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High Quality Bonds in the Spotlight

There is an old adage in the investment world that ‘diversification is always having to say you are sorry’, as there is usually one (or more) parts of the portfolio that is a bit disappointing.  Every asset class has its day in the spotlight, for good or for bad, at some point.  

Over the past couple of years, shorter-dated, high-quality bonds that constitute strong defensive assets have delivered low returns and have had a finger pointed at them, by some.  Bond yields have been at historical lows, with yields on 5-year UK government gilts at or below 1% for the past three years.  Today they stand at around 0.2% and that is before the impact of inflation.  It is understandable that investors find low yields frustrating, but one needs to look at the bigger picture.  Bonds sit in long-term portfolios predominantly to provide some stability at times of equity market turmoil.

In the face of these low yields, investors have had two straight choices: accept the fact and stoically maintain the quality of their bonds; or go in search of yield by owning lower credit quality bonds and/or bonds of longer maturity.  We know that many have been tempted by the latter strategy.  We have stuck to the former to defend the portfolio at times of equity market turmoil such as this.  Remember that the lower the credit quality of bonds, the more they act like equities.

We think of yield-driven bond strategies – particularly high yield bonds – as akin to picking up pennies in front of a steamroller, which works nicely until you trip over.  The chart below looks at the performance of different types of bonds since the equity markets began to fall in February this year.  

It reveals that high-quality bonds have more or less held their value, doing the job asked of them.  As one moves down the credit spectrum to lower quality companies, returns become increasingly negative.  Owning these lower quality bonds, but with longer maturities, simply magnifies these falls (heading from left to right in the chart).  As it has always done, scared money runs from higher risks (including the possibility of default on bonds from less healthy companies) which drives yields up and prices down. It tends to move into high-quality, liquid assets driving bond yields down and prices up.

 

As Warren Buffet once said:

‘Only when the tide goes out do you discover who’s been swimming naked.’

Fortunately, your portfolio has kept its trunks on!  

 

Use of Morningstar Direct© data

© Morningstar 2020. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied, adapted or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information, except where such damages or losses cannot be limited or excluded by law in your jurisdiction. Past financial performance is no guarantee of future results.

Data set

Data label Market index used
Global Govts 1-5 Hdg Markit iBoxx GBP Gilts TR
Gilts 1-5 TR FTSE WGBI 1-5 Yr Hdg GBP
GBP Corp 1-5 TR Markit iBoxx GBP Gilts 1-5 TR
Global Corp TR Hdg GBP Markit iBoxx GBP Corporates 1-5 TR
GBP Corp TR BBgBarc Global Aggregate Corporates TR Hdg GBP
GBP Corp BBB TR Markit iBoxx GBP Corporates TR
Global High Yield TR Hdg GBP Markit iBoxx GBP Corp BBB TR
Emerging Equity BBgBarc Global High Yield TR Hdg GBP
Developed Equity MSCI EM NR USD
UK Equity MSCI World NR USD

 

Risk warnings

This article is distributed for educational purposes only and must not be considered to be investment advice or an offer of any security for sale. The reference to any products is made only to make educational points and must, in no circumstances, be deemed to be any form of product recommendation.

 

This article contains the opinions of the authors but not necessarily Donald Wealth Management (the Firm) and does not represent a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. 

 

It is not a promotion of Donald Wealth Management’s services. Donald Wealth Management strongly suggests that no investor should act on any of these ideas without first seeking financial advice.

 

Past performance is not indicative of future results and no representation is made that the stated results will be replicated. The value of an investment is not guaranteed and on encashment you may not get back the full amount invested. Errors and omissions excepted.

 

Donald Wealth Management is a trading style of Donald Asset Management Limited which is authorised and regulated by the Financial Conduct Authority in the United Kingdom (FRN: 223784). Donald Asset Management Limited is registered in England and Wales under Company No. 4675082. The registered office address of the Firm is: Stable End, 12 Heather Court Gardens, Four Oaks, West Midlands, B74 2ST.

 

Rebalancing – Do I Really Have to?

Humans have a hard time being investors.  Normally, we like to purchase things when they are cheap and avoid them when they are expensive, but that is often not the case for equities.  We tend to get overly optimistic and enthusiastic when equity markets rise dramatically, as they have done since the Global Financial Crisis a decade ago.  Yet when markets fall materially, we feel bruised and cautious, seeking to hang onto our stable bonds and even selling equities to avoid further falls in portfolio value.  That’s rarely a good idea, especially if you do not need the bulk of your capital in the foreseeable future.

As a client you will know that we have always sought to rebalance your portfolio on a regular basis, by which we mean returning it to the original target allocation that we initially established with you.  Most often, over the past few years, rebalancing has meant selling growth assets (equity-like) and buying defensive assets (bonds) in a contrarian manner.  This has helped to avoid the portfolio becoming dominated, over time, by the riskier growth assets component of the portfolio and to keep you within your emotional tolerance for falls, your financial capacity to weather them and your need to take risk in the first place.

Logically, the reverse also applies; at times like these the proportion of equities in your portfolio will have fallen below their long-term target.  This matters because your portfolio now has too little risk and it will be harder for the growth assets remaining to recoup the falls in value when markets eventually recover.

We can work that idea through with a simple example.  Imagine you own a £10,000 portfolio split 50% (£5,000) into growth assets and 50% into defensive assets.  In the growth assets portion, you own 50 units of a global equity fund priced at £100 per unit.  Growth assets fall by 40%.  Let’s assume your defensive assets are unchanged in value.  You still own 50 global equity fund units, but they are now priced at £60.  Your growth-defensive split has moved from 50/50 to 37.5/62.5.  Time to rebalance.

Figure 1: Market falls leave you underweight growth assets

Rebalancing

Source: Albion Strategic Consulting

Rebalancing i.e. buying equities to realign the portfolio with its allocation target, helps to ensure a quicker recovery back to where you started.  This is because the breakeven price of your equity holdings is now lower.

So, let’s now assume that you rebalance by taking £1,000 from your defensive assets and buying growth assets to get you back to a 50/50 split (left hand grid below).  You can buy 16.7 units at £60 with the £1,000 raised.  To get your portfolio back to its starting value of £10,000 your now 66.7 global equity units need to rise 50% to £90 per unit (middle grid).  However, an un-rebalanced portfolio (right hand grid) only rises to £9,500 with this 50% rise.  In fact, to get back to a portfolio value of £10,000 and un-rebalanced portfolio requires a rise of 67% in the global equity units to £100.

Figure 2: Rebalancing helps the portfolio to recover faster

Rebalancing

Source: Albion Strategic Consulting

Even if the markets fall again after rebalancing, the opportunity exists to rebalance again, likewise further reducing the rate of return required to get back to where you were compared to un-rebalanced portfolios.  That takes courage and discipline, when your emotions are telling you to do the opposite.

The issue of a potential rebalance on the back of large market falls is certainly being considered and don’t be surprised if we raise this with you.  You now know why.  Remember, if you are drawing an income from your portfolio, withdrawing from bonds can get you closer to your target.  Likewise, if you have incoming cashflows, this too can be used to buy growth assets.

As David Swensen, CIO of Yale University’s Endowment and one of the world’s most highly respected institutional investors states[1]:

‘The fundamental purpose of rebalancing lies in controlling risk, not enhancing returns.  Rebalancing trades keep portfolios at long-term policy targets by reversing deviations resulting from asset class performance differentials.  Disciplined rebalancing activity requires a strong stomach and serious staying power.’

Do you really need to rebalance?  The answer for most investors is likely to be ‘yes’ when the time comes.  If we feel a rebalance is necessary, we will be in touch to discuss this with you.

As ever, please feel free to give us a call if you have any questions.

Risk warnings

This article is distributed for educational purposes only and must not be considered to be investment advice or an offer of any security for sale. The reference to any products is made only to make educational points and must, in no circumstances, be deemed to be any form of product recommendation.
This article contains the opinions of the authors but not necessarily Donald Wealth Management (the Firm) and does not represent a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.

It is not a promotion of Donald Wealth Management’s services. Donald Wealth Management strongly suggests that no investor should act on any of these ideas without first seeking financial advice.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated. The value of an investment is not guaranteed and on encashment you may not get back the full amount invested. Errors and omissions excepted.

Donald Wealth Management is a trading style of Donald Asset Management Limited which is authorised and regulated by the Financial Conduct Authority in the United Kingdom (FRN: 223784). Donald Asset Management Limited is registered in England and Wales under Company No. 4675082. The registered office address of the Firm is: Stable End, 12 Heather Court Gardens, Four Oaks, West Midlands, B74 2ST.

[1]    Swensen, D., (2000) Pioneering Portfolio Management.  New York: The Free Press

How Long is Long-Term?

For many investors – particularly those in retirement – the question ‘how long is long-term?’ could also be translated as ‘I’m getting on a bit, so should I still be investing in the stock market?’.  When it comes to systematic investing – that is to say, capturing specific market risks in a disciplined and rules based manner – a subsidiary question might also be ‘should I still own value and small cap stocks, as their excess returns, relative to the market, can take some time to come through?’.   

Even at 80, when investors may begin to ask themselves the question ‘how long is long-term’ they should still consider 20 years to be a sensible horizon.  After all, according to a useful little calculator provided by the Office for National Statistics, today, an 80-year-old woman has an average life expectancy of 90, a 1-in-4 chance of reaching 94 and 1-in-10 chance of getting to 98.  Consider the following:

  • As an investor in equities, you have around a 1-in-4 to 1-in-3 chance that you will suffer a loss in any one year. Yet at a 10-year horizon a 60 equity /40 bond ‘balanced’ portfolio has a better than 1-in-20 chance.
  • For long-term investors, cash is an extremely dangerous asset class, particularly when viewed after the effects on inflation, as it should be.  It is worth noting that over the 10 years since the Credit Crisis those placing their assets in UK cash have lost over 20% of their purchasing power. 
  • Portfolios tilted towards value and smaller company stocks exhibit worst-case outcomes materially better than un-tilted portfolios at 10-year horizons and beyond.  This helps answer the question whether an investor who is 80 should include value and smaller company stocks in any equity allocation they hold. They probably should.
  • Investors with horizons longer than 10 years – even those simply seeking to maintain purchasing power – should own a meaningful level of equities in their portfolio.
  • Cash and bonds alone are unsuitable for most longer-term investors. 

Answering the question

On balance, ‘long term’ should be defined as 10 to 15 years minimum.  Above 15 years, the chances of a negative purchasing power outcome are low, but the risk still exists!  To be prudent, 15 years might be considered as the lower end of ‘long term’, which is still within the investment horizon of most investors, including those in their 80s.  We hope that helps answer the question.

Other notes and risk warnings

Use of Morningstar Direct data

Morningstar Direct © 2019. All rights reserved. Use of this content requires expert knowledge. It is to be used by specialist institutions only. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied, adapted or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information, except where such damages or losses cannot be limited or excluded by law in your jurisdiction. Past financial performance is no guarantee of future results.’

Risk warnings

This article is distributed for educational purposes only and must not be considered to be investment advice or an offer of any security for sale. The reference to any products is made only to make educational points and must, in no circumstances, be deemed to be any form of product recommendation.

This article contains the opinions of the authors but not necessarily Donald Wealth Management (the Firm) and does not represent a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. 

It is not a promotion of Donald Wealth Management’s services. Donald Wealth Management strongly suggests that no investor should act on any of these ideas without first seeking financial advice.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated. The value of an investment is not guaranteed and on encashment you may not get back the full amount invested. Errors and omissions excepted.

Donald Wealth Management is a trading style of Donald Asset Management Limited which is authorised and regulated by the Financial Conduct Authority in the United Kingdom (FRN: 223784). Donald Asset Management Limited is registered in England and Wales under Company No. 4675082. The registered office address of the Firm is: Stable End, 12 Heather Court Gardens, Four Oaks, West Midlands, B74 2ST.

Some Thoughts On Bonds….

‘You don’t need bonds until you need them!’

Anon.

Challenging times

In response to the very low yield on bonds, some investors have been tempted to chase higher yielding bonds, in an attempt to squeeze some return out of what feels like an unproductive portfolio allocation.  This is, unfortunately, an accident waiting to happen.  The phrase ‘picking up pennies in front of a steamroller’ comes to mind.

Others are asking whether they should be holding cash as bond yields are ‘inevitably’ going to rise, denting bond returns, at least in the short term.  Neither approach makes much sense.

We should be looking forward to yield rises

At some point in the future, yields are likely to rise back to higher levels.  The problem is that no-one knows when, how quickly and with what magnitude it will happen.  Investors should be looking forward to yield rises, because in the future their bonds will be delivering them with a higher yield, hopefully above the rate of inflation.

When yields do rise, bond prices will fall, creating temporary losses.  At that point bonds now earn an investor more than they did before the rate rise and they reach a breakeven point where the new higher yield has fully compensated them for the temporary capital losses suffered.  The time to break even is equivalent to the duration (similar to maturity) of an investor’s bond holdings.  Short-dated bonds with a three-year duration will break even after three years.  Below is a hypothetical example.  Follow it through.

Table 1‑1: The impact of a 2% rise in yields on a 3-year duration bond portfolio

2% rise in yields on a 3 year duration bond portfolio

Note: * We have assumed that the capital loss is approximated by the rise in yields times the duration.  In reality, due to convexity – capital losses would not be quite so great.

Holding cash deposits is not the solution

Imagine that an investor felt that rate rises were likely to occur, with a detrimental – albeit temporary – impact on bond returns in the near future.   They decide to place a deposit for three years, receiving interest of 1.5% p.a., comparable to the current yield on three-year bonds.  In three years’ time when their deposit matures, they end up with the same return as the bond portfolio (green-coloured cell in the table above).  Why bother?

Long-term investors should stick with their bond holdings.  At some point they will need them to protect against turmoil in the equity markets. Remember ‘You don’t need bonds until you need them!’.

Other notes and risk warnings

This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale.

This article contains the opinions of the authors but not necessarily Donald Wealth Management (the Firm) and does not represent a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.

It is not a promotion of Donald Wealth Management’s services. Donald Wealth Management strongly suggests that no investor should act on any of these ideas without first seeking financial advice.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated. The value of an investment is not guaranteed and on encashment you may not get back the full amount invested. Errors and omissions excepted.

Donald Wealth Management is a trading style of Donald Asset Management Limited which is authorised and regulated by the Financial Conduct Authority in the United Kingdom (FRN: 223784). Donald Asset Management Limited is registered in England and Wales under Company No. 4675082. The registered office address of the Firm is: Stable End, 12 Heather Court Gardens, Four Oaks, West Midlands, B74 2ST.

In the News – January 2017

dog reading newspaper

The latest stories in the news, which may be of interest to our clients.

The end of BTL?

Buy-to-let landlords are switching from residential to commercial property, says the Telegraph.

Auctioneers say the imminent start of the new tax regime for residential BTL, which will severely cut net of tax returns, has prompted many landlords to look at shops, offices and industrial units. The rental yield is often higher and tenants pay many of the costs residential landlords have to fork out for, including insurance, repairs and rates. But capital growth is much less likely than in the residential market.

Grandparents lose credit

Thousands of grandparents are missing out on valuable National Insurance credits, says the Telegraph.

The specified adult childcare credit is designed to protect the pensions of grandparents who retire early to care for grandchildren so that their parents can go back to work. If you miss a whole year of NI contributions, this results in a cut of £231 a year in the state pension, and the credit can avoid this. But since the credit was introduced in 2011, just 5,000 people have claimed it, though over 100,000 could be eligible.

Is care at home better?

With the care crisis, closures of care homes and huge residential care home fees, is organising care at home a better solution for some elderly people?

The Telegraph says that not only can costs be lower, but you stay in control, and may qualify for some local authority financial support. This is because if you stay in your own home but have assets of under £23,250 you qualify for financial support, whereas if a widow or widower goes into a care home the value of their house is used to pay for all or part of their care costs. Most people use a specialist agency to employ carers, who are usually paid well above the minimum wage that is usually paid to care home staff.

Boom in first time buyers

The number of first time property buyers in 2016 was the highest since 2007, says the Mail, with over 335,750 people getting onto the first rung of the property ladder.

Halifax says those purchasing their first property paid an average of £205,170, some 7 per cent above 2015s level. But since 2007 first-timers average deposit has more than doubled to £32,321 while in London it is now over £100,000. And mortgage terms are also getting longer, with 60 per cent of 2016 mortgages having a term of over 25 years.

Please note Donald Wealth Management does not provide mortgage advice.

Look to smaller banks for bonds

If you have a maturing fixed-rate bond, look to smaller banks for better rates, says the Mail.

Typical rates from the big banks are 0.5 per cent for one year and 0.55 per cent for two years, while smaller banks pay up to 1.4 per cent for one year and 1.6 per cent for two years. Like bigger banks they are all covered by the UK deposit protection scheme up to £75,000 per person per account. And NSI will launch a new three-year bond in March paying 2.2 per cent, though the maximum investment is limited to £3,000.

Cover your dog

Only one in four British dog owners has insured their pet, says the Times, yet vets bills can run into thousands if a dog suffers an accident or serious illness.

The most expensive type of policy maximum benefit comes in at an average premium of £247 a year for a pedigree animal, whereas accident-only policies cost just £52 on average. But premiums are also partly based on the breed of dog, with smaller and non-pedigree animals costing less to insure.

Carney warns on consumers

Bank of England governor Mark Carney has warned that consumer spending – rising fast recently – could be hit later in 2017 by rising prices set off by the decline in the sterling exchange rate.

He also noted that consumer debt is rising at its fastest rate since 2005. The UK was relying on consumer spending for economic growth – rather than exports or investment – which boded poorly for the future, Mr Carney said.

Watch out for tax traps

An analysis in the Financial Times identifies over 90 tax traps where an additional slice of income bears a marginal tax rate much higher than the normal rate.

For example, parents earning between £50,000 and £60,000 can suffer a marginal tax rate of 100 per cent since they lose as much child benefit as they get in salary. And because Scotland has the power to change tax thresholds but not National Insurance, someone living in Scotland with an S on their tax code will pay tax at 52 per cent on the slice of income between £43,430 and £45,000.

Inflation rising

Inflation as measured by the Consumer Price Index rose to 1.6 per cent in December, up from 1.2 per cent the previous month and higher than most forecasts.

Rising food and fuel prices were the main factors. The Retail Prices Index rose at 2.5 per cent compared with 2.2 per cent the previous month. Analysts said the decline in the sterling exchange rate was starting to feed through into prices.

UK house prices up 6.7 per cent

UK house prices rose in November for the first time since the Brexit vote, the Financial Times reported using data from the Office of National Statistics.

The 1.1 per cent gain in the month resulted in an increase of 6.7 per cent over the twelve months to November, taking the average to £217,928 £482,000 in London. Residential rents remained unchanged for the fifth successive month but mortgage approvals picked up from their August low.

Please note Donald Wealth Management does not provide mortgage advice.

Fitbit financier, hoarder or splasher?

Which of six financial personality types are you? asked the Financial Times, with some pointed comments about their flaws.

Fitbit Financiers, obsessively checking their balances, may seek control of money because they’ve lost control elsewhere in their lives, while Cash Splashers are generous only to impress. Hoarders see piles of cash as security while Anxious Investors watch their investments too closely and trade far too much, thus reducing the returns they get. Social Value Spenders buy to boost their self-esteem and may be as addicted as alcoholics. Lastly, the Ostrich ignores bills and tax demands until they threaten disaster.

Parents hold onto their cash

The Mail reports a survey about inheritance in which 30 per cent of parents said worries about their children’s relationships meant they didn’t want to give them money.

Some 14 per cent said they were bypassing their children and giving to grandchildren, about the same percentage as those who expressed doubt that a childs marriage would last. According to Google, searches on the question Should I get divorced? peaked the week after Christmas. The older generation prefer to make small gifts, and more of them are setting up discretionary trusts to retain control of their capital.

Rich inheritors

The older generation have seen their total wealth increase by 45 per cent over the past ten years.

That means their children will inherit more than previous generations – but also more unequally, says the BBC. Research by the Institute for Fiscal Studies showed that about half of UK households own about 90 per cent of wealth, which means that those who inherit from the rich will be very well off – even though most of those who inherit already have higher than average incomes and assets. The IFS says biggest cause of the discrepancy is housing wealth, and the difficulty young people have in buying a first home is making the problem more acute.

House price forecasts for 2017

The Mail rounded up house prices forecasts for 2017 from several sources, all of whom predicted slower growth than in 2016, ranging from flat Savills to 3 per cent RICS.

The big lenders – Nationwide and Halifax – expect average price rises of no more than 2 per cent. Almost a third of the Mails own readers surprisingly said they would like prices to fall in 2017 – presumably because they are struggling to make their first purchase.

Please note Donald Wealth Management does not provide mortgage advice.

Portability denied

Most modern mortgages are portable – you should be able to transfer them when you sell your home and buy another.

But the Telegraph claims that most lenders are denying borrowers ability to port their mortgages by forcing them to go through stringent affordability tests, despite the fact that the regulator has explicitly said this should not be necessary unless the borrower wants to increase the loan or extend the term. If the borrower does not fit the new affordability criteria, then they no longer qualify for the cheap tracker deal they currently have and will have to take out a loan at a higher interest rate.

Please note Donald Wealth Management does not provide mortgage advice.

Follow pension boss’s example

People are usually told not to even think about taking a transfer value from a scheme that guarantees a final salary pension, says the Telegraph.

But, it says, if someone as knowledgeable about pensions as former pensions minister Baroness Altmann is cashing in two of her final salary pensions, perhaps you should think again. In both cases, the transfer value of the pension had more than doubled in the past two years. The Telegraph quoted her remark:”I don’t mind giving up some final salary, guaranteed pension income in exchange for what seems a very good-value offer”.

HMRC deploys snooper computer

HMRC has spent over £100 million over several years developing a snooper computer that identifies people whom may be under-declaring their income, and the system is being deployed just as the January deadline for filing 2015-16 tax returns approaches.

The Connect system collects data not just from other government departments but from sources such as Airbnb, the Land Registry and eBay. It can also get information from banks in 60 countries. It flags likely targets for further investigation.

How to boost your credit score

One recent survey showed that 79 per cent of adults had no idea what their credit score was or how it affected them, says the Times.

Yet a poor credit score can not just make it harder and much more expensive to gain any sort of credit but also make it harder to get deals for mobile phones, rental agreements or utilities. Experts recommend checking your current score with one of the big three agencies – Experian, Equifax and and Callcredit. Those with poor scores should consider taking out a credit card with a low limit and paying the balance off every month. For young people, getting on the electoral register is another way of improving your rating.

Generation rent

The proportion of 25-year-olds who own their own home has fallen from 46 per cent to 25 per cent in the past 20 years, says the Telegraph, citing research by estate agency Savills.

But it is not just the young – the overall proportion of home owners has fallen from 72.9 per cent from its peak in 2004 to 64.1 per cent today. Rents are now much higher than mortgage payments, partly the result of an 88 per cent fall in the amount of social housing being built today compared with 20 years ago.

Please note Donald Wealth Management does not provide mortgage advice.

Inflation ahead

Three-quarters of the economists responding to the Financial Times annual survey said UK inflation was likely to top 2 per cent in 2017, while a third of them expected inflation to exceed 3 per cent during the year.

The 15 per cent decline in the exchange value of the £ is cited as the main cause, though there is still much disagreement on how quickly that will feed through to retail prices. Most economists still agree with the Bank of England that the rise in inflation will be temporary, since there is as yet no sign of an upturn in average earnings.

BTL landlords expect double hit

A survey of Buy to Let owners reveals that over 60 per cent of them expect to be hit not just by restrictions on the tax relief on mortgage interest which will be cut from 40 per cent to 20 per cent by 2020 but by new affordability rules on BTL lending set by the Bank of England.

These rules seem likely to penalise landlords with more than four properties, says the Financial Times.

Please note Donald Wealth Management does not provide mortgage advice.

Courier wins gig economy case

A courier for a London bicycle delivery firm has won her employment tribunal case to be regarded as an employee rather than a self employed contractor.

Ominously for business owners, the judge described the companys depiction of its couriers as self employed as window dressing. Several similar cases are due to be heard shortly by the same judge. Lawyers interviewed by the Financial Times said thousands more couriers were likely to pursue similar cases.

This article contains the opinions of the authors but not necessarily Donald Wealth Management (the Firm) and does not represent a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. It is not a promotion of Donald Wealth Management’s services. Donald Wealth Management strongly suggests that no investor should act on any of these ideas without first seeking financial advice.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated. The value of an investment is not guaranteed and on encashment you may not get back the full amount invested. Errors and omissions excepted.

Donald Wealth Management is a trading style of Donald Asset Management Limited which is authorised and regulated by the Financial Conduct Authority in the United Kingdom (FRN: 223784). Donald Asset Management Limited is registered in England and Wales under Company No. 4675082. The registered office address of the Firm is: Stable End, 12 Heather Court Gardens, Four Oaks, West Midlands, B74 2ST.

Asset insight: Lending your money to others (bonds)

Summary

When you place a deposit with a bank, buy a gilt or a corporate bond, you are in effect lending your money to those with a need to borrow from you. In return you expect to be paid interest on your loan and get your money back. This note is a primer on understanding how bonds work and why who you lend to, and for how long, matters. 

‘Investing in bonds requires attention to more than one event at a time. Driving requires a foot on the gas, hands on the wheel and eyes on the road. Navigating the bond market requires a foot on interest rates, a handle on the prospects of being repaid, and an eye on inflation.’

Steven Mintz – financial journalist

An introduction to bonds

Many investors get quite excited about equities but few stop to think much about the bonds that they own. They should.  Bonds play a very important role in an investment portfolio.  For many they represent the ‘safe’ part their portfolio that will provide protection when times get tough in the equity markets – as they always do from time to time – or simply maintain the value of their portfolio. But classifying bonds as ‘safe’ and equities as ‘risky’ leads some into poor bond choices.  In practice they range widely in character from ‘cash-like’ to ‘equity-like’, as we will explore below.  Before moving on, it is important to make sure that the basic mechanics of how bonds work are clearly understood.

Basic bond mechanics

Simply put, bonds are IOU’s issued by companies and governments to investors, which pay a fixed rate of interest to the lender, known as its coupon, and promises them that their principal will be returned at a set date in the future, known as its maturity date. In bond market parlance, the return that you expect to receive, on average per year, over the lifetime of a bond is known as its yield.  Always remember that as an owner of bonds you are acting as a lender to borrowers – you need to be comfortable with who they are and how long you are lending to them for.

The relationship between yield and price

The yield that the bond will deliver to you will need to be attractive and reward you for the various risks that you are taking on, which may relate to the market as a whole or may be specific to the issuer and structure of the bond.   At the time of issue the yield is more-or-less equivalent to the bond’s coupon.  As soon as the bond is issued, the bond market decides what the yield should be, based on how it perceives the risk of lending to the issuer of the bond.  The Eurozone crisis has provided an extreme example, where Greek, Spanish and Italian bond yields rose dramatically as the markets worried about being repaid both interest and capital.

As the coupon (rate of interest) is fixed throughout the bond’s life, the only way in which a change in yield demanded by the market can be delivered is through a change to the bond’s price. If yields rise, bond prices fall.  If yields fall, bond prices rise.   This is sometimes referred to as the bond see-saw, with yields at one end and prices at the other.

For example: imagine a bond is issued with a one year maturity at a price of 100 (its ‘par’ value) and a coupon of 4% p.a. If after issue the market demands a 6% yield, the bond’s price must fall to 98 to allow the investor to achieve a yield of 6% over the life of the bond.  This will be made up of the 4% cash coupon payments made and a 2% capital gain achieved when the bond matures at its par value of 100.

 

Figure 1: The bond see-saw

chart one

 

 

The components of a bond’s yield

At its simplest, the yield on a bond can be broken down into six components, some of which relate to all bonds (the first two below) and some of which relate to the specific circumstances of the issuer and the characteristics of the bond. Let’s first consider the lowest risk investment that we can make – lending on a short-term basis to the UK government:

  • Real yield: The real (after inflation) return that you expect to be paid in compensation for supplying your capital to the government, as opposed to utilizing it elsewhere to your benefit. Currently real yields are very low.
  • Inflation expectation: The market’s expectation for future inflation needs to be included to make sure that you receive the real return you are due, once inflation has been taken into account. Because this estimate for inflation has some uncertainty in it, investors expect a small premium for taking it on. Rising inflation leads to rising yields and thus negatively impacts bond prices. Changes in inflation expectations are a major component of high quality bond market movements.

As you move away from this risk-free position, the yield on the bond is going to rise as the risk of lending rises for some or all of the reasons below:

  • Credit (default) risk: This is the risk of not being paid the coupon on the bond and receiving the par value of the bond at its maturity date. The lower the credit quality of the bond’s issuer, the higher the yield must be to compensate for the higher chance of a default. Credit ratings provide a third party measure of how risky the borrower is[1].
  • Maturity (interest rate) risk: You would expect to receive a higher yield for lending longer, as you would when placing a deposit with a bank – in part because of the uncertainty about the rate at which you will be able to invest future coupons. This is not, however, a free lunch as the longer you lend your money for, the greater the impact a change in market yields (in response to changing risks) will have on the price of the bond. This is explored in a little more depth below.
  • Liquidity risk: The size of the bond issue, and who holds it, will impact on how liquid it is i.e. how easy it is to sell at a fair price. The less liquid the bond, the higher the compensation an investor will demand for holding it.
  • Structural risk: Certain structural features that may be more attractive to the borrower than to the investor, for which the investor needs to be compensated, such as an option for the borrower to repay the bond early if yields fall.

Tip 1: Always look out for the ‘average credit quality’ for any bond fund that you are invested in. Check out what the minimum average credit quality constraint is and review the distribution of the credit ratings of the holdings of the fund.

Longer maturity bonds are more volatile than shorter maturity bonds

The bond seesaw explains the generic relationship between yields and prices but not the magnitude of the price change for a given rise in yields. The sensitivity of a bond’s price to a change in yields is known as its ‘duration’ and is a measure described in years.  Put simply, it is the average time in which a bondholder is paid back and describes how far out along the price side of the bond see-saw you are sitting.

Rule of thumb to calculate gains or losses

Calculating a bond’s duration is complex, but don’t worry as you will never have to do it! What you do need to know is how sensitive the prices of the bonds you own are to movements in yields.  A useful rule of thumb exists to estimate this.

Duration X rise (fall) in yield = Capital loss (gain)

Below you can see very clearly that the longer the duration of a bond or a portfolio of bonds, the greater the change in price for a given movement in yields. This is important to understand.

Table 1: The longer the duration, the more volatile the price

Price change Duration
Yield Rise 1 Year 2 Years 3 Years 4 Years 5 Years 10 Years
1% -1% -2% -3% -4% -5% -10%
2% -2% -4% -6% -8% -10% -20%
3% -3% -6% -9% -12% -15% -30%

Note: This does not take into account the coupon that you will receive.

Tip 2: Always find out what the ‘weighted average duration’ of any bond fund product is. Duration figures should be readily available on a fund’s fact sheet.  Once you know the fund’s duration you can work out how much its price will fall for a given rise in bond yields.  Never own any form of bond investment without knowing its duration.

Bond market sectors

The figure below provides an indication of the spectrum of bond investments. By and large, bonds in the lower left hand corner are the least risky and bonds in the top right corner are the most risky.

chart two

 

 

 

 

 

 

 

Figure 2: Bonds vary widely in risk and potential return

 

 

 

In practice the industry gives labels to different categories of bond investments, some of which are summarised in the table below:

Table 2: Common categories of bond investments

Category Attributes Credit Maturity
Government (UK)
  • Known as ‘gilts’
  • Very liquid, high credit quality
  • Interest and capital repayment secure
  • Some inflation (index) linked issues available
AA All – short to very long
Global government bonds
  • Generally refers to investment grade
  • Indices structured in a number of ways
  • Often based on market capitalisation
  • Currency risk needs to be considered (hedged)
  • Growing number of inflation-linked issues
Investment grade All
Corporate bonds
  • Issued by companies
  • Tend to be less liquid providing a premium
  • A few inflation-linked issues
Investment grade Mainly short & intermediate
High yield corporate bonds
  • Issuers are in some sort of financial distress
  • Previously known as ‘junk bonds’
  • Low liquidity and high transaction costs
  • Prone to large swings in yields
  • Equity-like losses possible e.g. >-25% in the Credit Crisis
Sub-investment grade Mainly short & intermediate
Emerging market bonds
  • Issued by governments and corporations of emerging market countries
  • Many economies have improved in recent years
  • Mainly issued in local currency
  • Previously issuance was often in US dollars
  • Prone to large swings in yields
  • Risk of contagion between markets
  • Risk of large losses at times of crisis
Increasingly investment grade Short & some intermediate

 

 

Using bonds effectively in portfolios

The big issue, then, is how should you position the bond investments that form part, or all, of your portfolio? That depends on what your objectives are. If we look at the far ends of the risk spectrum, we can begin to get a clearer picture.  The generic needs of each type of investor are summarised in the figure below.

Figure 3: The needs of investors may differ

chart three

 

 

 

 

 

 

 

 

 

 

Source: Albion Strategic Consulting

Cautious investors worry about losses (and should worry about inflation)

By their very nature, cautious investors do not like to see large losses on their portfolios at any time. Most will accept that some small losses may occur as a result of bond yields rising and bond prices falling.  Those that cannot bear the thought of any losses at all are not investors but savers.  That introduces the other major concern – inflation.  Long-term cautious investors are vulnerable to bursts of unanticipated inflation, and need to try and protect their portfolios from it.  The 1970s is a prime example of when bonds fared poorly, losing up to one third of their purchasing power, in the face of very high inflation.  Even savers find it hard to avoid after-inflation losses – over the past three years they would have lost more than 10% of their purchasing power.  Many want some form of income from their portfolio, which bonds provide via their coupons.  The risk of deflation is also a concern.

Key dangers for long-term, cautious investors

  • Owning high yielding bonds: it is tempting to slide down the credit ratings to try and pick up extra yield. The problem is that higher yielding bonds (weaker issuers) are prone to large yield movements at times of market stress. Concerns over their ability to survive and pay coupons and repay principal rise. Yields rise and liquidity falls. High yield bonds can suffer equity-like losses (covered below) – not what a cautious investor wants.
  • Owning longer dated bonds: When yields are stable or falling, owning longer dated bonds is rewarded by higher yields than short-dated bonds and potential price appreciation. However, when yields rise, losses can be material (see Table 1 above).
  • Inflation: potential loss of purchasing power if inflation spikes unexpectedly. Owning only conventional bonds could be problematic.

A sensible bond solution

  • Low volatility: If you are a long-term, cautious investor you are well served by owning high credit quality (AA on average) shorter-dated bonds. This reduces the risk of uncomfortable losses, yet provides a little yield enhancement over the highest quality bonds, both through the lower (but still high) credit quality of the issuer, slightly lower liquidity and the longer duration (e.g. 3 years) compared to holding cash.
  • Inflation protection: An allocation to shorter-dated inflation-linked bonds provides protection from unanticipated inflation and makes sense in many instances. In practice, however, good products in this space are limited. Government backed inflation-linked certificates would fit this space well, if only they were still available.
  • Avoid currency exposure: All non-GBP currency exposure should be avoided by using products hedged back to GBP (or whatever the investor’s base currency is).

Risk tolerant investors, who own material allocations to equities

The main role that bonds play in these portfolios is to provide insurance against material equity market falls that will inevitably occur from time to time.

Take a look at the figure below. It provides support for why high quality bond assets make sense at times of equity market crisis, in this case driven by the Credit Crisis. While this is an extreme period, it does illustrate the point well.

 

Figure 3: Bond performance during the Credit Crisis (Nov. 2007 to Feb. 2009)

chart four

 

 

 

 

 

 

 

 

 

 

Data source: Morningstar Encorr 2013.  Copyright.  All rights reserved. (Footnote[2])

Conclusion

Bonds are a very important part of your portfolio. In a nutshell: bond prices are inversely related to bonds yields; the longer the duration of the bonds the more volatile they are; hunting for yield in high yield and emerging market bonds risks high losses; at times of market crisis, investors tend to flee to high quality liquid assets and out of lower quality bonds.

A sensible allocation should be made to high quality (e.g. average AA), shorter-dated bonds, avoiding all non-GBP currency exposure. As the old saying goes ‘the amount of interest you want should depend on whether you want to eat well or sleep well’.  Fortunately a well structured portfolio constructed to meet your goals should allow you to do both.

 

Other notes and risk warnings

 

This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily Donald Wealth Management (the Firm) and does not represent a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. It is not a promotion of Donald Wealth Management’s services.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated. The value of a unit linked investment is not guaranteed and on encashment you may not get back the full amount invested. Errors and omissions excepted.

Donald Wealth Management is a trading style of Donald Asset Management Limited which is authorised and regulated by the Financial Conduct Authority in the United Kingdom (FRN: 223784). Donald Asset Management Limited is registered in England and Wales under Company No. 4675082. The registered office address of the Firm is: Stable End, 12 Heather Court Gardens, Four Oaks, West Midlands, B74 2ST.

 

[1]       Rating agencies assign credit quality ratings to companies and government who issue bonds.  You will have heard the term ‘Triple-A rated’, which refers to the strongest issuer and is often used in everyday conversation.  UK government debt has recently been downgraded from AAA to AA by one of the rating agencies.  Ratings from AAA to BBB are known as investment grade and BB and below are known as sub-investment grade, high yield or junk.

[2]       UK equities – FTSE All Share Index;  UK gilts – FTSE British Govt. Index (up to 5 years);  Global bond – Citigroup WGBI 1-5 years hedged to GBP;  UK BBB – Barclays Sterling non-Gilts Baa Index; GBP high yield – BofAML GBP HY Index.