scenario, your bond funds are likely to be the best comfort you’ve got. 

When do you think the next recession will be? Never? Soon? Anytime now?

Such uncertainty means there’s still a place for bonds.

Take it steady,

The Accumulator

P.S. I can’t find a better place to put this bit, but because bond funds sell their bonds before they mature, yield-to-maturity is a fuzzier measure with funds than with individual bonds. It is still a useful bond fund comparator and your best guide to future expected returns, but with a fund YTM is not a guarantee of any particular return.

P.P.S. Take a look at our best bond fund ideas for help with your research.

1. By ‘older bonds’ we mean previously issued bonds that trade on the secondary market. We don’t mean newly issued bonds. [↩]
2. A bond’s principal is also called par value, nominal value, or face value. Essentially it’s the original value of the loan made to the bond issuer. [↩]