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Weekend reading: Bonds have taught us a lesson in 2014

Weekend reading

Good reads from around the Web.

Once about as exciting as an ice bucket challenge for a polar bear, in recent years bonds have provoked some fierce debate.

In fact, for years it’s been a near-consensus opinion that bonds have been in a bubble.

Yet it’s a bubble that’s staunchly refused to burst.

The uncertainty has even grabbed the attention of sleepy passive investors, who have caught the whiff of the fear about bonds and wondered if they should really hold them in their supposedly speculation-proof portfolios.

We’ve tried to do our bit to steady the nerves, pointing out that bonds are in your portfolio for stability, not the expectation of great returns.

And also that passive investing works because you let the maths do the work, not speculation.

Gilts do the business in 2014

For my part as a legendary speculator in my own spare bedroom, I’ll admit I’ve thought bonds over-priced for ages – and far too early.

But having been humbled many times by the markets, I’ve urged the more vehement posters in the comments of this website to curb their expressions of certainty.

Any time we typed the word ‘bonds’ in 2013 – even in a simple ETF portfolio update – it felt like everyone and their dog stopped by to tell us that bonds were set to crash in 2014, and if you must hold fixed interest, hold cash.

Yet as I write the Vanguard UK government bond fund has returned 6.79% so far in 2014, beating the 2.74% return from UK shares!

Oh Mr. Market, how you love to put egg on the faces of the overconfident.

Bonds, bonds, everywhere, and barely any income to drink

Of course the year is not done, and even a year is a small time period over which to judge an asset class.

Yet government bonds – and the co-incident swelling of public debt around the world – have been defying investors for years, as Elaine Moore explains in her summary of the situation for the FT this week (note: link is a search result):

…bond markets have flourished, forcing investors to reconsider the level of risk they are willing to take in credit markets to find respectable yields. Debt sold by European countries that once faced a forced exit from the Eurozone has attracted levels of interest that would have seemed incredible two or three years ago. […]

The switch into riskier bonds isn’t confined to Europe, either. Flows of money into emerging markets have also swung up, with the “taper tantrum” swiftly forgotten.

Countries such as Ecuador, Ivory Coast and Pakistan have returned to markets – after years of civil war, political turbulence or debt defaults – to find investors more than willing to lend at rates of just 6 or 7 per cent. Those are the sorts of yields that prime borrowers such as the UK or US had to pay before the financial crisis.

Surprising stuff.

Now, I don’t think the demand for bonds this year is a reason not to be cautious about the asset class.

You can’t escape the mathematics of bond returns, and with yields already so low there’s really no way we could have very strong nominal returns for many future years. (Well, unless we saw deflation. Even a 1% return from a bond might be attractive if inflation was negative by 2%, for example.)

And personally, as a reckless and ill-advised active investor, I’m holding cash and selected obscure fixed income securities like preference shares to diversify my largely equity-focused portfolio for now.

But if I was a pure passive investor, I’d still have the chunk of my money in UK government bonds that’s suggested for my risk profile, perhaps split between bonds and cash.

My word, bonds

Meanwhile if I was an investing enthusiast prone to sharing my certain opinions on investing websites and bulletin boards, I’d try to have just a little more humility when it comes to bonds.

This is for two reasons.

Firstly, it’s clear something has to give someday with bonds. But just like with stock market corrections, as 2014 has proven in spades the timing is at least difficult, and likely impossible.

Secondly, many private investors weaned on shares don’t understand the mechanics of fixed interest investments.

The reality is that rates can slowly rise, bond prices can go down, and you can still end up with a positive total return – because you’re getting income, and you’re reinvesting it at progressively higher yields.

As a Vanguard white paper quoted on FE Trustnet put it earlier this month:

“A simple duration analysis can give a rough estimate of the price return, but this ignores the income that an investor earns over time,” said Vanguard.

“As the graph [below] shows, despite realising a -10.4 per cent price return over the next 10 years, the investor’s cumulative total return is actually positive at 31.4 %.”

“On an annualised basis, this is 2.8 per cent per year, roughly equal to the current yield on the 10-year gilt, which emphasises that the starting yield is key in forming forward-looking return expectations in fixed income.”

“Clearly, just focusing on capital losses ignores the bigger picture.”

Here’s the graph (sorry about the size, it came that way):

20140731_Vanguard1Rates higher (as being predicted by the market at the time of the White Paper) would have resulted in an okay long-term return, as a decade of increasing income made up for the capital losses.

Cut out and keep that graph if you want to understand bonds.

More reading week on bonds:

Bonds: Looking beyond interest rate risk – A Wealth of Common Sense

Have a great bank holiday weekend!

From the blogs

Making good use of the things that we find…

Passive investing

Active investing

Other articles

Product of the week: Yorkshire Building Society has launched a one-year cash ISA paying 2%, which is easily enough to put it at the top of the Best Buys table says ThisIsMoney. Better yet, it allows transfers in!

Mainstream media money

Some links are Google search results – in PC/desktop view these enable you to click through to read the piece without being a paid subscriber of that site.1

Passive investing

Active investing

  • Buffett is hoarding cash, but Joe Public isn’t – Reuters
  • Terry Venables’ new football talent fund [Search result]FT

Other stuff worth reading

  • Where is your area in the UK house price lottery? – ThisIsMoney
  • Mini-bonds: Hitting up the customer (Also this) – The Economist
  • When a cashback offer seems too good to be true – Guardian
  • London landlord fined for renting room you crawl into – Guardian
  • The world is getting ‘super-aged’ at a scary rate – CNN
  • The economics of Ebola drugs – The New Yorker

Book of the week: Attention die-hard passive investors: A new edition of The Bogleheads’ Guide to Investing has just been released. I haven’t read it yet but I presume there’s a strong US emphasis, as per the forum that’s behind the book. Still sure to be plenty of wisdom in there though.

Like these links? Subscribe to get them every week!

  1. Reader Ken notes that: “FT articles can only be accessed through the search results if you’re using PC/desktop view (from mobile/tablet view they bring up the firewall/subscription page). To circumvent, switch your mobile browser to use the desktop view. On Chrome for Android: press the menu button followed by “Request Desktop Site”.” []
{ 17 comments… add one }
  • 1 gadgetmind August 23, 2014, 10:26 am

    My passive bonds (blend of ISXF (to balance my heavy bank pref holdings), SLXX and VGOV) have done the job, but my infrastructure holdings – bought as something “bond like” because of prevailing “wisdom” regards bonds – have done *very* well for me. No regrets.

    I’m actually a trifle odd, and find fixed interest interesting, but it’s now close to impossible to find anything that isn’t already at nose bleed levels.

  • 2 Louise @ Good Financial Choices August 23, 2014, 2:23 pm

    Great weekend reading, enough links with worthwile reading to occupy my rainy afternoon.

  • 3 dearieme August 23, 2014, 2:43 pm
  • 4 Alex August 23, 2014, 2:49 pm

    1. Thanks, as ever, for the links.

    2. For accuracy: the article “Why your fund’s return may be better than yours” is from Vanguard [US]; not Morningstar as written.

  • 5 Neverland August 23, 2014, 3:15 pm

    The thing about the coupon providing insurance for bond price drops only works if yields are relatively high. If yields are real low, like they are now, there isn’t much of a cushion

  • 6 Grand August 23, 2014, 4:06 pm

    This whole bond debacle has consumed me this month. I’ve gone back to posts from 2008 on Monevator, reading as much as I can in order to make an informed decision whether to stay within my asset allocation band for fixed income or to add cash to my life hack portfolio. I’ve even asked some fund managers in the area I work in for advice…. In the end I bought a holding of Vanguards Short term global bond fund (If interest rates rise, lower maturities mean the coupon can be reinvested in newly issued bonds if what i’ve learnt is correct)… And the main reason as to why I did was because from reading this website for the last 18 months, along with Berstien and Hale. Bond’s are not supposed to drive the returns of my portfolio, they’re a buffer for when things go tits up in the market…. (I’ve only been at the investing game for a year so am yet to experience this first hand) I just hope this theory is sound.

  • 7 Grand August 23, 2014, 4:22 pm

    Question to monevator readers – How many funds do you have in your portfolio’s? I’m at 10. Is this too many? – At the moment I feel that I am not diversified enough, I feel I am over exposed regions with high valuations and under esxposed to certain regions that have greater potential to grow. Below are my funds

    Global developed Small Cap equity
    Global Value Developed equity
    Global ex UK equity
    UK equity
    Emerging Markets
    Developed Europe
    Property Uk
    UK Gilts
    UK Gilts Inflation linked
    Short Term Global Bonds

    I remember reading this article on monevator http://monevator.com/preservation-of-wealth/ which really pushed home the argument for diversification, Is a portfolio with say 15 funds just far to complex?

  • 8 Jon August 23, 2014, 4:53 pm

    @Grand, after reading Hales book I got carried away. I,ve come full circle now and concluded simplification is best in life hold just 2 asset classes for my SIPP. Vanguard VWRL and cash. I will rotate out of cash into bonds when rates increase. It’s much easier to rebalance. I recall Monevator writing an article showing the differential in returns between a simple 2 asset portfolio compared to a multi asset portfolio was very small over the long term.

  • 9 weenie August 23, 2014, 6:37 pm

    @Grand – I’m invested in 20 funds so no, I don’t think 10 is too many! 🙂

    At some point in the future, I may do what Jon has done and go for simplification but I’m happy with all my holdings right now.

  • 10 The Investor August 23, 2014, 8:29 pm

    @Neverland — The graph assumes a starting yield of about 2.8% from memory. Not so high…

  • 11 Grand August 23, 2014, 8:59 pm

    @Weenie thanks for sharing @Jon are you more or less interested in personal finance since simplifying your portfolio?


  • 12 Aidan August 24, 2014, 1:56 am

    @Jon you might be waiting a long time. I would rather have gold and/or short duration bonds right now than cash which is guaranteed to lose real value.

    The extra 1-2% annual return you can squeeze from a tilted portfolio – trivial though it sounds – does add up over time and arguably it is only worth doing over a 20+ year duration due to extended periods where it might not work favourably. Incidentally, 2% extra per year compounded over 20 years gives nearly a 50% uplift. What’s not to like?

    Notwithstanding, I think I will eventually coalesce my various equity funds towards just VWRL during later decummulation. There is indeed a lot to be said for the simplicity of a two fund portfolio. But for me, anyway, that is a long way off.

  • 13 magneto August 24, 2014, 4:49 pm

    Notice when highlighting bonds can eke out a positive total return with rising yields, we forget that if the yield is spent, all that is left is falling capital.
    In contrast there is a tendency with stocks to look only at price/indices alone, when weighing up gains, forgetting the income.
    Nevertheless we grit ou teeth and hold IGLT, INXG, also as mentioned above Infrastructure Funds as quasi bonds, together with substantial cash while waiting to see what develops in fixed income.
    Thanks for the good article. This is a subject of great interest.

  • 14 Retirement Investing Today August 24, 2014, 6:13 pm

    Thanks for the hat tip TI.

    My plan and strategy is fully mechanical with the bonds portion of my portfolio consisting of NS&I Index Linked Savings Certificates and Index Linked Gilts. For now they both yield nothing in real terms so this post has come at a good time as I weigh up what to do next. Over the last 7 years doing nothing different has proven to be successful so that’s the likely path.


  • 15 The Investor August 24, 2014, 7:33 pm

    @RIT — Yes, they protect capital and I think are a great alternative for private investors. Successful is of course different to optimal in the circumstances. Holding governments bonds has been a great move, even if crazy European ones. I don’t know that it was predictable though.

    @All –Cheers for the comments! When I started investing few private investors knew or cared about bonds. I wonder what it says that we all have our views now?

  • 16 JAL August 25, 2014, 9:46 am

    Oooh… A nice bond piece that essentially reminds us all that we can’t time the market.. and then a link to an article telling us that Buffett is holding a lot of cash at the moment.. I feel like I’m being tested 😉

  • 17 Jon August 25, 2014, 9:03 pm

    @Grand, I’m still very interested in finance and read voraciously, bulk of my portfolio is held in a passive HYP within ISAs. My own experience is that activity is a performance killer. Doing nothing is very hard but once you,ve chosen your funds or shares, apart from rebalancing, do not change, sit on it.

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