Bond funds - very basic question

[mrodent]

You also make money from bonds when interest rates remain broadly the same. If equities crash, there is usually a "flight to safety" and bond prices rise as a result. That is the main reason why many people hold bonds in addition to equities. More often that not, the bonds rise when equities take a serious fall. Even if that does not happen, bonds dilute you losses when equities take a serious fall.

I have never understood bonds, one of the reasons I've never put much in them. However I have heard several times that "flight to safety" idea. And the idea which flows from it: that, since bonds and equities are meant to go in "countervailing" directions, bonds would help deliver improved stability, i.e. less volatility, in a portfolio.

But I remember looking at bond performance graphs in mid-2020. Firstly I looked at what happened in mid-March of that year, when equities plummetted to unseen depths, before recovering equally spectacularly, because it was the start of the pandemic. So did bonds (NB when I say "bonds" I don't mean ultra-short bonds, or even 2-year bonds, which might well have been more resilient: primarily I mean "funds involving bonds", which I believe usually means funds involving "laddering", i.e. an assortment of terms). The bond dip was more muted, but it wasn't countervailing.

So I started looking at previous periods when equities had gone down. A totally amateurish approach. But I could never see (just with the naked eye) much evidence of any countervailing effects.

I'm not saying this does not exist: but some serious number-crunching would have to be done to convince me that this "countervailing trend" of bonds isn't just an urban myth. Personally I now feel that bonds (except for ultra-shorts, or unless you're planning to hold them to term) should not be held by retail investors since they are too vulnerable to the capricious decisions of central bankers.

[tjh290633]

Back in the 1970s and 80s I invested in gilts for my mother-in-law, who would not countenance equities. That was when you could invest via the National Savings Register through your local sub-Post Office.

I only bought gilts standing below par, at a time when interest rates were running up to 15% or so. With coupons of between 8% and 13%, there was scope for capital appreciation.

As maturity was approaching, it made sense to do some switching, and she eventually sold out when she moved into care.

It's the old story of buy below par and either hold to maturity or sell above par.

TJH

[GeoffF100]

You will find some historical data here:

https://sierramutualfunds.com/media/128 ... r-2023.pdf

"From 1976 to 2021, every year that stocks were down bond returns were positive, providing a
ballast for the return on a traditional 60/40 portfolio*. However, in 2022, the benefit of holding
bonds to diversify an investment portfolio disappeared. Both stocks and bonds were down together,
and, as a result, the 60/40 portfolio experienced the second worst yearly return since the inception
of the Bloomberg US Aggregate Index in 1976."

The people writing that article are, of course, snake oil salesmen. They do not have a magic solution. More often than not, bonds do cushion the fall. The recent experience is not typical. The 60/40 portfolio is not dead, "60/40 investing: will 2024 match 2023’s bumper year?":

https://www.fidelity.co.uk/markets-insi ... mper-year/

[MDW1954]

Moderator Message:
Topic now moved to the (surely more appropriate) Gilts and Bonds board. --MDW1954

[mrodent]

You will find some historical data here:

https://sierramutualfunds.com/media/128 ... r-2023.pdf

That's an eloquent graph, thanks.

It begs 2 questions for me:
1) why? (the recent bucking of the trend) and
2) will the countervailing action return? (which may follow from the answer to 1)).

[GoSeigen]

@JohnW: The fund, and you, only lose out if you choose to sell now at £80.


This is not true. Both you and the bond fund have already lost the fallen market value. If you sell out you have the opportunity to buy similar securities at the new higher yield. If the value hadn't been lost then higher yields would not be available.’

I’ll tilt against that, because I can’t buy as many 'similar securities at the new higher yield' because I’ve only got £80 to spend.
If I buy a single bond for £100 with a coupon of 2%/year, with a duration of 10 years, and then the interest rate for that type of bond rises by 2%/year, my bond will fall in value by (duration x % interest rate change = 20%), £20 to £80. My bond is now yielding £2/year and will yield a further £20 over ~10 years to maturity ie ~£4/year.

I'm going to rewrite this section worded using standard bond terminology, my changes in italics. This is just so we can agree on the text that is being discussed:

"If I buy a single bond for £100 with a coupon of 2%/year, with a remaining term of 10 years (thus modified duration a bit less than 10 years), and then the yield for that type of bond rises by 2%/year, my bond will fall in value by (duration x % interest rate change = approx 20%), £20 to £80. My bond is now earning interest at £2/year and will mature for an additional £20 over ~10 years to maturity ie ~£4/year."

If you accept the above text then I'd say it is not quite correct. The price of your bond is actually about 84p for a 4% yield. This is partly because duration of the bond was less than ten years (it's about 9.1 years) and partly because (price change) = (duration) x (yield change) is only an approximation and works progressively worse for higher yield changes. A 2% ten-year bond priced at 80p has a 4.5% yield, not 4%.

So the bold part should read: "£2/year and will mature for an additional £16 over ~10 years to maturity ie ~£3.60/year."

You’re suggesting I should sell the £80 bond, buy 80% of a new £100 bond yielding 4%/year (using my £80), and receive ~£3.20/year in coupon and no capital gain. It not only doesn't sound like a good deal, but the market will set the yield of my £80 bond and your new bond at exactly the same yield to maturity if they have the same maturity, so why would you engage in the expense of trading tweedle dum for tweedle dee?

I'm not saying one should do anything, I'm saying one can.

The two bonds are the same: the remaining difference in non-reinvested return (£3-20 vs £3-60) will be made up by re-invested interest payments, which are twice as high for the new bonds (£4pa vs £2pa).

Obviously one wouldn't do the swap, but the fact that you can shows that the money has already been lost. Alternatively, I, who didn't buy the gilts at 2% yield, can now buy the same ones at 4% yield with the full £100 which I have held as cash or some other asset. I now have £100 of 4% yielding bonds, where you only have £84 of 4% yielding bonds.

GS

[GoSeigen]

You will find some historical data here:

https://sierramutualfunds.com/media/128 ... r-2023.pdf

That's an eloquent graph, thanks.

It begs 2 questions for me:
1) why? (the recent bucking of the trend) and

Because of the coincidental shift from bond bull trend to bear trend.

2) will the countervailing action return? (which may follow from the answer to 1)).

Yes, but possibly less pronounced than in the recent past due to ongoing bond bear market.


GS

[Hariseldon58]

It’s always worth bearing in mind that the good times lead to the bad times, bond yields were very low , this was great news if you had bought some time ago at higher yields, the cycle has turned.

Bond prices have fallen over the last couple of years as yields rise, they are more attractive now then they were….. the question is what next ?

[GeoffF100]

You will find some historical data here:

https://sierramutualfunds.com/media/128 ... r-2023.pdf

That's an eloquent graph, thanks.

It begs 2 questions for me:
1) why? (the recent bucking of the trend) and
2) will the countervailing action return? (which may follow from the answer to 1)).

(1). The banks drove down interest rates by buying bonds with printed money. Bonds shot up in price as a result. Anyone who bought bonds at the high prices was showing a loss when inflation eventually kicked in (as it does when you print money) and interest rates had to be increased. Ditto equity holders. Long term passive investors sat and shrugged their shoulders through all of this.

(2). Inflation will eventually go down, and business as normal will return, but nobody knows the timing of that.

Does it matter? Vanguard thinks not:

https://www.vanguard.co.uk/professional ... -portfolio

[JohnW]

I'm going to rewrite this section worded using standard bond terminology, my changes in italics. This is just so we can agree on the text that is being discussed:........
‘The two bonds are the same:

That’s useful to refine my ‘back of the envelope’ figures confirming that whether I trade in my £80 bond for a new higher coupon one, or not, the return outcome will be the same for me (trading costs ignored). As you say, my investing ‘error’ was buying the 2% bond when I should have waited for the 4% bond, but I don’t have a proven market timing strategy.
What I reacted to in your post was that it was a psychological deceit to hold the £80 bond rather than trading it for a higher yielding one; and I reacted because as we’ve now established both bonds will have the same yield when I’m deciding to trade in or hold. The new bond will not be higher yielding, just a bigger coupon. Your post might have misled a more naive investor; we’ll not be having any of that here.

‘So I started looking at previous periods when equities had gone down. A totally amateurish approach. But I could never see (just with the naked eye) much evidence of any countervailing effects. ...'m not saying this does not exist: but some serious number-crunching would have to be done to convince me that this "countervailing trend" of bonds isn't just an urban myth.

Your number crunching wish is our command. https://www.bogleheads.org/forum/viewto ... 3#p7065803
It’s clear, stock/bond correlations will do as they wish without regard for our needs so don’t rely on them.

‘Personally I now feel that bonds (except for ultra-shorts, or unless you're planning to hold them to term) should not be held by retail investors since they are too vulnerable to the capricious decisions of central bankers.’

When you get a handle on duration matching you might not feel so anti-bond. https://occaminvesting.co.uk/duration-m ... roduction/

[GoSeigen]

I'm going to rewrite this section worded using standard bond terminology, my changes in italics. This is just so we can agree on the text that is being discussed:........
‘The two bonds are the same:

That’s useful to refine my ‘back of the envelope’ figures confirming that whether I trade in my £80 bond for a new higher coupon one, or not, the return outcome will be the same for me (trading costs ignored). As you say, my investing ‘error’ was buying the 2% bond when I should have waited for the 4% bond, but I don’t have a proven market timing strategy.

Not much of a timing strategy is needed to avoid gilts at 0% yields!

GS

[GoSeigen]

What I reacted to in your post was that it was a psychological deceit to hold the £80 bond rather than trading it for a higher yielding one

The psychological deceit is pretending not to have suffered a loss when you have.


GS

[kempiejon]

What I reacted to in your post was that it was a psychological deceit to hold the £80 bond rather than trading it for a higher yielding one

The psychological deceit is pretending not to have suffered a loss when you have.


GS

I can sometime kid myself my profit hasn't realised yet. But for every £100 invested that is now worth £70 is £30 I can't invest elsewhere if I've got it wrong.

[International]

Thank you to all who replied. Feels like we've wrapped the thread up now.

My take-aways as relate to the original question are:
1) By buying into a fund I was buying the bonds held in the fund at their market price, vs buying new bonds at issue price
2) Those individual bonds will get their redemption value back eventually, and their coupon along the way.
3) All other things being equal, the redemptions and coupons from the basket of bonds would add to the value of the fund, over the millennia. However this would take a long time and so when we consider the opportunity cost then the loss is not made good.
4) There are differences of opinion as to whether bonds (and especially gilts) do offer useful ballast or counterpoint to equity moves. This is a key thing for me as I need to decide if I bother with them going forward, but I'll post more about that in the Retirement board.

If any of this is majorly off then do say, otherwise I think we can call this case closed Thank you for all the detailed thoughts, info and links.

[GeoffF100]

Thank you to all who replied. Feels like we've wrapped the thread up now.

My take-aways as relate to the original question are:
1) By buying into a fund I was buying the bonds held in the fund at their market price, vs buying new bonds at issue price
2) Those individual bonds will get their redemption value back eventually, and their coupon along the way.
3) All other things being equal, the redemptions and coupons from the basket of bonds would add to the value of the fund, over the millennia. However this would take a long time and so when we consider the opportunity cost then the loss is not made good.
4) There are differences of opinion as to whether bonds (and especially gilts) do offer useful ballast or counterpoint to equity moves. This is a key thing for me as I need to decide if I bother with them going forward, but I'll post more about that in the Retirement board.

If any of this is majorly off then do say, otherwise I think we can call this case closed Thank you for all the detailed thoughts, info and links.

1) There is no difference. New bonds are bought at their market price too (e.g. in a gilt auction).
3) The long term returns from equities and bonds on the US market (which has been the most successful and the most studied) have been almost the same, except for one 40 year period.
4) Bonds are certainly ballast for a portfolio, but they do not always move in the opposite direction to equities. Cash is ballast too, but usually pays less interest (the present time is an exception). There is also the possibility of making a rebalancing profit with a mixed portfolio.

[JohnW]

All other things being equal, the redemptions and coupons from the basket of bonds would add to the value of the fund, over the millennia. However this would take a long time and so when we consider the opportunity cost then the loss is not made good.'

As a statement of fact, I think I'm comfortable with that, but it wouldn't help me with investment decisions. If it helped you perhaps an example could help me.
It seems I could similarly say: 'when stock prices fall and dividends largely dry up during a pandemic, recovery occurs over millennia however the opportunity cost means the loss is not made good'. Is there anything to be done except ride it out if you think you should invest in stocks (and bonds)?

'There are differences of opinion as to whether bonds (and especially gilts) do offer useful ballast or counterpoint to equity moves'

If ballast means less volatility of price, then the long term data does show a 'ballast' effect; over quite short periods bonds could have more volatility than stocks. The data is what it is, opinion counts for something less.
If counterpoint means bonds go up when stocks go down, then the long term data shows there are multi-year periods when stock/bond correlations are positive and negative and close to zero meaning they are moving independently. One can't rely on their correlation to be negative, or whatever else you'd like it to be. It will be what it will be, and opinion about future correlations can be as wrong as it can be right.

[International]

All other things being equal, the redemptions and coupons from the basket of bonds would add to the value of the fund, over the millennia. However this would take a long time and so when we consider the opportunity cost then the loss is not made good.'

As a statement of fact, I think I'm comfortable with that, but it wouldn't help me with investment decisions. If it helped you perhaps an example could help me.

I agree, it might not help with investment decisions. I was trying to sum up the effect clarified on the graphs and the related thread over at Bogleheads. That thread was very helpful as a poster had modelled what I was musing about.