New to Drawdown

[JohnW]

We might have agonised over this before; and I'm not contesting your understanding of how bonds work. But if bonds have a useful place in one's portfolio we do ourselves a disservice by usually ignoring inflation linked bonds if they're available where one is.

To buy most/?all government bonds on the secondary market now one would pay the £2 (I'll call it 'higher price') for something with a redemption value of £1 (I'll call it lower price), as you say; this has resulted from interest rates falling since those bonds were issued. Those previously issued bonds pay a higher coupon rate than we can get otherwise with new bonds.

Then, as you say, at redemption you lose that price difference, but you've been fully compensated for it by receiving the higher coupon payment than you would have received if you'd bought a new bond when you bought the old one. That loss from purchase/sell difference will occur with zero inflation; it's a feature of interest rate changes. An inflation linked bond doesn't protect against that fall in bond value from purchase to redemption, as you say, but that fall is not due to inflation, and I was trying to point out that linkers protect against inflation.

Imagine buying a nominal government bond issued at £100, but now you have to pay £110 for it. After some years of inflation (since issuance) it matures and you redeem it for £100 - your purchasing power eroded. Imagine buying a linker issued at £100, but now you have to pay £110, but it's adjusted face value is £101 and keeps rising while you hold it. At maturity it is redeemed for £102 because inflation has pushed up its adjusted face value.
Now that's how I think linkers work. Does that represent the situation fairly?

[xxd09]

It might be of practical interest
I am 74 year old-17 yrs retd
I am 65% in bonds-I use one fund only
Vanguard Global Bond Index Fund hedged to the Pound (VIGBBD)
Averaging 3.4% pa for the last ten years
Deals with the volatility in my portfolio and the interest is a nice bonus
Cheap, simple and easy to understand
That’s it
xxd09

[dealtn]

Now that's how I think linkers work. Does that represent the situation fairly?

No it isn't, at least in practice, since you can not buy those linkers at par (or anywhere close to it). By convention the price quoted for linkers is the non-inflation adjusted price, so what you see quoted isn't taking into effect the change in RPI Index since issuance. (The exception is the old style 8 month lag index linkers where the methodology is different, and the RPI change is in the price)

A linker at the moment may well have a coupon of just 1/8%. That is not a high coupon, and isn't different to the coupons on issue for many years.

Interest rates at the moment are negative in the inflation adjusted space.

The 10 year linker at the moment is the 0.125% 2029 maturity which is priced at about 130. So lets imagine a scenario where there is zero inflation over the next 9 years, and for simplicity there has been no inflation since they were issued.

You pay £130 receive a few pennies interest every year. In 9 years time prices of the goods you could buy now, but won't until then, have not changed but your £130 is now £100. Your 9 interest payments have added barely more than a £ to that.

What about 50 years? Well you can buy the 0.375% 2062 maturity, that will cost you "only" £280. This time you get 52 years worth of pennies (about £20) and at maturity your £280 is repaid as just £100. Your purchasing power is now less than half of that when you invested.

You can calculate the same using any inflation outcome and it is the same result, although the maths is more difficult, and is perhaps harder to conceptualise. So if prices double over the lifetime of the bond say, you get back £200 (not £100), and your income will be double by the maturity compared to now, when you invest (and so you may have 50% more income over the lifetime of the investment) but that £200 is now only able to buy what £100 bought today because of inflation.

[JohnW]

The 10 year linker at the moment is the 0.125% 2029 maturity which is priced at about 130. So lets imagine a scenario where there is zero inflation over the next 9 years, and for simplicity there has been no inflation since they were issued.

You pay £130 receive a few pennies interest every year. In 9 years time prices of the goods you could buy now, but won't until then, have not changed but your £130 is now £100. Your 9 interest payments have added barely more than a £ to that.

What about 50 years? Well you can buy the 0.375% 2062 maturity, that will cost you "only" £280. This time you get 52 years worth of pennies (about £20) and at maturity your £280 is repaid as just £100. Your purchasing power is now less than half of that when you invested.

Thanks. That 10 year linker, with no inflation during its life as per your example, behaves very much like a nominal bond in that you lose out by spending £130 to have £100 of principal returned, but you do get paid interest along the way. That's not a shortcoming peculiar to linkers, it would be true of all bonds, but more relevantly does not consider the effects of inflation which is what we want linkers to help you with.
Your 50 year linker, I assume is also under the condition that inflation is zero. But we need an inflation example for you to show what happens with linkers.

You can calculate the same using any inflation outcome and it is the same result ...... So if prices double over the lifetime of the bond say, you get back £200 (not £100), and your income will be double by the maturity compared to now, when you invest (and so you may have 50% more income over the lifetime of the investment) but that £200 is now only able to buy what £100 bought today because of inflation.

In this, your inflation example, I think you're allowing that we buy the bond at issuance for £100 (the cost of nice shoes), then inflation adjusts its face value to £200 at redemption. During the bond's life the coupon payments will keep rising with inflation (you express it as 'your income will be double.....'.
Then you say the £200 you get at redemption will only buy you a pair of shoes (now costing £200, but previously £100). Surely, that is precisely what would be reasonable from an inflation linked bond, and that's what it delivers, I think.
In that latter example, it's quite possible that if you wait a week to buy that bond that its price will have risen to £110 although its inflation adjusted face value might still be only £105. You'll still get £200 back at redemption, but that return of principal won't compensate you for all of the inflation that occurs during that time, but it's because interest rate falls have taken some of the gloss off the purchase of any bonds now (now that this one's price has risen from £105 to £110).
Does that represent the situation fairly?

[dealtn]

I think you're allowing that we buy the bond at issuance for £100

The point you are missing is that you can not buy the bond, at issuance, or otherwise for £100!

Even at issuance you are handing over more than £100 to buy a £100 inflation linked product.

You might be giving the Government via the DMO at issuance £150 to buy the promise of a future £100.

IF the bonds were available at par in either the primary or secondary market then you would have a product to protect your Capital from inflation, but they aren't and haven't been for many years!

By buying linkers now you have inflation "protection" but only in the sense that you are locking in that Capital depletion.

[JohnW]

Sorry to have assumed you meant buying the bond for £100.

The point you are missing is that you can not buy the bond, at issuance, or otherwise for £100!

Are you saying that you will never be able, or have never been able in the past, to buy a government bond at or below its issuance price?

By buying linkers now you have inflation "protection" but only in the sense that you are locking in that Capital depletion.

Yes, I think it is important to make this distinction between linkers giving inflation protection, but not protecting you from a loss due to the buy/sell difference for which you get compensation in terms of better coupon payments (compared to newer bonds) in a falling interest rate time, like now.

[dealtn]

Sorry to have assumed you meant buying the bond for £100.

The point you are missing is that you can not buy the bond, at issuance, or otherwise for £100!

Are you saying that you will never be able, or have never been able in the past, to buy a government bond at or below its issuance price?

By buying linkers now you have inflation "protection" but only in the sense that you are locking in that Capital depletion.

Yes, I think it is important to make this distinction between linkers giving inflation protection, but not protecting you from a loss due to the buy/sell difference for which you get compensation in terms of better coupon payments (compared to newer bonds) in a falling interest rate time, like now.

I can't predict the future so won't make any claim such as "never" I'm afraid, but its sufficiently unlikely for me to see it being possible for many years. You would need interest rates to have risen sufficiently such that they are higher than inflation. In other words a positive real yield. (You could have bought at par, and even below, at times in the past.)

You do not get compensation for the buy/sell difference (as you put it). Bonds, be that conventional or linker, will have similar yield to maturity with the same redemption date (not exactly as a bond's "duration" is important, not maturity - but that's a whole different discussion). So a Higher Coupon Bond will provide you with a higher "income" but the fall in "capital" is greater when compared to a lower coupon security. So a bond issued, say 20 years ago, for 50 years might have a coupon of 4% if a conventional or 1% if a linker, and a "similar" one issued this year for 30 years might have 1% and 0.125% as its coupons.

BUT neither of those bonds, be they the 1% or 0.125% variety, will protect your capital unless you can buy them at par (or inflation adjusted par if that makes it easier to understand). If you have to spend £150 today to buy £100 worth of bonds that redeem at par you will be losing 1/3 of your capital invested (in real terms).

Spend £150 on such a bond and if prices (of goods) double you will have £200 to "spend" on its maturity not £300. A basket of goods that you could buy today as an alternative use for your money will then cost £300, and you will only have £200. You will have received a small amount of income on the way (and that income will gradually rise as RPI doubles), but it will be miniscule and come nowhere close to the £100 you are "short". If the bond pays 1% instead of 0.125% then you will indeed collect more income, but you would have spent perhaps £200, not £150 at the outset to balance those alternatives.

[anython]

My original plan was for my income to be made up of 3 streams. 10k a year from the HYP. 11k a year from the SIPP and 9k a year from the cash buffer until State Pension Age where the SP would take over that element.

Just coming back solely to the tax efficiency question, assuming you have no other earnings (and that the HYP is in an ISA) then of course you should increase the SIPP drawdown element to 12,500 (the amount of the personal allowance) and reduce the HYP element to balance.

If the personal allowance progressively increases in line with your personal inflation then you have taken tax out of the equation indefinitely, if not you can readjust the balance to continue withdrawing the pa amount each year.

One point to bear in mind though is that when you get to State Pension age, your tax position will change as the SP will be taxable, whereas spending your own cash is not.

Whilst there are no doubt other considerations, my thought would be to take the 25% TFLS now and progressively pump it into your ISA over the next 2-3 years (guessing based on the numbers you quote) by taking the HYP drawdown amount out of this cash rather than the ISA you can accelerate this process.

You will probably want to invest this cash inline with your approach for the SIPP rather than the HYP.

This gives you more scope once you reach State Pension age to take less drawdown from the SIPP and more from the ISA to therefore reduce your tax bill.

Of course as always this is somewhat second guessing what future tax policy will be, but whatever decision you make you are effectively doing that.

If you didn't want to take the TFLS now, you could alternatively increase the SIPP drawdown to £16,666 with 25% of this tax free, you still pay no tax. This surplus could then be more gradually dripped into your HYP (or just not withdrawn from it). That may well in fact be more tax effective in the long run, but just from a personal perspective I favour the flexibility of being able to access the lump sum in the event of any change in circumstance.

[flyer61]

airbus330...I fear we are both in the same smashed to bits industry. You possibly have departed from Virgin recently??

To mitigate having to enter full drawdown have you considered a part time job?

[airbus330]

My original plan was for my income to be made up of 3 streams. 10k a year from the HYP. 11k a year from the SIPP and 9k a year from the cash buffer until State Pension Age where the SP would take over that element.

Just coming back solely to the tax efficiency question, assuming you have no other earnings (and that the HYP is in an ISA) then of course you should increase the SIPP drawdown element to 12,500 (the amount of the personal allowance) and reduce the HYP element to balance.

If the personal allowance progressively increases in line with your personal inflation then you have taken tax out of the equation indefinitely, if not you can readjust the balance to continue withdrawing the pa amount each year.

One point to bear in mind though is that when you get to State Pension age, your tax position will change as the SP will be taxable, whereas spending your own cash is not.

Whilst there are no doubt other considerations, my thought would be to take the 25% TFLS now and progressively pump it into your ISA over the next 2-3 years (guessing based on the numbers you quote) by taking the HYP drawdown amount out of this cash rather than the ISA you can accelerate this process.

You will probably want to invest this cash inline with your approach for the SIPP rather than the HYP.

This gives you more scope once you reach State Pension age to take less drawdown from the SIPP and more from the ISA to therefore reduce your tax bill.

Of course as always this is somewhat second guessing what future tax policy will be, but whatever decision you make you are effectively doing that.

If you didn't want to take the TFLS now, you could alternatively increase the SIPP drawdown to £16,666 with 25% of this tax free, you still pay no tax. This surplus could then be more gradually dripped into your HYP (or just not withdrawn from it). That may well in fact be more tax effective in the long run, but just from a personal perspective I favour the flexibility of being able to access the lump sum in the event of any change in circumstance.

Thanks for the reply, having had the chance to ruminate on this for a week or so I had come up with the same options as you have suggested. While the choice of using UFPLS is very tempting I'm worried that Mr Sunak may be forced to close some of the more generous pension freedoms. The fact that my state pension will push me over the tax free limit had occurred to me and ISAing the money over the next 5 years would work. I'll have nother think while worrying about my diminishing HYP account.

[JohnW]

You do not get compensation for the buy/sell difference (as you put it). Bonds, be that conventional or linker, will have similar yield to maturity with the same redemption date (not exactly as a bond's "duration" is important, not maturity - but that's a whole different discussion). .

Thanks. I feel some learning coming on.
You’ve clearly pointed out that buying a higher coupon bond will cost you more than buying a lower coupon bond, if bought at the same time and with the same maturity (close enough), because the market adjusts their prices so they’re both equally valued for total return. What you gain on the coupon you’ll lose on the capital loss. That applies to linkers and nominal bonds.
It’s understandable, as you describe it, that the only way to get full return of capital is to buy at par or below, or in the case of linkers at or below their adjusted face value (and hold to redemption).
Bond purchases need to understand that, to avoid disappointment when their capital return is a capital loss, but I believe that they should also remember that whether they buy at par or well above par, the total return will be the same - the capital loss will be fully compensated for by the extra coupons if they choose one of those ‘above par’ bonds. I think another way to express this is: two bonds issued at different times and with different coupons, but the same maturity date (or duration) will have the same yield to maturity.

You would need interest rates to have risen sufficiently such that they are higher than inflation. In other words a positive real yield.

I think what you are saying is that when interest rates are lower than inflation you lose out, in total return, with bonds whether they're inflation linked or not.

[dealtn]

I think what you are saying is that when interest rates are lower than inflation you lose out, in total return, with bonds whether they're inflation linked or not.

I don't know what you mean here sorry.

It is perfectly possible to have a positive return from buying both types of bond, over many time frames, held to maturity or not. I am not sure what you are losing out to. Other alternatives?

My only intervention was to your comment that linkers provided inflation protection for Capital. They do but only in a limited sense. If you pay more than par for them, which is your only choice at present, your "real" capital will not be fully returned, and your purchasing power will diminish. It might be a better alternative to investing in other types of bonds, or other assets entirely. But that wasn't what you said.

[JohnW]

I think what you are saying is that when interest rates are lower than inflation you lose out, in total return, with bonds whether they're inflation linked or not.

I don't know what you mean here sorry.

How easy to be unclear! I meant that one would have less spending power at the end of the bond holding than at the beginning; so, losing out to inflation, with nominal or linker.

[dealtn]

I think what you are saying is that when interest rates are lower than inflation you lose out, in total return, with bonds whether they're inflation linked or not.

I don't know what you mean here sorry.

How easy to be unclear! I meant that one would have less spending power at the end of the bond holding than at the beginning; so, losing out to inflation, with nominal or linker.

Well if inflation turns out to be negative you could increase your purchasing power by having invested in non-inflation, ie. conventional bonds.

[JohnW]

Holding Fixed Income assets, particularly should inflation return, might not prove as riskless as you imagined.

Not sure if that's meant to include inflation linked government bonds, but their return and capital is protected against inflation.

And in that single sentence you demonstrate (and aren't alone as many others do too) a falsehood.

You rightly picked me up on this some posts back. I think it would have been more accurate to write:
'.....but their return and face value are protected against inflation.' As you noted, you can lose capital by means of what I called a buy/sell spread ie, you buy for a different (higher) price than they must be redeemed for.

But this bit I don't get: why do interest rates need to be higher than inflation to buy bonds at par?

Sorry to have assumed you meant buying the bond for £100.

The point you are missing is that you can not buy the bond, at issuance, or otherwise for £100!

Are you saying that you will never be able, or have never been able in the past, to buy a government bond at or below its issuance price?

You would need interest rates to have risen sufficiently such that they are higher than inflation. In other words a positive real yield. (You could have bought at par, and even below, at times in the past.)

Imagine the interest rate for bonds maturing in 10 years is and remains steady at 2%, and inflation has been and is forecast to be steady at 1%.
Imagine the government wants to borrow more. It issues new 10 yr bonds at 2% coupon. I’d imagine that the market would value a £100 bond at £100, because if they’re sold at auction anyone wanting a bond maturing in 10 years can buy on old bond with the same maturity and a yield to maturity of 2% or they can buy a new bond. So no one will pay >£100 for the new bond, and any offer to buy at £99 will be rejected if the issuance is well subscribed. Nuances will be wrong there but the idea is clear.
Now imagine a similar scenario, but the ‘interest rate’ or yield to maturity for 10 year bonds is 1% and inflation is 2%. The government wants to borrow, as above. It issues new 10 year bonds at 1% coupon. I would imagine that the market would price those at £100, for the same reason as above. But you seemed to be saying that under those conditions, interest rate below inflation, that you can't buy them for par (presumably because people will pay >£100) even though doing so would reduce their yield to maturity below 1% at a time when they can buy old bonds with the same maturity and 1% yield to maturity.

[dealtn]

But this bit I don't get: why do interest rates need to be higher than inflation to buy bonds at par?

Sorry to have assumed you meant buying the bond for £100.

Are you saying that you will never be able, or have never been able in the past, to buy a government bond at or below its issuance price?

You would need interest rates to have risen sufficiently such that they are higher than inflation. In other words a positive real yield. (You could have bought at par, and even below, at times in the past.)

Imagine the interest rate for bonds maturing in 10 years is and remains steady at 2%, and inflation has been and is forecast to be steady at 1%.
Imagine the government wants to borrow more. It issues new 10 yr bonds at 2% coupon. I’d imagine that the market would value a £100 bond at £100, because if they’re sold at auction anyone wanting a bond maturing in 10 years can buy on old bond with the same maturity and a yield to maturity of 2% or they can buy a new bond. So no one will pay >£100 for the new bond, and any offer to buy at £99 will be rejected if the issuance is well subscribed. Nuances will be wrong there but the idea is clear.
Now imagine a similar scenario, but the ‘interest rate’ or yield to maturity for 10 year bonds is 1% and inflation is 2%. The government wants to borrow, as above. It issues new 10 year bonds at 1% coupon. I would imagine that the market would price those at £100, for the same reason as above. But you seemed to be saying that under those conditions, interest rate below inflation, that you can't buy them for par (presumably because people will pay >£100) even though doing so would reduce their yield to maturity below 1% at a time when they can buy old bonds with the same maturity and 1% yield to maturity.

You won't be able to buy the any linker issued at par in that situation (although it will be market expectations of interest rates and inflation as you won't know the outcome of either until the maturity).

Consider. If we "knew" interest rates were 1% and would remain so, and we "knew" inflation was 2% and would remain so, do you think anybody would prefer to buy the 1% conventional bond if both prices were £100?

They would pay £100 in exchange for 10 years worth of £1 (as interest) and get the £100 back in 10 years time. Alternatively you could pay the government £100 to buy the linker and receive a growing income (as inflation ensured the income rose) and get back £122. Nobody would do the former, so demand for the latter product would dictate it traded at the outset at a higher price than the conventional. If the conventional is issued at par as you describe, the linker is issued above par.

Of course when such bonds are issued, and bought initially, we can't know what interest rates, and inflation, will be over the lifetime, but "markets" price that expectation.

[JohnW]

Yes, I wasn't explicit enough in my scenarios. I was considering only conventional bonds.
You earlier suggested that to be able to buy linkers at par interest rates would need to be higher than inflation.

But this bit I don't get: why do interest rates need to be higher than inflation to buy bonds at par?

Sorry to have assumed you meant buying the bond for £100.

Are you saying that you will never be able, or have never been able in the past, to buy a government bond at or below its issuance price?

You would need interest rates to have risen sufficiently such that they are higher than inflation. In other words a positive real yield. (You could have bought at par, and even below, at times in the past.)

.

But in trying to explain that, you’re now you’re saying they would still issue above par under those conditions.

But this bit I don't get: why do interest rates need to be higher than inflation to buy bonds at par?

Consider. If we "knew" interest rates were 1% and would remain so, and we "knew" inflation was 2% and would remain so, do you think anybody would prefer to buy the 1% conventional bond if both prices were £100?

They would pay £100 in exchange for 10 years worth of £1 (as interest) and get the £100 back in 10 years time. Alternatively you could pay the government £100 to buy the linker and receive a growing income (as inflation ensured the income rose) and get back £122. Nobody would do the former, so demand for the latter product would dictate it traded at the outset at a higher price than the conventional. If the conventional is issued at par as you describe, the linker is issued above par.

Of course when such bonds are issued, and bought initially, we can't know what interest rates, and inflation, will be over the lifetime, but "markets" price that expectation.

So, can you explain why you said that to buy a linker at par ...

You would need interest rates to have risen sufficiently such that they are higher than inflation. In other words a positive real yield.

[dealtn]

1% isn't higher than 2%

[JohnW]

Indeed.
I could have been clearer in distinguishing nominal interest rates, the ones commonly quoted, from real interest rates (those that are inflation adjusted). If nominal rates are 3% and inflation is 2%, then real interest rates are 1%, I think.
I can see, as you suggested, that you could buy linkers at par if nominal interest rates were greater than inflation AND the linker coupon is less than the nominal interest rate by the inflation rate.
But one could buy linkers at par if the nominal interest rates were LESS than inflation AND the linker coupon is less than the nominal interest rate by the inflation rate. I think. That would mean a negative real yield.
So, could you explain why you wrote, in order to buy linkers at par:

You would need interest rates to have risen sufficiently such that they are higher than inflation. In other words a positive real yield.