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Putative behaviours

Gilts, bonds, and interest-bearing shares
Newroad
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Putative behaviours

#348764

Postby Newroad » October 18th, 2020, 7:57 pm

Hi All.

I'm not sure quite how to ask what I want to ask, so please excuse, in advance, the quite possible poor framing of the question.

The received wisdom is that rising interest rates are bad for bonds - and all things being equal, they very likely are are. However, I recall a post, probably on The Lemon Fool, possibly in this forum (but also possible are "Passive Investing" and "Investment Trusts and Unit Trusts") suggesting that they aren't quite as bad for bond ETF's/Investment Trusts/Units Trusts as one might intuitively imagine.

My limited recollection of the post was that the rationale may have been that rolling reinvestment of maturing issues at higher rates minimised the downside - but I may misrecall completely. Further, even if I recall correctly, there may be other preconditions, e.g. steadily/gently rising rates as opposed to lurching/rapidly rising ones. Finally, the flip side of the argument would presumably be that lower rates have less upside that one might initially imagine.

If anyone can recall a link to the salient post, I would be grateful. Equally, if anyone cares to address the point from first principles, irrespective of the existence or otherwise of the original post, it would also be appreciated. If looking for a couple of examples to consider the behaviour of in a rising interest rate environment, may I suggest two of my holdings

    VAGP - A global bond ETF with an average maturity of around 9 years and an average quality of around AA-
    HDIV - A global debt and fixed income Investment trust with a median quality of around BB

As you might imagine, I am asking as I contemplate if and how I should cater for the possibility of rising interest rates around the world in the medium term.

Regards, Newroad

JohnW
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Re: Putative behaviours

#348809

Postby JohnW » October 19th, 2020, 5:50 am

I’ll have a shot.
I have no idea about an earlier discussion.
Firstly, if you hold individual bond(s) to maturity then interest rate changes won’t affect your anticipated returns on your bonds. You were promised certain coupons and a certain principal at maturity, so that’s what you’ll get if they don't default. Hence their attraction in meeting defined spending needs in the future. Buy a selection of them to make yourself a non-rolling bond ladder, and you can get a lumpy trickle of income for years to come.
By contrast, in a bond fund the bonds ‘kind of’ never mature, in that as they get to maturity they are replaced with newer ones so the fund’s mix of maturities doesn’t change, unlike the single bond you buy or your non-rolling bond ladder. As a consequence, as you noted with rising interest rates, that fund’s mix of bonds are not paying as much as a new mix getting higher interest coupons, and so the price of the fund falls; and the longer to maturity are its bonds, so the further it falls.
But with the continuing replacement of the fund’s maturing bonds, the fund accumulates new bonds paying the higher interest rates, and so the price drop is eventually compensated for by the higher coupons of its bonds. The longer the maturity of the fund’s bonds, the more the price falls and the longer to get coupon compensation for that fall. You can imagine how all that works as interest rates fall, I’m sure.
Folk generally like higher coupons, so rising interest rates aren’t all bad, or even bad at all depending on your circumstances.
Your fund examples look a bit like apples and oranges to me: different credit risk. I’ve go no idea how credit risk is impacted by interest rate changes.
Lastly, how do you deal with possible interest rate changes. Firstly, don’t bother guessing the change; 68 economists all got it wrong in 2014 https://www.marketwatch.com/story/yes-1 ... 2014-10-21
Perhaps you need to be positioned, invested, to cope with a move either way or no move. As a generalisation, your bonds’ durations are best if they align with your spending durations; the trouble with a bond fund is its duration usually doesn’t change but your spending horizons likely do.

GoSeigen
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Re: Putative behaviours

#348812

Postby GoSeigen » October 19th, 2020, 6:48 am

Newroad wrote:Hi All.

I'm not sure quite how to ask what I want to ask, so please excuse, in advance, the quite possible poor framing of the question.

The received wisdom is that rising interest rates are bad for bonds - and all things being equal, they very likely are are. However, I recall a post, probably on The Lemon Fool, possibly in this forum (but also possible are "Passive Investing" and "Investment Trusts and Unit Trusts") suggesting that they aren't quite as bad for bond ETF's/Investment Trusts/Units Trusts as one might intuitively imagine.

My limited recollection of the post was that the rationale may have been that rolling reinvestment of maturing issues at higher rates minimised the downside - but I may misrecall completely. Further, even if I recall correctly, there may be other preconditions, e.g. steadily/gently rising rates as opposed to lurching/rapidly rising ones. Finally, the flip side of the argument would presumably be that lower rates have less upside that one might initially imagine.


TBH this is Bond 101. As you seem pretty interested, I recommend reading a basic bond textbook.

In short, rising rates ARE bad for bond prices. But why are the rates rising? Rising inflation is a bad scenario because not only is the bond price falling but if you hold to maturity your buying power has shrunk too.

If I were to reword your question though, I'm guessing you are asking one of the following two:
1. Does an arbitrary bond fund outperform a (say) 10-year gilt in a rising-rate environment? or,
2. Does a bond fund with equal modified duration to a 10-year gilt outperform the latter?

The key phrase there is modified duration. If two bond investments have a similar modified duration then their response to changing interest rates will be similar. So for 1. above the answer would probably be yes if the modified duration of the fund is less than the gilt and no if it's more. For 2. above, the outcome would be similar except perhaps under extreme conditions.

Incidentally, matching the modified duration to the length of time you need to invest will ensure your actual return matches most closely the initial yield of the bond/fund if rates fluctuate during your holding period (and provided coupons are reinvested).

If modified duration means nothing to you then that textbook will help!


GS

JohnW
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Re: Putative behaviours

#348834

Postby JohnW » October 19th, 2020, 8:40 am

Indeed.
Bond neophytes beware however, the initial enquiry was about rising interest rates being bad for bonds, not bond prices. The distinction is relevant as some understanding of bonds reveals.
As well,
GoSeigen wrote:Rising inflation is a bad scenario because not only is the bond price falling but if you hold to maturity your buying power has shrunk too.

Considering only one bond, an inflation linked bond won't let you down like that; the coupon and 'face value' rise with the inflation. A fund of inflation linked bonds is probably the same, I'd imagine.
Hope that doesn't start a new brush fire.

Newroad
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Re: Putative behaviours

#348861

Postby Newroad » October 19th, 2020, 9:50 am

Hi JohnW and GoSeigen.

Thanks for your replies.

To be honest, my most likely action is "do nothing", i.e. keep my 40% bond "fund" weighting, half of which is passive with VAGP and half of which is active with HDIV (or similar - it depends whether we're talking SIPP, ISA or JISA). My understanding of bond basics is adequate - a few years back in the day at an investment bank working on their bond and repo settlement systems did no harm. However, the client managed "fund" perspective is a little different and there may be non-obvious subtleties I miss - hence the question.

JohnW's first reply was close in nature to the original discussion I was thinking of, whether or not it was one of his - thanks for that. Your point on credit risk is understood - HDIV and its friends in other parts of the family portfolio (IPE & CMHY) are clearly greater in this regard.

GoSeigen's alternate questions are perhaps implicit in what I am broadly musing on - see above about non-obvious subtleties.

Maybe I just need to do the maths, look at my time horizon etc. I could read a textbook as suggested - to learn/refresh the basics - but as per the tenor of the post above, it's the narrower "fund" part I'm most interested in. However, I note GoSeigen's take re similar behaviour from similar (aggregate) modified durations as compared to standalone bonds - so maybe that's enough for my purposes.

Regards, Newroad

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Re: Putative behaviours

#348906

Postby dealtn » October 19th, 2020, 11:38 am

JohnW wrote:Indeed.
Bond neophytes beware however, the initial enquiry was about rising interest rates being bad for bonds, not bond prices. The distinction is relevant as some understanding of bonds reveals.
As well,
GoSeigen wrote:Rising inflation is a bad scenario because not only is the bond price falling but if you hold to maturity your buying power has shrunk too.

Considering only one bond, an inflation linked bond won't let you down like that; the coupon and 'face value' rise with the inflation. A fund of inflation linked bonds is probably the same, I'd imagine.
Hope that doesn't start a new brush fire.


They rise "alongside" inflation, but the bond price also moves to par. So if you buy above (real) par then when it redeems at (real) par you will have seen a (real) decline in your capital.

If you don't understand that then there is a risk you will "be let down".

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Re: Putative behaviours

#348909

Postby dealtn » October 19th, 2020, 11:44 am

Newroad wrote:
The received wisdom is that rising interest rates are bad for bonds - and all things being equal, they very likely are


You need to be careful what you mean by rising interest rates.

Bond markets will price the (fixed) interest rates to that maturity date, which is not the same as the current short term interest rate. So in broad terms if short term rates are 0%, and 10 year rates are 2%, the implication is that the "average" short term rate over the 10 year period is 2%. This could be a smooth increase to 4% over that period with the short term rate at 2% in 5 years time etc.

So rising (short) rates might be good, or bad, for bonds depending how this rise occurs compared to the scenario that is priced in.

For instance (short) interest rates, might rise from 0% to just 1% over the first 5 years, lower than the priced in 2%. In this case Bonds will likely have done well, despite rising interest rates.

Newroad
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Re: Putative behaviours

#348917

Postby Newroad » October 19th, 2020, 12:03 pm

Understood, dealtn.

More of an issue with my attempt to frame the question than a fundamental lack understanding on my part.

Regards, Newroad

JohnW
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Re: Putative behaviours

#349044

Postby JohnW » October 19th, 2020, 9:23 pm

dealtn wrote: but the bond price also moves to par. So if you buy above (real) par then when it redeems at (real) par you will have seen a (real) decline in your capital.

If you don't understand that then there is a risk you will "be let down".

Important point, succinctly put.

Newroad
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Re: Putative behaviours

#349097

Postby Newroad » October 20th, 2020, 8:33 am

Morning, All.

For what it's worth, I decided to take GoSeigen's advice and read a textbook! The question was - "Which one?".

I've decided to go for (a second hand copy of) the following

https://www.amazon.co.uk/s?k=All+About+Bonds%2C+Bond+Mutual+Funds%2C+and+Bond+ETFs&ref=nb_sb_noss

mainly because it explicitly mentions funds and ETF's, which are the sub-focus of my interest.

Regards, Newroad

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Re: Putative behaviours

#349110

Postby GoSeigen » October 20th, 2020, 9:14 am

Newroad wrote:Morning, All.

For what it's worth, I decided to take GoSeigen's advice and read a textbook! The question was - "Which one?".

I've decided to go for (a second hand copy of) the following

https://www.amazon.co.uk/s?k=All+About+Bonds%2C+Bond+Mutual+Funds%2C+and+Bond+ETFs&ref=nb_sb_noss

mainly because it explicitly mentions funds and ETF's, which are the sub-focus of my interest.

Regards, Newroad


Probably not a bad introduction though reviewers describe it as "dry". For a more precise academic approach you really can't beat this book:

https://www.amazon.com/Introduction-Bon ... 047068724X

GS

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Re: Putative behaviours

#349133

Postby 88V8 » October 20th, 2020, 10:01 am

Fresh in the mind with the (paper) tax return recently submitted, in the UK most bonds are not currently subject to CGT.
But if one buys bond ITs, gains are taxable.

Also, I believe, the maturity gain on index-linked bonds is taxed as income.

The tax tail shouldn't wag the dog of course, but with tax rates set to rise one's tax wrapper becomes more valuable, in addition to avoiding a lot of complexification.

V8

Newroad
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Re: Putative behaviours

#349198

Postby Newroad » October 20th, 2020, 1:27 pm

Thanks, 88V8.

All relevant investments for me are within tax efficient wrappers (SIPP, ISA, JISA) - but the point is well made.

Regards, Newroad

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Re: Putative behaviours

#349402

Postby JohnW » October 21st, 2020, 7:07 am

GoSeigen wrote:Probably not a bad introduction though reviewers describe it as "dry". For a more precise academic approach you really can't beat this book:

https://www.amazon.com/Introduction-Bon ... 047068724X

GS

You can read most of the first 50 pages of that on google books. Take a deep breath if you're not a mathematician.
And you can read the first 40 pages of a previous edition of Annette Thau's The Bond Book. Not a formula in sight.


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