(U.K) Advice sought on Long Term Gilt index

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LongTermInvestor88
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(U.K) Advice sought on Long Term Gilt index

Post by LongTermInvestor88 » Tue Apr 17, 2018 11:59 am

Hi Bogleheads

After some initial posting and questions on designing portfolio I settled on more of a slice and dice global portfolio. Because investing for long term 30 odd years. Decided to go 90 percent equities. I have read in few posts and Tim Hales book that for someone with such a high equities holding as this longer term bond's/gilts may provide a better diversifier for equity falls. With current low interest rates and expected rises what are people's thoughts on using this as a strategy. My understanding is that if rates increase as expected bond prices will fall. I Am considering the vanguard inflation linked gilt index. If these interest rate rises are expected would the price of this index be priced in at the moment? Or does this not work similarly to equities? Thanks

magneto
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Re: (U.K) Advice sought on Long Term Gilt index

Post by magneto » Tue Apr 17, 2018 12:56 pm

LongTermInvestor88 wrote:
Tue Apr 17, 2018 11:59 am
Decided to go 90 percent equities. I have read in few posts and Tim Hales book that for someone with such a high equities holding as this longer term bond's/gilts may provide a better diversifier for equity falls.
Am considering the vanguard inflation linked gilt index. If these interest rate rises are expected would the price of this index be priced in at the moment? Or does this not work similarly to equities? Thanks
Seem to recollect Tim Hale generally suggests keeping Bonds to short-duration?
Take the risk on the Stock-side?

Was the high Stock situation a special case?
Can almost then see some logic.
Which page?

On the pricing - Yes and No
Expectations can change.
'There is a tide in the affairs of men ...', Brutus (Market Timer)

alex_686
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Re: (U.K) Advice sought on Long Term Gilt index

Post by alex_686 » Tue Apr 17, 2018 1:01 pm

First, why gilts? Is your primary currency the UK pound? If so, o.k. If not I would be worried about currency risk.

Second, expected increases in bond yields are already priced in. We can dig into this if you want.

LongTermInvestor88
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Re: (U.K) Advice sought on Long Term Gilt index

Post by LongTermInvestor88 » Tue Apr 17, 2018 1:37 pm

magneto wrote:
Tue Apr 17, 2018 12:56 pm
LongTermInvestor88 wrote:
Tue Apr 17, 2018 11:59 am
Decided to go 90 percent equities. I have read in few posts and Tim Hales book that for someone with such a high equities holding as this longer term bond's/gilts may provide a better diversifier for equity falls.
Am considering the vanguard inflation linked gilt index. If these interest rate rises are expected would the price of this index be priced in at the moment? Or does this not work similarly to equities? Thanks
Seem to recollect Tim Hale generally suggests keeping Bonds to short-duration?
Take the risk on the Stock-side?

Was the high Stock situation a special case?
Can almost then see some logic.
Which page?

On the pricing - Yes and No
Expectations can change.
Magneto "The more risk tolerant long-term investor At the other end of the risk spectrum, imagine that you are a pretty risk tolerant investor comfortable with suffering interim losses in pursuit of more aggressive goals. As a consequence you own a pretty high allocation of equities/risky assets, let us say 80%. Unlike the cautious investor, you are protected reasonably well from inflation by owning equities and global commercial property in your growth-oriented mix. You are not too worried by volatility, as reflected in your risky asset mix, unlike the cautious investor. What you really want to do is to own the best diversifier when the equity market crashes, but giving up as little equity exposure as you can. UK gilts are a potentially strong diversifier of equity market risk. Despite their normally positive correlations to equities, at times of equity market trauma high-quality bonds (gilts) have the potential, although not the certainty, to act as havens of safety and liquidity, with commensurate positive consequences for yields (down) and prices (up) as investors flood into this asset class. David Swensen of the Yale University endowment fund makes this point clearly. ‘Only high quality, long-term bonds perform well in times of severe stress, allowing investors to view the opportunity costs of holding bonds as an insurance premium incurred to insulate portfolios from extreme positions.’ (David Swensen, CIO Yale Endowment) This seems to make logical sense and the empirical evidence seems to support the case reasonably well. As ever, in investing you will be able to find occasions when this did not work. It is a question of balance. Simply owning lower volatility, shorter-dated, high credit quality bonds works as a reasonable alternative. Note that this exposure could be gained by owning non-GBP denominated bonds, but with all currency hedged back to Sterling by the fund manager."

LongTermInvestor88
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Re: (U.K) Advice sought on Long Term Gilt index

Post by LongTermInvestor88 » Tue Apr 17, 2018 1:39 pm

alex_686 wrote:
Tue Apr 17, 2018 1:01 pm
First, why gilts? Is your primary currency the UK pound? If so, o.k. If not I would be worried about currency risk.

Second, expected increases in bond yields are already priced in. We can dig into this if you want.
I am in the U.K Alex so yes currency is pounds

Valuethinker
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Re: (U.K) Advice sought on Long Term Gilt index

Post by Valuethinker » Wed Apr 18, 2018 4:16 am

LongTermInvestor88 wrote:
Tue Apr 17, 2018 11:59 am
Hi Bogleheads

After some initial posting and questions on designing portfolio I settled on more of a slice and dice global portfolio. Because investing for long term 30 odd years. Decided to go 90 percent equities. I have read in few posts and Tim Hales book that for someone with such a high equities holding as this longer term bond's/gilts may provide a better diversifier for equity falls. With current low interest rates and expected rises what are people's thoughts on using this as a strategy. My understanding is that if rates increase as expected bond prices will fall. I Am considering the vanguard inflation linked gilt index. If these interest rate rises are expected would the price of this index be priced in at the moment? Or does this not work similarly to equities? Thanks
Hi

Nominal bonds are probably a better hedge against stock market volatility than inflation linked (which are more volatile). Conversely, as a long term investment (but see below) inflation linked are better.

For the sort of barbell portfolio you are trying to construct then LT nominal gilts are probably the best asset. Note however that 10% gilts will make almost no difference to the volatility of your portfolio. You are not buying enough insurance to really matter. If you are less than 20% or 25% say in gilts, it's not going to make much difference-- it's only when you get to that level that it has *some* impact.

Some more points re UK gilts market below

Indexed Linked Gilts are a nightmare. The problem is the actuarial rules force the pension funds and insurance cos to hold long duration inflation linked assets.

Thus the price gets bid up and the yield gets bid down. If you look in the FInancial Times, you will see ILGs yielding -1.5% : yes, that's right, if inflation is as the market expects it to be you will lose 1.5% of your wealth, in real terms, every year-- compounded. And the LT gilt index has a duration of over 20 years.

Solutions:

- straight gilts - but here again the duration is long (about 12.9 years). If interest rates rise, then the value of the fund will fall. However just owning the gilt index is a reasonable strategy

- ST gilts - this is what I settled on - the return is just about 0 at current yields (but then, the 10 year gilt is yielding about 1.2% last I checked?)

- international bonds - however generally they hedge back to GBP (see below)

- take credit risk - hold corporate bonds. I would recommend sterling corporate bonds funds - investment grade only. There's risk in that, the largest sector of issuance is financial services, so if we reran 2008-9 it would be double whammy (the banks go down, their bonds go down). It probably gives you another 1% or so in yield

I would also argue if HM Opposition becomes the government in the next election, then GBP drops at least 10%-- it depends on whether it is a surprise or not whether the market moves before the election (it tends to follow the polls) or waits until after. Perhaps the most likely outcome is some sort of Minority Government in coalition.

You may or may not want to hedge your currency exposure re your equities. Generally I do not.

What funds you have available to you in pension, ISA etc makes a big difference. Don't forget to collect your employer match in your pension. The rule of thumb is:

- pension first, to employer match
- ISA
- pension
- taxable account

Valuethinker
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Re: (U.K) Advice sought on Long Term Gilt index

Post by Valuethinker » Wed Apr 18, 2018 4:41 am

alex_686 wrote:
Tue Apr 17, 2018 1:01 pm
First, why gilts? Is your primary currency the UK pound? If so, o.k. If not I would be worried about currency risk.

Second, expected increases in bond yields are already priced in. We can dig into this if you want.
UK gilts are an odd one. The long gilt is down around 1.4% yield (30 year).

There's structural things going on:

- via the Quantitative Easing programme, the Bank of England (on behalf of HM Treasury) owns c. 30% of all gilts outstanding

- UK pension funds are required to hedge their long term liabilities w long term risk free assets - this creates a structural demand for both nominal and Index Linked gilts which drives the yield down. Index Linked Gilts yield minus real rates of -1.5% ish across the curve.

So it's not entirely clear that the current yield for gilts reflects expectations of interest rate rises. At least gilt yields of 1% and inflation of over 2% seems a long run unsustainable position.

There's also event risk. HM Official Opposition (the Labour Party) has signalled an intention to use monetary policy to fund infrastructure projects-- central bank buys bonds directly from infrastructure companies. Such a plan would cause sterling to fall, and probably inflation to rise.

If the UK economy remains weak, Brexit turns out to be a mess, then perhaps the market is correctly forecasting interest rate rises. Unemployment however is at a 2 decade low (there's some issues with that I won't go into re Zero Hours contracts etc.), immigration is going to be sharply cut back, so therefore inflation could turn out to be more of a problem than the market currently thinks and the Bank of England more hawkish.

For 10% of a portfolio it won't matter much, but given the low yields on Indexed Linked Gilts (minus 1.5% real) and the long duration of the ordinary gilt index (around 12.9 years, the longest of any major govt bond index) I have "solved" the problem by holding ST gilt funds (with effective yield of nearly zero).

However I still have the currency risk-- event risk if we get a change of government. C'est la vie, my options are relatively limited inside my pensions.

LongTermInvestor88
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Re: (U.K) Advice sought on Long Term Gilt index

Post by LongTermInvestor88 » Thu Apr 19, 2018 7:22 am

Thank you Valuethinker real helpful again which is very much appreciated. As with Vanguard the fund I am looking at is www.vanguardinvestor.co.uk/investments/ ... _fund_link

Am I right in thinking that bond index's operate in much the same way as equities? I.e that the current expectations of bonds are priced in already and this is what I am effectively buying? If you look at the fund am considering there seemed to be big gains in price in 2013 and again 2015 what do you think caused this just out of interest? My bond allocation is quite small as you rightly said. I'm not so much at present looking for safety. I can tolerate the extra volatility. My thinking is a longer term rebalancing benefit. With yearly rebalancing and continuing to sell high buy low it seems quite unlikely that I won't be gaining something from this strategy

Valuethinker
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Re: (U.K) Advice sought on Long Term Gilt index

Post by Valuethinker » Thu Apr 19, 2018 11:35 am

LongTermInvestor88 wrote:
Thu Apr 19, 2018 7:22 am
Thank you Valuethinker real helpful again which is very much appreciated. As with Vanguard the fund I am looking at is www.vanguardinvestor.co.uk/investments/ ... _fund_link

Am I right in thinking that bond index's operate in much the same way as equities? I.e that the current expectations of bonds are priced in already and this is what I am effectively buying? If you look at the fund am considering there seemed to be big gains in price in 2013 and again 2015 what do you think caused this just out of interest?
Yes market expectations are embedded in the Yield Curve (years to maturity on the X axis, yield of the bonds on the Y axis).

The big price gains were the market's realization that interest rates were not going to be rising as soon as they thought, due to lower inflation prospects/ a weaker economy/ signals by the Bank of England re interest rates.
My bond allocation is quite small as you rightly said. I'm not so much at present looking for safety. I can tolerate the extra volatility. My thinking is a longer term rebalancing benefit. With yearly rebalancing and continuing to sell high buy low it seems quite unlikely that I won't be gaining something from this strategy
If you use long duration bonds like that you are increasing your protection against deflation.

However +1% in interest rates, all things being equal, will cause a -20% fall in the value of the fund (all things are never equal, but it's a rough guide ie -1 x Duration)- -however the reverse is true if interest rates fell by 1% (it would not be easy for the Bank of England to engineer a -1% fall in interest rates across the whole yield curve, if its current Base Lending Rate is 0.5%). You are taking a big bet that bond yields don't rise.

You pays your money and you takes your choice. Your strategy, vs. a conventional gilt index (duration about 12.9 years) will give higher volatility. In actual return terms *at the moment* the upward slope on the gilt yield curve is not particularly steep. The market does not pay a big premium in terms of higher yield for going out 30 years rather than 10 years on gilts.

I'd be more comfortable with a conventional gilt index fund/ ETF. 12.9 years is plenty of duration for me. If we have further falls in inflation (currently 2.7%) then that's a poor strategy.

BTW your assumption that long bonds hedge equities better is true:

- IF it's a recession with cuts in interest rates that causes the fall in equity markets

However if it is some other factor, such as political disruption, you could see a spike in interest rates *and* a fall in markets. In which case, the two are going to go down together.

Let me give you an example. Imagine the next government in the UK is well to the left of the current one - I think we'd agree that is possible ;-). Then, we could see UK interest rates spike (investors impose a higher risk premium on sterling assets given uncertainties re deficit and inflation from the next government). And we could see equity markets fall-- UK for sure, on fears of higher taxation. But it might come at a time of global geopolitical uncertainty ;-). Your 2 factors in your portfolio (long duration equities, long duration bonds) would both be working against you.

When 30 year gilts are running at something like 1.6% yield (or they were, haven't checked for a few weeks) then you are taking big risk on moves in interest rates.

Valuethinker
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Re: (U.K) Advice sought on Long Term Gilt index

Post by Valuethinker » Fri Apr 20, 2018 3:39 am

https://www.bloomberg.com/markets/rates ... t-bonds/uk

Yield on 10 year gilt 1.49%

Yield on 30 year gilt 1.89%

Unless you believe the UK is going into a deflationary slump, then you are being paid very little for the additional risk of holding the 30 year bond (0.4% - 40 basis points).

I do not find that to be attractive in terms of risk/ return. And the equivalent 30 year Indexed Linked Gilt (which is more or less risk free) is

https://www.fixedincomeinvestor.co.uk/x ... oupid=3530

-1.4% assuming a 3% inflation rate.

This does not seem like good risk/ return to me, to go out to 30 years on the yield curve. I'd rather own the gilts market, which has the longest duration of any government bond market (c. 12.9 years). That's plenty of interest rate risk to take when yields are this low.

I believe there are structural factors why long gilts yields are so low: 1. Quantitative Easing programme has bought these bonds up, limiting supply and lowering yields 2. pension funds and insurance companies are, by actuarial rules, forced to hold these securities to hedge their liabilities.

LongTermInvestor88
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Re: (U.K) Advice sought on Long Term Gilt index

Post by LongTermInvestor88 » Fri Apr 20, 2018 11:24 am

Hmmm 🤔 there is alot to this choice of bonds thing isnt there Valuethinker 🙂. The description of circumstances of long term bonds and equities heading down together have gave pause for thought. Although really do find hard to accept such low returns on the ST Gilts. As hold such a global equities portfolio am looking again at www.vanguardinvestor.co.uk/investments/ ... _fund_link. This is a popular lifestrategy fund. I like the global aspect, this may hedge my global equities well? Although like most bond funds didn't seem to hold value in last correction I do imagine this does provide quite low correlation should there be big falls in equity prices over a sustained period of time. Would you imagine this to be the case Valuethinker? and that this might be a good compromise on the barbell approach i am seeking.

Valuethinker
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Re: (U.K) Advice sought on Long Term Gilt index

Post by Valuethinker » Fri Apr 20, 2018 4:58 pm

LongTermInvestor88 wrote:
Fri Apr 20, 2018 11:24 am
Hmmm 🤔 there is alot to this choice of bonds thing isnt there Valuethinker 🙂. The description of circumstances of long term bonds and equities heading down together have gave pause for thought. Although really do find hard to accept such low returns on the ST Gilts.
The good news is that, with 10% of your portfolio (to my mind, you'd be better off with 20%), it won't make much difference ;-).

As hold such a global equities portfolio am looking again at www.vanguardinvestor.co.uk/investments/ ... _fund_link. This is a popular lifestrategy fund. I like the global aspect, this may hedge my global equities well?
The nature of foreign currency hedging is that it brings returns between risk free bonds back to the return of the risk free bond in the currency into which you are hedged. Thus, 1% pa for a GBP hedged fund.

Any additional return you receive is the consequence of additional credit risk. Plus in that fund optionality-- many of the corporate bonds, and US mortgage backed securities, have call risk-- the risk that the borrower can repay earlier if interest rates drop, and extend and repay later (than expected) if interest rate rises (thus, duration is not constant, but moves against you: outwards if interest rates increase, downwards if interest rates fall => exactly the opposite of what you as an investor would wish).

Advantages of this fund:

-lower duration thus less sensitive to rising interest rates than a straight gilt index fund

Disadvantage:

- higher credit risk and higher correlation with equities. Thus, when your equity portfolio is falling, this one is more likely to fall.

Given this is 10% of your portfolio, I'd take the ordinary gilt index fund and be done with it. Duration 12.9 years from memory-- that's enough. Plenty of interest rate risk, but also you'll do well if interest rates do not rise as fast as the market expects.

The ST gilt fund will pay close to 0%, but for 10% of your portfolio that's not terribly meaningful against it paying 1% (10% of your portfolio paying 0% vs. 10% paying 1%). The advantage of the gilts fund is if there is deflation - it will do better.
Although like most bond funds didn't seem to hold value in last correction I do imagine this does provide quite low correlation should there be big falls in equity prices over a sustained period of time. Would you imagine this to be the case Valuethinker? and that this might be a good compromise on the barbell approach i am seeking.
Higher correlation w equities than a straight investment grade government bond fund: global or UK gilt fund.

If it hits the fan like 2008-09, then corporate bonds and anything but investment grade countries, will go down with equities. A lot of corporate bonds are actually issued by financial institutions, and that would really hurt in a rerun of that scenario.

LongTermInvestor88
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Re: (U.K) Advice sought on Long Term Gilt index

Post by LongTermInvestor88 » Mon Apr 23, 2018 7:14 am

Valuethinker wrote:
Fri Apr 20, 2018 4:58 pm
LongTermInvestor88 wrote:
Fri Apr 20, 2018 11:24 am
Hmmm 🤔 there is alot to this choice of bonds thing isnt there Valuethinker 🙂. The description of circumstances of long term bonds and equities heading down together have gave pause for thought. Although really do find hard to accept such low returns on the ST Gilts.
The good news is that, with 10% of your portfolio (to my mind, you'd be better off with 20%), it won't make much difference ;-).
As hold such a global equities portfolio am looking again at www.vanguardinvestor.co.uk/investments/ ... _fund_link. This is a popular lifestrategy fund. I like the global aspect, this may hedge my global equities well?
The nature of foreign currency hedging is that it brings returns between risk free bonds back to the return of the risk free bond in the currency into which you are hedged. Thus, 1% pa for a GBP hedged fund.

Any additional return you receive is the consequence of additional credit risk. Plus in that fund optionality-- many of the corporate bonds, and US mortgage backed securities, have call risk-- the risk that the borrower can repay earlier if interest rates drop, and extend and repay later (than expected) if interest rate rises (thus, duration is not constant, but moves against you: outwards if interest rates increase, downwards if interest rates fall => exactly the opposite of what you as an investor would wish).

Advantages of this fund:

-lower duration thus less sensitive to rising interest rates than a straight gilt index fund

Disadvantage:

- higher credit risk and higher correlation with equities. Thus, when your equity portfolio is falling, this one is more likely to fall.

Given this is 10% of your portfolio, I'd take the ordinary gilt index fund and be done with it. Duration 12.9 years from memory-- that's enough. Plenty of interest rate risk, but also you'll do well if interest rates do not rise as fast as the market expects.

The ST gilt fund will pay close to 0%, but for 10% of your portfolio that's not terribly meaningful against it paying 1% (10% of your portfolio paying 0% vs. 10% paying 1%). The advantage of the gilts fund is if there is deflation - it will do better.
Although like most bond funds didn't seem to hold value in last correction I do imagine this does provide quite low correlation should there be big falls in equity prices over a sustained period of time. Would you imagine this to be the case Valuethinker? and that this might be a good compromise on the barbell approach i am seeking.
Higher correlation w equities than a straight investment grade government bond fund: global or UK gilt fund.

If it hits the fan like 2008-09, then corporate bonds and anything but investment grade countries, will go down with equities. A lot of corporate bonds are actually issued by financial institutions, and that would really hurt in a rerun of that scenario.
Hi Valuethinker

I've decided to go with your suggestion on 10 percent of the ordinarily gilt index fund. I've also decided to up bonds by another 10 percent and use this for the Global bonds fund. I think the two combined offer me some diversification benefits and should atleast provide pretty decent stability should equities fall. Although you point on the potential risks of the corporate bonds has been noted and appreciated

Valuethinker
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Re: (U.K) Advice sought on Long Term Gilt index

Post by Valuethinker » Mon Apr 23, 2018 3:31 pm

LongTermInvestor88 wrote:
Mon Apr 23, 2018 7:14 am


Hi Valuethinker

I've decided to go with your suggestion on 10 percent of the ordinarily gilt index fund. I've also decided to up bonds by another 10 percent and use this for the Global bonds fund. I think the two combined offer me some diversification benefits and should atleast provide pretty decent stability should equities fall. Although you point on the potential risks of the corporate bonds has been noted and appreciated
Hi

I think it's a better solution, in truth.

What you want is an asset allocation you can stick to through thick and thin, and which gives you ammunition for rebalancing precisely when it's psychologically hard to do-- when equity markets are falling.

As to the split of funds-- the reality is, we will only know after the fact which one was the "right" fund, and so it's better to "split the difference".

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