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:
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,
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.
Also highly recommend the below:
Some common themes there, and another calculator to play with.
I’m a bit disappointed that you didn’t refer to index linked bonds at all
You could at least link some of the old articles about index linked gilts, like this one which looks appropriate six years later
Another great article!
I was just yesterday trying to figure out whether bond funds or direct holding of bonds is better in the present environment (maybe an article idea there??). I found one Forbes article saying direct holdings are safer because you can hold to maturity. Another article suggested that in the long run the assumed benefits of directly holding bonds to maturity is a “myth” and the reasoning seems to make sense (here: https://www.northerntrust.com/documents/commentary/investment-commentary/maturity-bond-funds-vs-individual-bonds.pdf)
Another question is this: if you want to buy bonds from cash savings, is it better to wait until you think bond prices have stabilised (thereby avoiding the capital loss, but missing out on coupon payments during the period of falling prices)? Or is it better to just buy now and get the yield payments and suck up the capital loss?
Obviously the answer depends on how MUCH bonds fall, but is there a simple rule of thumb to work out where the tipping point is between “better to buy now” vs “better to wait”?
Perhaps it is as simple as saying the current 4.5% yield on 10 year gilts means that unless gilt prices FALL 4.5% over the next year, you’ll do better buying the bond now (assuming a 0% cash savings interest rate)?
And I assume that as yields rise, future falls would have to be bigger before you’re losing out overall buying now vs waiting?
Sorry to follow up my comment I see you have articles addressing both my questions already! Whoops!!! 🙂
Off to do some reading 🙂
Thank you for the article.
Having been engrossed in a discussion about IL gilts on another forum I can understand why you didn’t expand into that. Robert Armstrong has a ponder about this in todays FT in his Unhedged column. He can’t figure it out either.
Well I bought more of the RL global short duration IL bond fund today. I can’t be bothered going through the rigmarole of phoning through an order to buy an IL gilt directly and besides which it seems a waste of an ISA to invest in something not open to cgt. On such a basis is theory sacrificed to reality.
Can I ask if, when searching for an analogy, ‘It’s like a heavy snowfall that covers a pothole ‘ was the best available ? 🙂 .
@ Optimistic – Cheers and that’s a good link, thank you for sharing.
@ Jim Bob – Re: individual bonds vs bond funds
There is a situation in which individual bonds make sense but it’s more about your circumstances as an investor and less about prevailing macroeconomic conditions.
Here’s a more detailed version of the article you’ve linked to which I think gives a clearer and more independent take on the topic of bond funds vs individual bonds:
Kitces shows that bond funds can profit from selling bonds before maturity by rolling down the yield curve (the same point that Northern Trust make). But he also shows that whether it ‘pays off’ for you depends on the future path of interest rates – which nobody can know.
Hence, earning the profit entails an element of risk.
The investor who has *less* reason to take that risk is the *retiree*. A retiree has fixed liabilities that they want to meet through their portfolio.
The overriding concern is to ensure you can pay those inevitable bills and individual bonds are very good at doing that because you know how much they’ll earn if you hold to maturity.
It makes *less* sense to take a punt on the ‘rolling bond yield’ tailwind vs possible capital loss from selling before maturity if you’re a retiree who overwhelmingly wants to make sure the cash is on hand to pay the bills.
So in theory a ladder of maturing individual bonds makes the most sense for someone in that situation.
In practice, the situation is not clear cut.
Firstly, a retiree doesn’t know when that procession of bills is going to end i.e. they don’t know when they’re going to exit stage left – so you have to keep extending the bond ladder – which starts to look a lot like a bond fund.
Secondly, both methods incur costs.
Thirdly, managing your own individual bond portfolio takes quite a lot of effort, especially as you get on in life. You may have to pay someone to do it for you. (An annuity is one way around this).
The bond fund answer to the interest rate risk problem is duration-matching but it’s not a perfect match.
Overall, I think it’s true that retirees minimise their interest rate risk with individual bond portfolios but that doesn’t mean they’re the best solution when you look at the bigger picture.
If I was in my seventies then I’d look to meet my liabilities with an annuity, avoid the hassle of managing a bond ladder, and hope to benefit from the annuity’s mortality credits.
As for trying to profit from predicting interest rates – I’d forget about it.
@ Mr Optimistic – re: linkers. It’s just a different article for a different day. When an article weighs in at over 2000 words and takes a good few days to write, you’ve got to stop somewhere! There are always more articles to write.
As for any analogy – I’m sure there are always better ones out there. Finding them is the trick 🙂
Just as an aside, I usually have 2 or 3 in mind and just play with them awhile to see which one I can make work best. Sometimes nothing works and I scrap them all. Occasionally I ‘focus group’ them by trying them out on Mrs Accumulator. She loves that 🙂
I’ve always done 100% equities as early 40s accumulating and comfortable with the volatility. Is this still the case as interest rates rise ?
And I’m assuming the time to trim exposure to equities if I was is not now during a 20 to 25% bear market
Thank you for you thoughts. What do you think about investing in gold and bond 50/50? It looks like the price of gold is compressed like a spring. I expect it will be above 2000$ this year.
Thanks for the good article. I’ve never bought a bond but have started to consider them. I’m a lifetime active investor who made a stash mostly in high risk resource shares, paid off the mortgage and am about enter semi-retirement at 47, would have been full retirement but sequence risk is too high currently. I’m trying to get my head around bonds in terms of what they might offer as an attractive rate of low risk fixed income at regular intervals, more so than from a capital growth point of view. How attractive are they compared to fixed rate savings accounts in this regard? Or dividend-paying shares?
I currently use some of the large mining companies for dividends to provide a baseline of income but am wondering if bonds with a 4%+ coupon might be useful for this, and with lower risk.
I must admit I look at this slightly differently. My IL fund is down 40% over the last 3 years, the actual return remains the same as the coupon doesn’t change But % return changes as my fund has gone through the floor, this is supposed to cheer me up?? Regarding bonds maturing being replaced with higher coupon bonds, I would have gained from these anyway so no net gain!
Re: “There are always more articles to write.”
IIRC, not so long ago, you were a tad concerned that there might not be anything much to write about once you started de-accumulation!
@Bally — Naturally we’d all like to have avoided the massive drawdown I expect and in the particular case of long-dated IL funds it is indeed going to be a big slog indeed to climb back (which is why I’m so pleased @TA switched the Slow and Steady into shorter-dated IL bonds — something I was ambivalent about at the time on ‘should we faff it’s meant to be passive’ grounds. He was way ahead of most on this issue and it was a great call.)
However I think one thing you’ve overlooked in your summary is reinvesting coupons.
To take an extreme and absurd example to make the point (and ignoring inflation): a ten-year asset with a par value of £100 and a 10% coupon (i.e. pays out £10 a year) will earn a vastly higher return when you’re reinvesting the coupon if it falls to £10 for nine years before rebounding to £100 in year 10, compared to if it sat at £100 throughout.
For nine years you’ll be buying an extra £10-income-a-year for £10-and-rising of reinvestment income — a 100%+ return in a year. And compounding!
And while I can’t work out the final return in my head, you’d have *vastly* more ‘units’ of the asset you bought along the way versus if it was static at £100 (each year from year two you’re buying an income generating ‘unit’ worth £100 for £10 with your initial coupon, and you’ll buy far more as the years go on due to compounding).
Obviously that would never happen in the real world, outside of crypto Ponzi schemes anyway. I’m making the example very extreme to show the principle. But FAR more subtle-y that’s what’s also going on with bonds as their prices fall.
If you’re spending the income and you paid over par initially then there’s no amazing miracle to be found, agreed.
You bought / held an asset that by three years ago had soared far above its inflation-adjusted par value, due to investor demand for yield. (Perhaps 2-3 times as high in very long-dated IL bonds).
It was always going to return towards par eventually. It has done so quickly. 🙁
However there is a silver lining, which is what the article is about. 🙂
Nicely explained, I know how hard it is to explain this topic, you’ve done a great job.
Must admit the recent market movements have caused me to significantly reduce my unhedged US$ TIPs. The currency movements have more than covered the price falls due to rising yields.
Tucking into sterling bonds now…
The previous articles referenced of the 60/40 reappraisal and ZXSpectrum48K are comments are particularly interesting looked at from todays viewpoint.
It’s very important that we cover our future requirements and make portfolio allocation decisions accordingly, bonds can be very useful, the correct decision may not always bring the best outcome… hindsight is a wonderful thing.
@TA, thanks for the excellent explanations. But while I have got an understanding of the impact on individual bonds, what happens with the typical mix of bonds found in a fund (thinking particularly of the bond portion of LifeStrategy)?
As I understand it there is a mix of durations, which may be held to maturity or sold earlier, and which will be constantly renewed through new purchases.
Thanks for another great article, TA.
Like @Fatbritabroad, I am currently 100% in equities as I have a long time horizon and am confident that I can ride out frightening paper losses.
The recent market chaos has got me thinking about making changes. Not immediately of course… at my next annual review!
1. With many analysts predicting lower expected returns in equities, and with much more appealing yields on bonds, is allocating ~20% to bonds now a no-brainer even for those with a high risk appetite? Perhaps it always was, and it has just taken this crisis to show it to me.
2. You warn most investors against long bonds. But again, if I can be confident of holding out in a crisis, isn’t it the most sensible option for those with a long (30 years+) time horizon?
3. I saw you allude to this separately… is it now time to ditch UK bonds in favour of a £-hedged global bond fund?
Can anyone suggest platforms on which it is possible to buy individual gilts and linkers, other than HL? Thank you
Another wonderful and very informative article.
I find it hard to swallow the losses,as I have just reached retirement age,and have a large proportion of my portfolio in Gilts. Yes,they will eventually recover,but if that takes a decade or so,it’s somewhat cold comfort to me.
@Mr Slow – you can buy individual gilts via IWeb (only over the phone) and online via Interactive Investor (although from what I saw at a glance at the weekend, not the full range).
Thanks, a good article. The bonds in my portfolio haven’t really been smoothing the ride recently! Having been retired over a year now I’m lucky to be sitting on a decent amount of cash I’m running down without having to touch investments, but trying to decide whether I should put some in gilts – not something I’ve dabbled with and it all seems a bit scary to try new things at the moment. The exemption of UK gilts from CGT should make it something considering maybe for a non sheltered account if there is some recovery? Meanwhile I just looked at the last update on my NS&I indexed linked certificates – these things have gone gangbusters the last year with about 10% added, so that is something but the proceeds are locked in until they are cashed.
@Fatbritabroad – historical data from previous rising interest rate periods suggests that equities and bonds maybe in for a disappointing spell. We’re on the brink of recession, inflation is high, and we’re suffering the backlash from a period of extremely high asset valuations. I think we’re going to have to grit our teeth awhile.
That said, I think your personal situation should dictate your asset allocation. I don’t know how long you’ve been investing but you’re relatively young and if you started circa 2009, you’ve probably enjoyed a period of strong returns since your late 20s. The weather may well be choppier as you head towards your fifties with more to lose than you did a decade or two ago. We may be very different but as my portfolio grew, I became much more risk averse in my forties. I’m still comfortable with volatilty but 100% equities isn’t for me anymore.
@Fin – Personally I wouldn’t invest more than 10% in gold, though I’ve seen some sources make a reasonable case for 20%. Gold’s horrible 30-year losing streak from the early ’80s to the noughties is seared on to my brain.
@ Peter – the attraction of high-quality, government bonds for me is as a portfolio diversifier. You can check the yield-to-maturity of any bond (or bond fund) vs cash or dividend equities, but in a recession AA+ intermediate govies should perform better than both.
@ Hariseldon – cheers! Appreciate that. Bonds are much harder to explain than equities! I guess mostly because we’re much less familiar with them but there’s so much jargon to deal with too.
@ Jonathan B – everything in the piece applies to bond funds. Note the chart specifically refers to bond fund mechanics – it’s modelling a simplified fund with a range of maturities that are sold one year before maturity date.
Your bond fund has a yield-to-maturity and its portfolio of individual bonds are aggregated into its average maturity and average duration metrics.
What I don’t like about LifeStrategy is Vanguard don’t seem to publish those bond metrics. They can be worked out though. I’ll have a go at that and write up a (hopefully) short post on how to do it.
If anyone does know where Vanguard publish LifeStrategy duration metrics (rather than just a blank), please let me know.
@ Talexe – as they say: “diversification is the only free lunch in investing.” The most important diversifier for an equity portfolio is high-quality government bonds.
You’re right that if you own an equity dominated portfolio (say 70%+) then long gov bonds are the best diversifier i.e. they’re the asset most likely to yin when equities yang.
Despite knowing that, I invested in an intermediate gov bond fund because: it gave me reasonable diversification in a crisis but left me less exposed to losses in a rising interest rate environment. I’m glad I didn’t go long. That said, what you say is true. I think I’d want to see more evidence that inflation is coming under control before I risked long bonds but there’s a good section on how to manage long bond risks with a cash component in this piece:
See the ‘Long bond duration risk management’ section.
Re: UK government bonds vs £-hedged global government bonds – it’s an individual decision but I think we’ve just had a bracing lesson in single country risk and how “it can happen here.”
@AtlanticSpan – I hear you. I’m in much same boat and yes, couldn’t agree more. It’s a tough situation. Raging inflation at the start of retirement is just what we didn’t need. I’ll throw one more silver lining into the mix though, because it’s better than reaching for my cyanide pills.
Warnings that historical safe withdrawal rates were unsustainable were primarly based on the extremely low bond yields that became the norm after the Financial Crisis. Retirements are now more sustainable as bond yields return to normality. It’s bloody painful but we’re better off in the long run.
@ BillD – The scenario in which nominal government bonds don’t work is when inflation gets out of control. That’s what we’re dealing with. Compounded by a self-inflicted crisis in confidence in UK finances. Thanks Liz.
In theory, index-linked gilts should solve the inflation problem but many people own long duration index-linked gilts which were inappropriate because they’ve been pounded by rising yields which overwhelmed their inflation protection.
The best defence against UK inflation is your index-linked certificates – as you say they’ve been going gangbusters thanks to their inflation protection untarnished by the rising yield problem. It’s a huge shame that the UK government stopped issuing them.
Where does all this turmoil leave VLS high in bonds allocation, I’m too scared to look.
I can’t vouch for their accuracy, but Morningstar does quote Effective Duration figures for Lifestrategy funds, e.g.
That says 8.99 years for VLS40 as of 31/08/22 which seems feasible when the largest holding – global bond index fund – is 7 years. Then elements like the UK bond funds push it up.
@Norman – Thank you. FYI I also found I was able to do it via AJ Bell. I couldn’t find any links to Gilts on their website, but they are visible if you search for the exact SEDOL code on the AJ Bell Buy/Sell page (example BMGR279). You are then given an indicative price and directed to deal over the phone.
My gut feeling is that if the “risk free” return of bonds rises (and keeps rising) it will cause complete carnage to the investment world.
Take property investment – basically borrow at 2% and pocket a gross yield of 5%. Benefit from cashflow and appreciation (falling yields).
Put mortgages at 6%+ and fair value of property could half (alongside the cost of living crisis).
Boring investments in infrastructure goes the same way. Prices are getting hammered right now as yields rise.
Corporate debt is huge – government debt – government debt.
I don’t know for sure but it’s never been a secret that all this debt will never be repaid but so long as interest rates were held down, it was affordable. And falling yields made us all feel richer.
What exactly happens when this unwinds? Something akin to previous crashes – 1929, 1999, 2008 are all in my mind.
It might be that the stage is set and there’s no stopping what will happen next – and it won’t be pretty
I have to say I’m a bit frustrated by all of this. I was under the impression that an investment in bonds carried quite a lot less risk than investing in shares. The considered view of the financial industry seemed to be that, as you age and with less time to wait for “events” to turn around, best put more of your savings into “safer” bonds. Is that still the case? It’s certainly why I recently bought the VLS 40% equity, 60% bond fund and now want to know is that more risky, or less risky, than the 60% equity, 40% fund? To which I suspect the answer will be “That depends”. Honestly, stuffing cash under my mattress is becoming an increasing attraction as my “investment strategy”. At least I then know where it is.
@TA apologies, I see Monevator has already used the Morningstar figures in past Lifestrategy articles
Here’s a direct mention of duration by Vanguard themselves, in case it’s useful
@jim – not much of a consolation but I’m sure lots of people will feel the same way. If people haven’t dived into the fundamentals, via Monevator and so on, easy to get the impression bond funds are more stable than they are
@TA depends what you mean by investing really . I’ve had a pension since 18 that I’ve contributed heavily too. Now at about £320k
I came to the isa party late but due to changing this about 9 years ago and switching some pension contributions and a couple of unfortunate inheritances im sat on about 200k isas in isas. Last inheritance was relatively recent so have about 100k in cash ( well premium bonds ) that I’m now umming and ahhing about whether to lock in longer cash savings in the hope inflation is relatively transitory or yoloing and investing a chunk of it which would involve using a gi account for the first time.i was considering moving but 6% mortgages now put me off that idea
Think I’ll steer clear of bonds, it all seems a bit of a mess. My Vanguard Lifestrategy 60/40 certainly does.
I was reading today about a comment someone made on the BBC, about the Conservatives, post-Boris: ” The ringmaster has left the circus, and now the lions are eating the clowns.”
Apologies if this is a really simple question but how do you work out a yield to maturity of, for example, a single (non-index linked) gilt. I know the price and the advertised yield but my non-mathsy brain can’t work out how I would calculate the YTM.
More apologies if this is covered above but I couldn’t see it.
@Mark C — Take a look at the very old article of ours below, which gives a simple by-hand explanation:
It’s far easier and more accurate to use a calculator or to look up the yield to maturity if possible.
Note that article was written in 2009 at the start of more than ten years of moving towards near-zero interest rates, so some of the language may seem a bit cavalier about how bonds and their coupon payments interact over time. (Which, again, amplifies why it’s been so messy coming off near-zero for very long duration bonds and bond funds).
Preference shares touching 8% yield! I bought a big chunk (10-15% NW) when 6.2% – tempted but too risky
@ Mark C – here’s a decent YTM calc:
@ Ballard – no, thank you for the prompt. I didn’t think to go to Morningstar this time. Brain on strike.
With regard to the Vanguard Fixed Income funds, portfolio characteristics eg Yield To Maturity etc they are available to view on the Vanguard Professional Pages.
That’s right, they do for fixed income but not for LifeStrategy bizarrely:
You can calculate yield to maturity for a vanilla bond with Excel and probably other spreadsheets, using the YIELD() function. I suggest googling it for details, but as an example, to calculate the yield to maturity of the gilt I bought yesterday, Treasury 0.125% 30/01/2026, with a price of 87.146 on settlement date 14 Oct 2022, enter this in a cell
=YIELD(“14 oct 2022″,”30 jan 2026”,0.125%,87.146,100,2,1)
To break that down:
“14 oct 2022”, Settlement date, 2 working days forward of the trade date for gilts
“30 jan 2026”, Bond maturity date
0.125%, Annual coupon rate
87.146, Price, clean price ie without accrued interest
100, Par value of bond, usually 100
2, number of payments per year, 2 for gilts
1 day count basis – a bit geeky. Use 1 for gilts.
Note! if you cut and paste the function to Excel it will not work as the double apostrophes round the dates will get messed up – so change them to “normal” double apostrophes.
I miss the website fixedincomeinvestor dot co dot uk — does anyone know of a ‘replacement’? Without a Bloomberg terminal to hand (!) finding comprehensive data on individual bonds is a real faff without that site.
@Owl — Indeed, me too. This is pretty good though: https://reports.tradeweb.com/
Sign up (it’s free) and you can get yields-to-maturity on all gilt types based on yesterday’s closing prices. You can download them, too!
@Naeclue — Thanks for that!
I read a couple of pages of this article before I realised that it’s talking about bond funds, and not bonds held individually. Comments like this : “That’s because rising bond yields equate to higher future income payments” don’t hold for individual bonds. The annual coupon that I receive hasn’t changed, unless I sell my bond and buy a new one.
I know that *you* know that, but I suspect that many readers probably don’t.
This is a really interesting article on bond fund behaviour especially in a rising rate environment. A couple of questions from me my first time posting a question on the website. I am a big fan of Monevator!
1. Why don’t vanguard life strategy funds have a higher duration component in their bonds? You had mentioned ideally your duration of your bond portfolio should be your investment horizon. Then for vanguard life strategy 80/20 why isn’t the duration 30yrs?
2. I never looked into buying bonds directly. How do you do this in the UK market?
3. Am I right in saying that currently bonds and equities are positively correlated? Hence bonds are not offering the protection they actually normally do in portfolios?
Thanks for this article.
You mentioned at one point that you might write a bit more about matching bond fund duration to time horizon. It would be helpful to know a bit more about how to do this in practice.
For example, the Vanguard UK Gov Bond Index has an average duration of 11.3 years, average maturity of 15.8 years. It has obviously just taken a battering.
If I had a time horizon of, say, 12 years, this might be the “right” fund for me – if I’ve understood rightly – as I have time to ride out the dip. However, in 4 years time, I would be wanting a bond fund to match a time horizon of 8 years. So how to investors deal with this. Do we use rebalancing to gradually shift into lower average duration funds (if we can find them)? And in doing this, do we then fail to capture the recovery from losses, which depended on holding the fund for a longer period of time?
@ A Putters – I’m glad you enjoy the site and thank you for the comment.
According to Morningstar, the modified duration of LifeStrategy 80 is 8.88. That means its bond allocation is equivalent to an intermediate bond fund.
I don’t know how they chose that duration but I’d guess that LifeStrategy is a mass market product so they chose a fairly middle-of-the-road duration. I doubt many LifeStrategy investors use it to duration-match and duration 30 is risky in a rising rate environment.
Re: buying bonds directly – you can buy on the secondary market using a regular broker such as AJ Bell, Interactive Investor, iWeb, HL etc.
The UK’s Debt Management Office also has info here:
Yes, it’s fair to say that bonds and equities are positively correlated right now and high-quality government bonds are absolutely not protecting portfolios from equity downturns.
Correlations move over a range and the correlation between equities and bonds is positive more often than not. The reason they protect equity-dominated portfolios (but not all the time) is because the correlation often goes negative during a recession when demand slumps.
However, another common scenario is that equities and bonds go down together but bonds suffer less than equities i.e. the correlation is positive and bond protection is limited to not being as bad as equities.
Sometimes bonds perform worse than equities during a downturn – this typically happens in an inflationary crisis / stagflationary recession i.e. like the one we’re dealing with now.
There’s more on this played out historically in the UK here: https://monevator.com/how-to-protect-your-portfolio-in-a-crisis/
The upshot is that you’re better protected with a wider range of assets than equities and conventional bonds e.g. cash, gold, index-linked bonds
@ Chris F – the sentence you quote is preceded by two lines talking about bond funds. Then followed by an example talking about bond funds…
You’re right, that if someone never buys another individual bond after interest rates rise, or doesn’t reinvest their income, or doesn’t own a bond fund, or a rolling portfolio of individual bonds, then they won’t benefit from the higher income payments available.
@ Haphazard – thank you, I’ll do my best to answer those questions in the article I’m planning.
Some of my bonds have suffered worse than equities, this time, and March 2020, so I’m thinking just hold equities, cash, and gold. I don’t think that the increased yield, interest, coupon, or whatever will make up for the loss that will take more time to recover than I possibly have been allocated by GA and the GR.
If equities take a pounding will you stop investing in those? What about if gold loses 50%?
I thought equities had taken a pounding, mine certainly have, partly because some of them are tied in with bonds. Maximum gold holding would be 5%, I wouldn’t be worse off , that’s for sure.