New to bonds - trying to understand [UK]

For investors outside the US. Personal investments, personal finance, investing news and theory.
Sister forums: Canada, Spain (en español)
---------------
Post Reply
Topic Author
seeker7
Posts: 5
Joined: Sat Oct 05, 2019 4:40 am

New to bonds - trying to understand [UK]

Post by seeker7 » Sat Oct 05, 2019 1:57 pm

Hello everyone,

I have been trying to invest in different ways for 15 years without satisfactory results. After reading a few books and blogs, I decided to stop trying to pick stocks and time the market. So I decided to just invest in a mix of equity and bonds, rebalance regularly and increase the share of bonds as the deadline approaches.

However, I am totally new to bonds, treasuries, gilts, etc. I am based in the UK, but my question is quite general. If I have a look at a bond ETF like this one:

https://vanguardinvestor.co.uk/investme ... _fund_link

It seems to me the annual prices vary quite wildly (-3.8%, +15%)... I thought bonds were a lot less volatile than this. At the end of the day, they are just a fixed income product with a low probably of something going wrong (I'm talking about treasuries or gilts here, not junk bonds), so how come the prices vary so much?

Thank you for any help in clearly my confusion!

TedSwippet
Posts: 2474
Joined: Mon Jun 04, 2007 4:19 pm
Location: UK

Re: New to bonds - trying to understand [UK]

Post by TedSwippet » Sun Oct 06, 2019 12:54 pm

Welcome.
seeker7 wrote:
Sat Oct 05, 2019 1:57 pm
It seems to me the annual prices vary quite wildly (-3.8%, +15%)... I thought bonds were a lot less volatile than this.
Gilt and bond prices are historically perhaps less volatile than stock prices, but they can still be pretty volatile even so. The simplest thing to understand is how the prevailing interest rate affects their prices. If interest rates fall, the price of gilts and bonds on the secondhand market generally rises so that the 'coupon' -- that is, what they pay out -- drops when viewed as a percentage of the price by an approximately similar amount, and the other way around if interest rates rise.

That's not the only factor, though. The safety (creditworthiness) of the issuer is another. So is inflation. And just like stock market, bond prices will move on perceptions or expectations of changes in these factors (Brexit, sigh), as well as any actual changes (such as a central bank or government setting an interest rate). The performance and volatility of a bond or gilt fund is an averaging out of all these things over the bonds or gilts that it holds.

More in this wiki page: Bond basics - Bogleheads

xxd091
Posts: 92
Joined: Sun Aug 21, 2011 4:41 am
Location: UK

Re: New to bonds - trying to understand [UK]

Post by xxd091 » Sun Oct 06, 2019 2:47 pm

Brave confession-we’ve all been there on our steep investment learning curve!
Have you tried reading John Bogles books about index investing in order to understand the investing policy
Lars Kroijer has a good website and a book
We are all indexers here which does take some of the “sting” out of choosing investments including Bonds
Good Vanguard website for U.K. investors-Monevator.com has good info
xxd09
PS Personally I have only one bond fund .Vanguards Global Bond Index Fund hedged to the Pound - they choose all the Bonds ,rebalance within the fund and it’s cheap.Returned 5% pa over the last 10 years

Valuethinker
Posts: 38939
Joined: Fri May 11, 2007 11:07 am

Re: New to bonds - trying to understand [UK]

Post by Valuethinker » Mon Oct 07, 2019 4:19 am

seeker7 wrote:
Sat Oct 05, 2019 1:57 pm
Hello everyone,

I have been trying to invest in different ways for 15 years without satisfactory results. After reading a few books and blogs, I decided to stop trying to pick stocks and time the market. So I decided to just invest in a mix of equity and bonds, rebalance regularly and increase the share of bonds as the deadline approaches.

However, I am totally new to bonds, treasuries, gilts, etc. I am based in the UK, but my question is quite general. If I have a look at a bond ETF like this one:

https://vanguardinvestor.co.uk/investme ... _fund_link

It seems to me the annual prices vary quite wildly (-3.8%, +15%)... I thought bonds were a lot less volatile than this. At the end of the day, they are just a fixed income product with a low probably of something going wrong (I'm talking about treasuries or gilts here, not junk bonds), so how come the prices vary so much?

Thank you for any help in clearly my confusion!
Almost no (none?) market forecasters ever expected the UK government to be able to borrow at a rate *lower* than the 1930s, for this long. It is unprecedented. Thus fixed income instruments (bonds) with good credit ratings have done much better than one would have expected when buying them. 2 or 2.5% on a UK gilt is worth a lot more if 10 year yields drop to 1.5% (guessing that yields were around 2.5% when the bonds were issued).

Bonds do zing around. If one holds the underlying bonds directly, though, they will always redeem at par i.e. £100 per £100 of face value (Indexed Linked Gilts work differently ie what Americans call TIPS and are Real Return Bonds in the jargon - inflation linked).

On the way the price will go up and down, and the rate at which the coupons (fixed payment, twice annually for 99% of gilts) (payments are called a "dividend" in archaic UK terminology - it's not a dividend in normal finance language, it's interest aka a coupon for a bond) are reinvested in gilts (which is what a bond fund does) varies all the time.

But as an investor you still get your money back. (Assuming you did not buy the bonds at a premium to £100 face value).

For lots of reasons most of us hold bond funds. So we experience that price volatility, but our actual final returns are more stable because of the coupons being paid regularly by the underlying bonds (and reinvested in the fund, if Accumulating units, paid out if Distributing units).

Gilts have their own peculiarities:

- UK has a lot of political risk right now (since June 23, 2016). We are on our 3rd Prime Minister in that time, etc. Most of that risk is seen in volatility in exchange rate (if you are worried, you sell the GBP). It also causes a "flight to safety" ie own gilts because you are concerned about a recession (I am steering around divisive political discussions, here). Buying gilts actually pushes the prices up, and thus the yields down (Yield to Maturity).

- the Bank of England's policy of Quantitative Easing (Central Bank buys govt bonds from the banking system, to try to increase the money supply and stimulate economic activity) means c. 1/3rd of all gilts were owned by the B of E - that's the first time in all of history this has happened. Again that drives the price up, and the yield down.

- the gilt index (a weighted index of all the straight gilts (ie not index-linked) in issue) is long duration. Modified Duration estimates the sensitivity of the bond price to changes in interest rates. So the gilt index has a c 13 year duration. Versus 7-8 years for the US & German government bond markets.

Roughly speaking, a +1% in interest rates (at all maturities, an important simplification) means that gilts prices would fall by -13%, whereas US or German by -7-8%.

But of course interest rates have been going the other way, and so the gilt index has given very good returns. But it is inherently more volatile (both ways) than other government bond markets.

The origins of the long duration of the gilt index are in the funding patterns of UK pension funds and insurers. They are legally required to match long term liabilities (final salary pensions in particular) with long term assets. As most private sector FS schemes are closed to new members (and to new accruals by existing members) the funds are moving towards certainty - sell equities, buy gilts. Gilts have no exchange rate risk (pensions are paid in GBP) and they have (theoretically) no credit risk. Consider the British Telcom pension fund, which has something like 50,000 employees and 450k pensioners or deferred pensioners (people no longer accruing benefits, but owed a pension at 60 or 65). As that moves from equities to bonds to reduce risk, it buys a lot of bonds.

Given how long pensioners live (and their spouses!) the pension funds need very long term assets to match the liabilities. Hence in 2005 the Chancellor issued 50 year gilts - to meet demand. There is a 2055 out there (not sure if there is a longer maturity than that). And the 30 year gilt market was significant in size and it was very rare for countries to borrow for periods of much longer than 10 years (mostly US, UK, Canada and Australia I think). Of all the major economies, until recently the UK had the longest term (time to maturity) bonds out there - although Austria now has a 100 year bond (the modern state of Austria was only created in 1918, so this is a bond with a maturity longer than the Austrian Republic has lived).

As an investor:

- you are getting very low yield on gilts (but better than Eurozone investors, where safe government bonds (German, Dutch) pay negative yields)

- you have an unusual sensitivity to interest rate rises

It's still reasonable to hold a gilt fund as "safe" money. It will be volatile but +/- 10% is not huge volatility compared to stocks (from memory FTSE100 dropped nearly 50% in the 2008-09 crash).

The bigger problem is the depreciation of GBP - I'd have to get into politics to talk about why I think GBP could be long term headed for parity with Euro and USD. And therefore higher inflation, and a change in government (politics, again) could herald more inflationary policies. However index linked gilts are paying c. -2.0% real yields i.e. if inflation is as the market expects over the life of the ILG, you are guaranteed to lose 2% real value of your money every year.

For this reason, I think a lot of investors here hold a global government bond index fund hedged into GBP. That eliminates exchange rate risk pretty much, and has a lower duration and probably a slightly higher yield than the gilt index. You are spreading your credit risk across developed world governments.

A global credit index fund (Investment Grade) also holds corporate bonds, and that will introduce greater correlation with equities, and volatility. I.e. if we have a recession, it could show negative returns even if interest rates are low or falling.

Holding Emerging Market bonds, or sub investment grade bonds (high yield aka "junk") is throwing a lot more equity risk into the portfolio - reducing the diversification benefit.

At which point I shrug. You either keep money within the £75k limit in UK bank accounts per financial institution, earning less than 1%, or you gamble a bit and hold gilts, or you hold global bond hedged into gilts.

Only the first of those options will have no price volatility.

Topic Author
seeker7
Posts: 5
Joined: Sat Oct 05, 2019 4:40 am

Re: New to bonds - trying to understand [UK]

Post by seeker7 » Tue Oct 08, 2019 7:36 am

Hi everyone,

Thanks a lot for your answers, that's really useful.

Just a thought experiment:
A. I buy a 1 year bond for £1,000 with an interest rate of 2%
B. Fund ABC buys the same 1-year bond at the same date and this is its only investment

Let's ignore any fees and inflation.

With option A, I end up one year later with £1,020.

With option B, am I right in thinking that the fund will be priced on year later at £1,020 too, even though the price of the fund moved up and down during that year depending on various circumstances?

In other words, is it correct to say that a bond fund price will, on average, increase (or maybe decrease nowadays) at the same rate of the bonds it bought?

Side question: does a bond index fund buy and sell bonds or does it holds them until maturity?

Cheers

glorat
Posts: 269
Joined: Thu Apr 18, 2019 2:17 am

Re: New to bonds - trying to understand [UK]

Post by glorat » Tue Oct 08, 2019 10:02 am

seeker7 wrote:
Tue Oct 08, 2019 7:36 am
With option B, am I right in thinking that the fund will be priced on year later at £1,020 too, even though the price of the fund moved up and down during that year depending on various circumstances?

In other words, is it correct to say that a bond fund price will, on average, increase (or maybe decrease nowadays) at the same rate of the bonds it bought?

Side question: does a bond index fund buy and sell bonds or does it holds them until maturity?
Your side question is actually the main question. In B, the index fund will also be buying other bonds as they appear and selling bonds either as they mature or fall outside its investment criteria (if any)

So yes, strictly speaking in 1 year time that portion of the bond is worth 1020. But your original question is why bond prices move up and down.

Suppose interest rates went up from 2% to 3%. That means you could buy a bond for £1000 that will be worth £1030 in a year's time. The £1000 face value of your bond isn't really worth £1000 anymore because to get to that same £1020 you *know* you will get in a year's time you only need to pay about £990 for the 3% bond instead. Therefore your original bond has dropped in value from £1000 to £990 just because interest rates move. Oops, you fund holding your bond has lost in value! Bad news. Welcome to interest rate risk

But there is good news too because there is reinvestment risk. Although your fund has lost 1% due to the 1% change in interest rates, because your fund buys and sells bonds, your fund held over the long term will be increasing its returns from 2% to 3%. So your future returns will be higher and bond value will catch up.

So you can see that today's fund value and the future fund value (i.e. interest rate risk vs reinvestment risk) tend to operate in different directions. Over the long term, the lesson is you should ignore bond fund value fluctuations.

Finally, a not on duration... in my example above, a 1% rise in interest rates caused a 1% drop in bond value. In reality, most bonds have duration several times this (depending on the maturity). You can look up the duration number of your ETF on websites. If the duration is 5, then a 1% rise in interest rates causes a 5% fall in fund value. (But again, don't worry too much... your future returns will tend towards being 1% annually higher eventually)

Hope that helps with the intuition

Topic Author
seeker7
Posts: 5
Joined: Sat Oct 05, 2019 4:40 am

Re: New to bonds - trying to understand [UK]

Post by seeker7 » Tue Oct 08, 2019 10:25 am

Hi Glorat,

Thanks a lot for your answer. It's starting to all make sense to me. And indeed I need to have this intuitive understanding that things make sense before I feel comfortable investing.

Thanks!

Topic Author
seeker7
Posts: 5
Joined: Sat Oct 05, 2019 4:40 am

Re: New to bonds - trying to understand [UK]

Post by seeker7 » Tue Oct 08, 2019 10:31 am

Now my next question: Why invest in bonds in these times of record low interest rates?

glorat
Posts: 269
Joined: Thu Apr 18, 2019 2:17 am

Re: New to bonds - trying to understand [UK]

Post by glorat » Tue Oct 08, 2019 7:40 pm

seeker7 wrote:
Tue Oct 08, 2019 10:31 am
Now my next question: Why invest in bonds in these times of record low interest rates?
What's the role of bonds in your portfolio?

For bogleheads, the answer isn't typically returns so interest rate isn't so important

Valuethinker
Posts: 38939
Joined: Fri May 11, 2007 11:07 am

Re: New to bonds - trying to understand [UK]

Post by Valuethinker » Wed Oct 09, 2019 9:13 am

seeker7 wrote:
Tue Oct 08, 2019 10:31 am
Now my next question: Why invest in bonds in these times of record low interest rates?
1. diversification. Low credit risk government bonds tend not to fall during stock market crashes, and even rise in a "flight to safety" as they did in 2008-09.

A lot of the original work was done with US Treasury Bonds & the S&P 500 stock index (biggest US stocks).

It showed a correlation between 0.0 - 0.1 against the S&P 500.

Seen in a risk-return framework, then, you can lower the volatility of your 100% equity portfolio, without sacrificing too much return, by going from 0% bonds to 30-40% bonds. It's quite striking that you don't give up as much return as you might think (if they were perfectly correlated) and that's a major reason for the durability of the 60% equities/ 40% bonds portfolio.

EDIT : probably worth saying that the gain in the opposite direction is even more dramatic. Compared to a 100% bonds portfolio, a 20% S&P 500 80% bond portfolio has had both *lower* volatility and *higher* returns. The diversification gain from adding stocks to a bond portfolio is even greater.

Graphically if you draw the Efficient Frontier (expected return on the Y axis, volatility on the Y axis) the curve joining the points of 100% bonds and 100% equities (which runs from lower left to upper right) bends out and to the left as you add more of the uncorrelated asset. Empirically, the point closest to the Y Axis (ie minimum volatility) was about 20 E/ 80 Bonds.

If they were perfectly correlated it would just be a straight line - for any expected return you just pick the percentage of equities you want.

2. if bond returns are low, then logically everything else must be. There are timing differences, so you cannot say that for any given year, but logically a world where bonds earn 1-2% is not a world where equities can keep returning say 8-10%. Equities are "over rewarding" in that world.

(there's a one off step change in valuation. UK indexed linked gilts are yielding minus 2.0%. In that world, equities and property (houses and commercial) gets a one off valuation uplift - you really see that in the UK housing market (even now, houses are roughly 5x their price in 1992?). Arguably we have had that step change in global equity markets).

Bond returns are lousy, but they will look a lot less lousy when the stock market pulls its next 20 per cent pullback (December 2018, roughly), or 35 per cent bear market (2000-03 dot com crash) or 50 per cent (2008-9). Not all bear markets are short and sharp like 2008.

It's always worth comparing likely bond returns against National Savings products and bank accounts. In Europe, for small savers, 0% in the bank looks better than Eurozone bonds.

magneto
Posts: 1012
Joined: Sun Dec 19, 2010 10:57 am
Location: On Chesil Beach

Re: New to bonds - trying to understand [UK]

Post by magneto » Thu Oct 10, 2019 5:19 am

seeker7 wrote:
Tue Oct 08, 2019 10:31 am
Now my next question: Why invest in bonds in these times of record low interest rates?
This is a question that have been grappling with of late.
Why buy sub-inflation yields, to guarantee a loss of purchasing power over time ?
Is the bond market, esp UK, an accident waiting to happen ?
Just because others seek a theoretical balanced portfolio, with stocks and bonds, are we obliged to stop thinking about value and follow suit ?
Have cut back our own bond holdings now to shorter duration unhedged US Gov't bonds, which are more reasonably valued using IBTS and TIP5.
(adds a degree of 'currency insurance')

In the UK we are presently spoilt for choice for high total return stocks, with decent yields.
There is clear value on offer.

Therefore replacing much of bonds with UK REITs, those value stocks and plentiful cash, which together eke out a +ve real yield (above inflation), underpinned with growth.
While more than content to use trackers alongside bonds in an undervalued rising market, we may in the UK today need to engage the brain, stop and ask - what on earth are we doing ?
'There is a tide in the affairs of men ...', Brutus (Market Timer)

Valuethinker
Posts: 38939
Joined: Fri May 11, 2007 11:07 am

Re: New to bonds - trying to understand [UK]

Post by Valuethinker » Thu Oct 10, 2019 9:11 am

magneto wrote:
Thu Oct 10, 2019 5:19 am
seeker7 wrote:
Tue Oct 08, 2019 10:31 am
Now my next question: Why invest in bonds in these times of record low interest rates?
This is a question that have been grappling with of late.
Why buy sub-inflation yields, to guarantee a loss of purchasing power over time ?
Is the bond market, esp UK, an accident waiting to happen ?
Just because others seek a theoretical balanced portfolio, with stocks and bonds, are we obliged to stop thinking about value and follow suit ?
Have cut back our own bond holdings now to shorter duration unhedged US Gov't bonds, which are more reasonably valued using IBTS and TIP5.
(adds a degree of 'currency insurance')

In the UK we are presently spoilt for choice for high total return stocks, with decent yields.
If the stock prices don't go down, of course. Paging Imperial Tobacco.

40% of the value of the dividends paid by the FTSE100 is paid by Royal Dutch Shell in its 2 listed forms. BP was once 20% of all dividends paid by F100 stocks - and then Deepwater Horizon happened. Vodafone's special dividend was something 1% of the value of the European index (including UK). One is talking about a very few stocks that have both the dividend yield & the market cap.

You've got HSBC RDS BP BATs (tobacco) Imperial Diageo (drinks) GSK (drugs) Astra Zeneca (drugs) BHP Billiton (mining)-- I'd have to check the others but that's 40% of the index right there. They are all sectors with severe structural changes going on where the dividend is not rock-iron clad safe.
There is clear value on offer.

Therefore replacing much of bonds with UK REITs, those value stocks and plentiful cash, which together eke out a +ve real yield (above inflation), underpinned with growth.
While more than content to use trackers alongside bonds in an undervalued rising market, we may in the UK today need to engage the brain, stop and ask - what on earth are we doing ?
And what happens if the share prices go down?

I happen to agree with you re UK interest rates - the combination of Quantitative Easing + political factors has driven the yields on UK government bonds to incredibly low levels. But, shrug, that does not mean that "normal service will shortly be resumed". I could see a long period of wrenching adjustment as we exit whole industries (like car making) - structural adjustment as we strive to become "Singapore upon Thames".

Given the international dimension of F100 companies (60-70% foreign earnings) that's not such a worry but it does mean currency-hedged returns for safe assets will be really low, and will stay low.

If there are dividend cuts coming or other disruptions, then bonds are not going to look so expensive, and shares not so cheap.

Topic Author
seeker7
Posts: 5
Joined: Sat Oct 05, 2019 4:40 am

Re: New to bonds - trying to understand [UK]

Post by seeker7 » Thu Oct 10, 2019 9:28 am

I think the main problem I have is that it would be difficult for the rates to fall further, so if I invest in bonds now, I am pretty much guaranteed to make a loss compared to inflation because (a) the interest rate I get is less than inflation and (b) as soon as interest rates rise again, the value of my bonds will plummet.

Why not consider alternatives like a savings account?

Valuethinker
Posts: 38939
Joined: Fri May 11, 2007 11:07 am

Re: New to bonds - trying to understand [UK]

Post by Valuethinker » Thu Oct 10, 2019 9:34 am

seeker7 wrote:
Thu Oct 10, 2019 9:28 am
I think the main problem I have is that it would be difficult for the rates to fall further, so if I invest in bonds now, I am pretty much guaranteed to make a loss compared to inflation because (a) the interest rate I get is less than inflation and (b) as soon as interest rates rise again, the value of my bonds will plummet.

Why not consider alternatives like a savings account?
1. yes savings account is a worthwhile alternative. Remember to stay within the £85k limit for each financial institution - the financial compensation fund limit.

Halifax is paying 0.55% for 2 year notice account ;-).

2. consider that interest rates could fall to Japanese levels (depends on the political situation, in truth) which are even lower

3. short term gilt funds earn almost zero interest, but have much lower modified duration. That odd feature of the gilt weightings - that the UK has such a large weighting to very long term gilts (to meet the needs of institutional pension & insurance investors) means you are more exposed on the downside on interest rate moves.

Half in ST gilt fund with a duration of say 2.5 years, and the regular gilt fund with a duration of say 13 years, would give you a duration of around 7.5 years for your bond portfolio.

4. a global government bond fund, GBP hedged (most are), would have a lower duration (the process of currency hedging would bring its yield & prospective returns quite close to that of a gilt fund but the duration will be lower).

I went down exactly the same route you did, about 3-4 years ago, concluded that interest rates could go nowhere but up, and bought a ST gilt fund. Interest rates then went down ;-).

Post Reply