It’s a hard time to be a risk-averse investor. All the funds in the Monevator model portfolio are burning red and raw. And whereas in previous market beatings our bonds have acted like a shock-absorbing magazine down the trousers, this time they’ve been as much relief as barbed wire underpants.
Let’s cut to the gore. Brought to you in 5D-Nightmare-O-Vision:
[1]
The Slow & Steady portfolio is Monevator’s model passive investing [2] portfolio. It was set up at the start of 2011 with £3,000. An extra £1,055 is invested every quarter into a diversified set of index funds, tilted towards equities. You can read the origin story [3] and find all the previous passive portfolio posts [4] tucked away in the Monevator vaults.
Year-to-date the model portfolio is down 10%. In cash terms, we’ve given up one year of growth.
That doesn’t sound so bad… until you slap on 9% inflation.
In real terms we’re heading into bear country.
Big picture, that’s still okay. You’ve got to be able to handle bear markets [5]. They run wild at least once a decade.
But things seem especially grim right now because nothing seems to be working.
In particular, if you thought bonds were ‘safe’ then the current crash must feel bewildering. Unfortunately, high, unexpected inflation [6] is the bête noire of bonds.
Long bonds have had a dreadful year so far. 2022 looks like it could inflict scars as deep [7] as 1974’s real loss of -29% or 1916’s -33% on holders of UK gilts.
Other fixed income sub-asset classes have been various shades of awful, too:
What rampant inflation does to fixed income
[8]
Source: justETF [9]. 7 Dec 2021-9 Jul 2022. (I’ve used representative ETFs for ease of charting).
When high inflation takes the world by surprise this is what you’d expect to see.
Fixed income funds take capital losses because bond prices [10] fall as their yields rise.
Long duration gilts crash hardest. They’re full of low-yielding bonds with decades to go until they mature, and so their prices fall farthest when their interest rates climb.
Long-dated index-linked bond funds (labelled ‘long linkers’ on the chart) face-plant for the same reason. They’re stuffed full of low-interest bonds that are uncompetitive versus the higher-yielding bonds now entering the market. So their yields must rise – and their price fall – to bring them back in line. We first warned of the dangers [11] baked into such funds in 2016.
Short gilt funds are less perturbed by rising yields. Like the other bond funds their holdings are repriced as interest rates rise, hence the small loss we see on the chart. But as their bonds have only a few years left to run, they were already priced closer to their redemption value. This means there’s less scope for capital losses. Moreover the uncompetitive bonds they own will mature sooner and disappear off the books. The fund will recycle the money released into higher-interest paying bonds. Over longer timeframes this process can offset the fund’s capital losses with higher income, bolstering total returns.
Better than nothing
As a bond holder, earning a higher yield will make you better off. But it takes time to recover from the initial price drop.
The higher-yielding bonds we now own are like nanobots. Laying down interest like beads of protein, they’ll eventually seal the hole that was torn in your wealth by rising rates.
Every bond fund benefits from this same self-regenerating mechanism. But it takes higher-yielding long bond funds more time to redeploy and they have a bigger hole to fill. Hence the greater losses we see.
The upside is that in a stable or falling interest rate environment – such as the past decade – long bond funds eventually outperform their shorter-dated brethren. (Something to look forward to again, someday.)
A medium or intermediate gilt fund (labelled ‘medium’ on the graph) is a muddy compromise sitting between the long and short bond paths charted above.
Even short index-linked bond funds (labelled ‘short linkers’) suffer capital losses from rising yields. When those falls overwhelm their inflation-adjusted interest payments, the funds disappoint despite the inflationary backdrop.
That’s what’s happening right now with the Short Duration Global Index Linked fund in the Slow & Steady portfolio.
We’d prefer it to stiffen against inflation immediately like a bulletproof vest. Unfortunately we must do some bleeding first.
At least our linker fund is less bad than most of our other holdings. (How’s that for a glowing recommendation?)
Cash is like an extremely short-dated bond, hence there are no capital losses in the chart. That’s as good as it gets in the current moment. Though obviously cash is still down after inflation.
No good choices
While long and medium government bond funds will unfortunately be a liability if market interest rates continue to rise, you’ll thank god for them if the economy tips into a deep recession. (Of the non-stagflationary variety).
That’s why you’d be wrong to throw your medium bond holdings onto the fire.
You might be cursing your luck if you’ve recently been burned. But you shouldn’t question your need for diversification. For an escape pod with a decent chance of working when the wheel of fortune suddenly spins again.
Personally I’ve felt like a bystander caught in a Mexican standoff for a while now. Trapped between the cocked pistols of rising rates, market shocks, and inflated asset prices.
There was no way out without getting hurt.
The best we could do was advocate a multi-layered defence [12] against the uncertainty:
- 60% Global equities (growth)
- 10% High-quality intermediate government bonds (recession resistant)
- 10% High-quality index-linked government bonds (inflation resistant)
- 10% Cash (liquidity and optionality)
- 10% Gold (extra diversification)
A young, risk-tolerant investor should probably opt for more in equities and allow future decades of compounding to smooth out the potholes in the road.
Ready for anything
There seems a reasonable probability that higher inflation [13] will stink the place up for longer than most of us imagined 18-months ago.
If that’s so, then our portfolios are in for a hard time.
But don’t mistake probability for certainty.
The masters of the universe didn’t see inflation coming. They said it was transitory. Now it could herald regime change [14].
They don’t know and neither do we.
So keep your options option.
New transactions
Every quarter we buy £1,055 of shots for our portfolio punch bowl. Our poison is split between seven funds, as per our predetermined asset allocation.
We rebalance using Larry Swedroe’s 5/25 rule [15]. That hasn’t been activated this quarter.
These are our trades:
UK equity
Vanguard FTSE UK All-Share Index Trust – OCF [16] 0.06%
Fund identifier: GB00B3X7QG63
New purchase: £52.75
Buy 0.234 units @ £225.24
Target allocation: 5%
Developed world ex-UK equities
Vanguard FTSE Developed World ex-UK Equity Index Fund – OCF 0.14%
Fund identifier: GB00B59G4Q73
New purchase: £390.35
Buy 0.78 units @ £500.22
Target allocation: 37%
Global small cap equities
Vanguard Global Small-Cap Index Fund – OCF 0.29%
Fund identifier: IE00B3X1NT05
New purchase: £52.75
Buy 0.145 units @ £363.39
Target allocation: 5%
Emerging market equities
iShares Emerging Markets Equity Index Fund D – OCF 0.19%
Fund identifier: GB00B84DY642
New purchase: £84.40
Buy 45.867 units @ £1.84
Target allocation: 8%
Global property
iShares Global Property Securities Equity Index Fund D – OCF 0.17%
Fund identifier: GB00B5BFJG71
New purchase: £52.75
Buy 22.265 units @ £2.37
Target allocation: 5%
UK gilts
Vanguard UK Government Bond Index – OCF 0.12%
Fund identifier: IE00B1S75374
New purchase: £305.95
Buy 2.01 units @ £151.93
Target allocation: 29%
Global inflation-linked bonds [17]
Royal London Short Duration Global Index-Linked Fund – OCF 0.27%
Fund identifier: GB00BD050F05
New purchase: £116.05
Buy 106.273 units @ £1.09
Dividends reinvested: £80.72 (Buys another 73.92 units)
Target allocation: 11%
New investment = £1,055
Trading cost = £0
Platform fee = 0.35% per annum.
This model fund portfolio is notionally held with Charles Stanley Direct. Take a look at our online broker table [18] for cheaper platform options if you use a different mix of funds. InvestEngine [19] is even cheaper if you’re happy to invest in ETFs only.
Average portfolio OCF = 0.16%
If all this seems too much like hard work then you can buy a diversified portfolio using an all-in-one fund [20] such as Vanguard’s LifeStrategy series [21].
Interested in tracking your own portfolio or using the Slow & Steady investment tracking spreadsheet? This piece on portfolio tracking [22] shows you how.
Take it steady,
The Accumulator