Bond funds - very basic question

[Arborbridge]

Well, I have always been confused by bonds, so much that I reduced the funds I did own to one only - jsut as a sort of experiment and when I couldn't think what else to do with the capital.

That was the Invesco Monthly income plus - which I quite liked the sound of as up to 20% is held in equities.

It is essentially giving me a fixed amount of cash a month (around 5 or 6% yield) but as has been mentioned, the capital has suffered as expected though overall increased. The XIRR achieved since 2009 is 8.9% (to endDec 2023).

I've done little with this fund (I think I added some at one stage) but the TR has been better than my HYP over the same period and the risk and volatility seem very low. I asl myself why I both with a HYP?
My HYP does give me an increasing income, but presumably, if I had re-invested a portion of the income from this fund every few months, that income would have increased to.

All very odd.

Arb.

[PrefInvestor]

In recent years, there were a few issues of ultra low coupon conventional Gilts with short maturity dates. That's where coupons could be as low as one quarter of 1%. I don't think any corporate issues would have gone that low. Now that interest rates have risen and the market prices stand at a discount to maturity value, these can be of interest to tax paying individuals by being nearly tax free. Gilts aren't subject to Capital Gains tax and the interest is next to nothing.

Well I have frequently looked at the list of available gilt issues on my brokers website and IMHO. I would characterise them as follows:-

1. There are a lot of gilts yielding less than 3%, some less than 1%. To me these are worthless from an income perspective (right now I am currently getting a yield of 7%+ on most of my investments). Some are at prices that would offer a significant capital gain but ONLY if held to maturity, when they would be repaid at par. However the maturity dates on those of interest are too long to be viable eg 2035 or later. I’m not prepared to wait that long receiving a pittance in terms of yield for a payday many years away. The best gilt available as of today has a maturity of 2026 and would seem to offer a gain at maturity of 7.5%, so still a low annual effective yield and of no great interest.
2. Those offering anything close to worthwhile yields are currently trading at a premium, reducing the effective yield that you receive. The best gilt on offer in this category would is a 6% gilt maturity in 2028 but is currently priced at 110p so offering an effective yield of about 4.5% per annum by my reckoning. That’s pretty poor with yields available on other investments.

Everything I have is fully tax sheltered up so any savings on CGT and tax with gilts are of no advantage to me, but might be to other people I appreciate.

New gilt issues might possibly offer some value but TBH I doubt it.

So I quite accept that maybe I am looking at this wrongly but from my perspective I just do not see gilts as of any interest to me.

ATB

Pref

[88V8]

... Gilts aren't subject to Capital Gains tax and the interest is next to nothing.

....Everything I have is fully tax sheltered up so any savings on CGT and tax with gilts are of no advantage to me, but might be to other people I appreciate.

I think that's the nub of it.
Individual gilts have the merit of a known yield at time of purchase if held to redemption but more so - leaving aside moments when gilt yields are anomalously attractive - they are a resource for those who wish to shelter significant amounts of capital.
They are to CGT as farmland is to IHT, but without the puddles.

V8

[GeoffF100]

[Those offering anything close to worthwhile yields are currently trading at a premium, reducing the effective yield that you receive. The best gilt on offer in this category would is a 6% gilt maturity in 2028 but is currently priced at 110p so offering an effective yield of about 4.5% per annum by my reckoning. That’s pretty poor with yields available on other investments.

Some of us need yield like we need a hole in the head. We are swimming in income, and do not want to pay tax on more of it. 0.125% will do nicely, or failing that TG31 has yield of 0.25%. Beyond that, there are linkers paying 0.125%. I have TG36. Good for kicking the can down the road.

[bluedonkey]

I have found this website really useful for seeing yields to maturity, etc.
https://www.yieldgimp.com/gilt-yields

I've posted this link before so apologies if I'm repeating myself.

[daveh]

[Those offering anything close to worthwhile yields are currently trading at a premium, reducing the effective yield that you receive. The best gilt on offer in this category would is a 6% gilt maturity in 2028 but is currently priced at 110p so offering an effective yield of about 4.5% per annum by my reckoning. That’s pretty poor with yields available on other investments.

Some of us need yield like we need a hole in the head. We are swimming in income, and do not want to pay tax on more of it. 0.125% will do nicely, or failing that TG31 has yield of 0.25%. Beyond that, there are linkers paying 0.125%. I have TG36. Good for kicking the can down the road.

The point was I had cash that I couldn't shelter that was earning between 3-4% income that was going to push my interest well over the £1000 allowance. So I invested it in 5 equal tranches of low coupon gilts between August and October last year (which was a very opportune time), all will give me between 4.2 and 4.75% per annum equivalent return on maturity (plus the small coupon payments on top) and no tax. The gilts were TN24, TN25, T26, TN28, TG31 priced at 97.86, 93.39, 89.86, 83.51, and 72.64 respectively. I'll get back 100 when they mature. TN24 matures at the end of the month. Not sure what I'll do with the cash then as prices have gone up a fair bit and the yield to maturity is now below 4% and the remaining 4 gilts are about it wrt low coupon gilts that are available. May just hang on to it (the cash) and use it for part of next years ISA allowance or may spend it as I need to do some work on the house. But it was a very useful place to dump cash at the end of last year.

[JohnW]

You have lost money holding your L and G fund and whilst you will get some income from the fund you won’t get the capital loss back unless interest rates drop to what they were around the time you bought the fund.

A minor point before the main; you haven't 'lost money' if you don't sell, you've lost value or 'made a paper loss'.
But the main point is all the bonds in the fund which experienced this fall in value as interest rates rose are henceforth increasing their value back towards their redemption value. If they were bought by the fund for ~£100 each then fell in value, they will come back to that £100 value at maturity. How can that be 'a capital loss''?

[GeoffF100]

You have lost money holding your L and G fund and whilst you will get some income from the fund you won’t get the capital loss back unless interest rates drop to what they were around the time you bought the fund.

A minor point before the main; you haven't 'lost money' if you don't sell, you've lost value or 'made a paper loss'.
But the main point is all the bonds in the fund which experienced this fall in value as interest rates rose are henceforth increasing their value back towards their redemption value. If they were bought by the fund for ~£100 each then fell in value, they will come back to that £100 value at maturity. How can that be 'a capital loss''?

There is the interest too, of course. Many people bought bonds near the peak of the bond bull market, and are now showing a loss. Many people seem to be saying that bonds are bad, because they lost money on them. They may well be selling them and buying equities at the top of an equity bond market.

The best time to buy an investment is usually when everyone says it is rubbish, and the worst time is usually when everyone says it is great. Unfortunately, it is virtually impossible to get the timing right, unless you have a time machine, and I do not know anyone who has.

[dealtn]

You have lost money holding your L and G fund and whilst you will get some income from the fund you won’t get the capital loss back unless interest rates drop to what they were around the time you bought the fund.

A minor point before the main; you haven't 'lost money' if you don't sell, you've lost value or 'made a paper loss'.
But the main point is all the bonds in the fund which experienced this fall in value as interest rates rose are henceforth increasing their value back towards their redemption value. If they were bought by the fund for ~£100 each then fell in value, they will come back to that £100 value at maturity. How can that be 'a capital loss''?

It's not a minor point - it's a major one.

It is a loss. Thinking otherwise is delusional.

You do not have insight to the future, or a time machine, so relying on what the known (sic) future value is to be, is wrong and unreliable. Much can happen at the personal level, let alone the investment level, in between "now" and "then".

The worth of any investment is what it can be realised for "now". If that is lower than the original value then it IS a loss. Just because you don't crystalise it doesn't make it any less so.

[International]

Thanks all for the replies.

These last three posts are getting to the nub of why I posted the question in the first place. I'm trying to work out the mechanism of this bond (actually gilt) fund going forward.

We don't know what will happen with interest rates or the economy but I'm trying to get to the bottom of what happens to the input money over time in a bond fund. I know this particular fund is for gilts, so might be particularly anaemic, but I think the principles would be the same as for bond funds(?).

It's an academic exercise at present. If I took the loss today by selling the fund it would represent 0.16% of the overall portfolio, so I can let it sit there if I want.

The academic exercise matters to me as:

1) I'm curious and want to understand the underlying mechanics in a bond fund. This would help me understand whether I can wait it out and the fund would just recover due to principals coming back and new interest coming in or if really that input money is gone for good.

2) I want to work out how much I bother with bonds and gilts going forward. This is relevant as I am in a pre-retirement sort of phase so am thinking about whether I want to restructure my investments to be more defensive or not. I'll post more about that over on the Retirement board in due course.


Right now I am thinking I can't really tell as I don't know what the fund bought and sold. If it bought a face value gilt of £100 for £500 and the resale value is now £10 it would take a long time to recover that loss, even if the fund gets the £100 principal back at maturity. New, more profitable deals, especially if interest rates declined, would plug that gap over time, but that depends on time and interest rate changes. But, I *don't* know what they bought and sold at and know the fund has a mix.

I'll go and see if I can find the ticker.

[GoSeigen]

It's not all bad as the income will increase as newer bonds are purchased with higher coupons.

This is this kind of thing I am trying to work out. If I hold for long enough then does the total come back? GS suggests not. I am happy to wait indefinitely

Of course it will come back, but you will only "get back" the very poor yield you bought in the first place. Which in my book is still a loss, because I don't want to make a zero yield or even negative yield over twenty years!!!

but if there is no chance of recovery I would be better to move the 66% remaining into something more useful.

I'm also trying to work out if I ever buy any more. Clearly someone does as all UK Govt debt is in such issues.

For some reason I have a mental block on bonds!

Bonds are the easiest of securities to price and understand, far easier than shares for example. If they're still confusing maybe read a standard text.

The question to ask yourself is "what is your aim with the capital invested in the bonds?" Yields now are around 4%, so effectively, by holding on to the bonds you will get 4%pa nominal return from that capital (at current valuation). If you are happy with that, then keep it there.

My view is that inflation will remain from here so real yields are unlikely to be higher than 2%. Also, I believe bonds have returned to a secular bear market so real returns may be even poorer. I require 3% net of costs, inflation and tax so that would only be suitable for the most conservative part of my portfolio. Your assessment may well be different and that's fine, but the first thing to accept is that the purchase price is in the past and your decision is based on the current situation: getting something "back" is not the name of the game.


GS

[GoSeigen]

When bonds are issued, they are bought at the market price, which can be greater of less than the maturity value.

Ah! I had assumed that bonds were bought at a face value when they were first issued, rather than a market price. Thank you Geoff.

There's possibly some confusion here. The return on any security is derived from TWO types of cashflow: 1. the "capital" cashflows, i.e. purchase and sale values and 2. the income cashflows: dividends or interest.

So the relevant values at issue of a bond are: 1. the issue price and the redemption price (usually they are the same) and 2. the coupon.

When @GeoffF100 says that bonds are issued at the market price, that means the yield currently required by the market. At issue time, any terms at all can be set for the bond: the actual values for the above 1. and 2. are entirely arbitrary, as long as the yield meets the market's required level.

The convention with gilts is to issue them at close to 100p, redeem them at 100p and set the coupon to the current market yield. The process is a bit more complicated as there is an auction but that is the essence. It is not however required to be done that way: the issue price and redemption prices could be quite different (an amortising bond); the face value could be something other than 100p. Always though, the yield is what the market will bear and that determines what the coupon and "capital" values will be.

GS

[International]

Here we go. ISIN: GB00BG0QNV10

There is an up-to-date factsheet on fundslibrary, but I am not (yet?) allowed to post links.

[GoSeigen]

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.

This is a commons investing psychological trick to kid yourself that you can hold on for dear life and "get your money back". It is not a sound approach to investing.

The honest way to deal with your losses is to ask yourself what factors caused you to pay too much in the first place. Having identified those, you then ask whether similar factors still apply. You look at your investment afresh, at current valuation and ask whether it is still justified in light of the new insight you have gained. If your prior mistake would lead you to make a similar mistaken purchase today, then obviously it is not right to be holding that security, AEBE. Just sell it (or at least reduce) and move on.

Gilts are a great example actually. Gilts a few years back were at the end of a wonderful secular bull run. It had always been the case (as mentioned by others on this thread) that if shares crashed gilts would rise. So fearful of COVID or war or whatever, one may have been tempted to buy gilts, no matter how low their yield.

Looking back now, the mistake in that analysis was failing to realise three things: 1. gilts were ridiculously expensive and 2. their bull market was about to become a bear market and 3. (largely corollary) inflation would not remain close to 0. Have those factors changed today? IMO only the price factor has changed. Yes, gilts are no longer ridiculously expensive. However, I believe that the low-inflation era is largely over, and that bonds are in a secular bear environment now. So to me that justifies being cautious about wanting to hold on to gilts. I'd be wondering whether other assets hold much better prospects than gilts for 1. their inflation protection and 2. their being in or about to enter a bull market.



GS

[International]

The question to ask yourself is "what is your aim with the capital invested in the bonds?"

Thanks for the continued discussion.

My aim in holding any bonds and gilts in this particular ISA has been defence of overall value, ballast if you will. In this I was following the conventional wisdom of the 80/20 portfolio of 80% equities and 20% bonds for a balanced growth portfolio. As I have topped up over the years I have roughly kept to that ratio.

It so happens that part of the top-up in March 2020 went into this particular fund so it provides a good case study as it is particularly bad, which is why I've chosen to post about it. It's a specimen under the microscope, isolated from the rest of the portfolio.

I will post in the Retirement board about the overall when I've had chance to put together a succinct description, but in general my situation is that having had a vanilla "growth" goal for the last 30 years I'm now thinking about how I should structure things so I'll be positioned to take my income from the portfolio when I want to. Hence thinking about how/if bonds/gilts play a role in that overall. Conventionally they do, but we wouldn't be on this board if we like the conventional wisdom would we ?

[GoSeigen]

he effective yield that you receive. The best gilt on offer in this category would is a 6% gilt maturity in 2028 but is currently priced at 110p so offering an effective yield of about 4.5% per annum by my reckoning. That’s pretty poor with yields available on other investments.

Just a point of order: in the bond world, running yield is not yield. Yield is YTM or YTC if the bond will be called. So what PrefInvestor calls "effective yield" is actual yield for people talking about bonds. Shares may be different, but let's try to keep to some simple bond conventions when discussing them...


GS

[JohnW]

The return on any security is derived from TWO types of cashflow: 1. the "capital" cashflows, i.e. purchase and sale values and 2. the income cashflows: dividends or interest. So the relevant values at issue of a bond are: 1. the issue price and the redemption price (usually they are the same) and 2. the coupon.’

Nicely put, and what the questioner might have not fully grasped yet.

‘Right now I am thinking I can't really tell as I don't know what the fund bought and sold. If it bought a face value gilt of £100 for £500 and the resale value is now £10 it would take a long time to recover that loss, even if the fund gets the £100 principal back at maturity.’

I don’t think you need worry about what the fund bought or paid for what it bought. It’s enough that you know the fund’s duration (you’d be mad not to when you invest in it) and the maths and reasons for bonds/funds falling or rising in value when interest rates change: duration in years x % change in rates = % change in value. Long maturing funds are more sensitive to interest rate changes.
The reason you don’t need to agonise over how much the fund paid for its bonds is in the first quote above.
If 10 year bond yield is now 2%/year, the fund can buy a bond maturing in 10 years with 2% coupon for £100; if interest rates now rise, the bond value will fall but return to £100 in 10 years. All your profit is coupon, no capital gain or loss (if you hold to redemption, and the Treasury doesn’t default).
But, were the fund to have bought for £500 a bond maturing in 10 years, its coupon would have been much more than 2%/year, because buyers and sellers know it will be worth £100 at redemption in 10 years, and so to get the same return as is available from the 2% coupon bond the £500 bond needs to make up for the capital loss with bigger coupons.
Whichever of the two bonds the fund buys, the return will be the same if held to maturity.
You’ve seen the formula above showing interest rate sensitivity with duration. You’ve seen the graphs in bogleheads forum showing how a bond fund regains its mojo after interest rate rises. How would knowing how much the fund paid for its bonds affect any investment decision?
As you noted, it’s been painful watching bond prices fall so far/fast in recent times, but think for a moment: as a bond holder long term, would you rather be holding bonds in a high interest period or a low interest period? High obviously.
When interest rates start and continue falling, bond prices go up, so you move from a high coupon return period, to a falling coupon return period but it’s a rising capital value period. And in reverse, when interest rates are rising, bond prices (and thus capital value) fall but coupon return is improving.

[GoSeigen]

Thanks all for the replies.

These last three posts are getting to the nub of why I posted the question in the first place. I'm trying to work out the mechanism of this bond (actually gilt) fund going forward.

We don't know what will happen with interest rates or the economy but I'm trying to get to the bottom of what happens to the input money over time in a bond fund. I know this particular fund is for gilts, so might be particularly anaemic, but I think the principles would be the same as for bond funds(?).

It's an academic exercise at present. If I took the loss today by selling the fund it would represent 0.16% of the overall portfolio, so I can let it sit there if I want.

The academic exercise matters to me as:

1) I'm curious and want to understand the underlying mechanics in a bond fund. This would help me understand whether I can wait it out and the fund would just recover due to principals coming back and new interest coming in or if really that input money is gone for good.

2) I want to work out how much I bother with bonds and gilts going forward. This is relevant as I am in a pre-retirement sort of phase so am thinking about whether I want to restructure my investments to be more defensive or not. I'll post more about that over on the Retirement board in due course.


Right now I am thinking I can't really tell as I don't know what the fund bought and sold. If it bought a face value gilt of £100 for £500 and the resale value is now £10 it would take a long time to recover that loss, even if the fund gets the £100 principal back at maturity. New, more profitable deals, especially if interest rates declined, would plug that gap over time, but that depends on time and interest rate changes. But, I *don't* know what they bought and sold at and know the fund has a mix.

I'll go and see if I can find the ticker.

You're over-thinking this.

-Buy a gilt. You now hold a gilt.
-Buy another gilt with a different maturity date. You are now running a bond fund.


The main differences comparing your fund to the commercial bond fund are 1. the number of components and 2. the level of costs extracted from the fund.


For your fund of gilts you can calculate the same numbers published by the commercial fund: the duration, the running yield, the cost of a unit, etc etc. There really is no more magic involved (assuming no use of derivatives etc).


GS

[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.
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?

[JohnW]

The honest way to deal with your losses is to ask yourself what factors caused you to pay too much in the first place.’

‘
That is so tempting, as though it would allow us to foretell the future. It ain’t necessarily so.

‘You look at your investment afresh, at current valuation and ask whether it is still justified in light of the new insight you have gained.’

Or, having thought through to a sensible asset allocation based on fundamental issues you simply accept market behaviour which you don’t like and carry on, rather than try to predict the future or chase past returns.

‘Gilts are a great example actually. Gilts a few years back were at the end of a wonderful secular bull run.’

People said that for a decade or so before interest rate started up with a vengeance. Market timing ain’t easy, even for the pros. Bill Gross was the bond fund genius for many years until he wasn’t.
Rather than ‘these are the lessons we learnt, remember them for next time’, where are the lessons from the past that said ‘don’t go into gilts with low yields just because there’s a pandemic’?