Bond markets

[sidicks]

DibblyDobbler said:

I've recently put about 30% of my pot into actively managed corporate bond funds - from what I can see they have both made smallish positive gains almost every year for some time so seem like a sensible safe side to my portfolio (which is largely in high income equity funds).

But I read a disturbing piece today about a bond market 'rout' which seemingly is going to happen when interest rates eventually start to rise. How will this work though? Is it because of defaults on bonds? Or what might actually happen in this scenario?

Any advice would be appreciated!

The price of a fixed income asset will fall when interest rates go up - the future payments (coupons and redemption proceeds) have a lower discounted value when the discount rates increase.

Of course, increasing interest could have an effect on default rates if increased debt costs mean that companies are unable to service that debt, but this is less likely unless interest rates spike significantly.

[DibblyDobbler]

sidicks said:

The price of a fixed income asset will fall when interest rates go up - the future payments (coupons and redemption proceeds) have a lower discounted value when the discount rates increase.

Of course, increasing interest could have an effect on default rates if increased debt costs mean that companies are unable to service that debt, but this is less likely unless interest rates spike significantly.

Thanks very much for the reply

So simplistically - if a company borrows £100 and agrees to repay £105 a few years later that arrangement (ie the bond) is not going to change (assuming there's not a default) but the £105 is worth less if interest rates go up so the value of the fund which holds the bond will fall?

So am I daft to hold bonds at the moment or is it still a sensible part of a portfolio?

Cheers.

[Condi]

DibblyDobbler said:

Thanks very much for the reply

So simplistically - if a company borrows £100 and agrees to repay £105 a few years later that arrangement (ie the bond) is not going to change (assuming there's not a default) but the £105 is worth less if interest rates go up so the value of the fund which holds the bond will fall?

So am I daft to hold bonds at the moment or is it still a sensible part of a portfolio?

Cheers.

If you have a bond paying £105 in today's money, at 0% interest rate/inflation (which are generally linked in terms of asset pricing and alternative investments) then 105 in 2 years time is the same as 105 today - and a 5% return.

However, if interest rates and inflation are higher, then the £105 in today's money will be worth comparatively less in 2 years time, maybe only £101 in real terms? So only a 1% return.


At the moment interest rates dont show much sign of rising, even with the lower £ and increased inflation that will bring. It would be a daft thing for the treasury to do at the moment. Other parts of the world dont look so rosy either.

[iantr]

I thought this was a good illustration of the impact of discount rate changes:

Ben Inker of GMO said:

"... the trouble with returns that come from falling discount rates is that they represent an increase in the present value of the asset without any increase to the cash flows to the asset class. The future expected return to the asset has fallen, and in a way that more or less precisely counteracts the increase in current value. In other words, the present value of the assets has risen but the future value of the assets has not. Nowhere is this clearer than for the purest long-duration asset in existence, the zero coupon bond. Let’s say that you will need, with absolute certainty, $1 million in 2026. The safest way to reach that goal is to buy a $1 million face value 10-year zero coupon Treasury bond maturing in 2026. Such a bond currently has a yield of 1.625%, which means it will cost you $851,127 to buy it today. Assume that tomorrow the yield falls by 1% to 0.625%. Your brokerage statement will declare the value of your bond to be $939,596, a gain of over $88,000. Whoopee! You’ve just made over half of the necessary return over the next 10 years in a single day. But the value of that bond in 2026 has not changed at all. It has a fixed maturity value of $1 million. The only thing that has changed is the discount rate being applied to that cash flow, not the cash flow itself. Assuming you still need $1 million in 2026, there is no windfall to spend. Economically, nothing has changed for you, whatever your brokerage statement says.

[DibblyDobbler]

Thanks Gents - I think I am a bit clearer now.

Given interest rates are likely to rise only very slowly if at all in the near future I will probably keep some loot in these funds (especially given the lack of low risk alternatives!).

[sidicks]

DibblyDobbler said:

Thanks Gents - I think I am a bit clearer now.

Given interest rates are likely to rise only very slowly if at all in the near future I will probably keep some loot in these funds (especially given the lack of low risk alternatives!).

The relevant consideration is NOT where current interest rates are, it is where future interest rates are predicted to be.

In other words, the current pricing of bonds already factors in a certain level of future interest rate rises. The issue is whether actual future increases will be greater or lower than currently predicted - that's what will impact the value of the bond (as well as the perceived credit risk of the bond).

[DibblyDobbler]

sidicks said:

The relevant consideration is NOT where current interest rates are, it is where future interest rates are predicted to be.

In other words, the current pricing of bonds already factors in a certain level of future interest rate rises. The issue is whether actual future increases will be greater or lower than currently predicted - that's what will impact the value of the bond (as well as the perceived credit risk of the bond).

Thanks again. That also makes me think I'll sit tight for a while with my bond funds.

The article which rattled me slightly is here - one choice quote is 'The Bank has developed new “market maker of last resort” powers in anticipation of a nasty bond rout so it can mop up billions of pounds of assets in the absence of real buyers.' Any thoughts on that?

[Condi]

DibblyDobbler said:

Thanks again. That also makes me think I'll sit tight for a while with my bond funds.

The article which rattled me slightly is here - one choice quote is 'The Bank has developed new “market maker of last resort” powers in anticipation of a nasty bond rout so it can mop up billions of pounds of assets in the absence of real buyers.' Any thoughts on that?

Anything could do pop at the moment. Cash is the only safe investment but with 0 return on savings there are a lot of people and companies looking for a return, and so (IMO) most assets are, if not over-valued, then on unstable foundations. I dont think that there is any bigger risk of bond routs than there is of the stock market correcting down.

[DibblyDobbler]

Condi said:

Anything could do pop at the moment. Cash is the only safe investment but with 0 return on savings there are a lot of people and companies looking for a return, and so (IMO) most assets are, if not over-valued, then on unstable foundations. I dont think that there is any bigger risk of bond routs than there is of the stock market correcting down.

Thanks.