Should I buy Bonds? Are we at the peak of the interest rate cycle? (2023)

Introduction

The interest rate cycle is about to peak, so now might be a good time to buy bonds as falling interest rates can drive bond prices higher. Should I buy bonds?

I look at:-
UK Government bonds
UK Corporate bonds
UK Index linked bonds
Short & long duration bonds
Bond funds
Emerging Market Bonds

I consider the correlation between bond and equity returns. I look at how much of my portfolio should be in bonds. Are stocks expensive compared to bonds? I look at the 10 year bond yield vs the stock market earnings yield.

Content

Is now the time to buy bonds? Well, with some bond prices having fallen by over 20 percent in the last 12 months, it could be argued that if you enjoy bottom, fishing now might be a good time to pick up some bonds at a bargain price.

Looking on some good interest rates and the possibility of capital appreciation.

However, there are risks to this and I'm going to outline in this video My Views on bonds and we're going to look at all sorts of different ways.

You can analyze and invest in them.

What is a bond? It's basically one party lending money to another over a specified time period that could be indefinite with a specified amount of interest to be paid each year in a particular currency.

So all the returns from bonds are fixed in nominal terms, just like your mortgage.

So then the types of bonds that we have are government issued ones.

Corporate bonds issued by companies there's different durations from just a few months to 30 years, there's different currencies, so GBP US dollars or even Argentinian Pesos and some government bonds are index linked or they have inflation protection.

Why do people hold bonds? Well, basically, this quite strong asset backing behind Bonds.

In terms of ideally, you will get your money back, so there's some Capital certainty there.

Ideally they have lower volatility than stocks where the earnings can fluctuate quite a lot over time and potentially bonds might rise in price when equities fall.

If there's this flight to safety and there's a potential trade-off between risk and return, where bonds have potentially lower risk and they will probably offer lower returns, but sometimes that is a trade worth taking bond prices, move inversely with interest rates.

So if you imagine a 10-year bond paying two percent interest after year, one interest rates rise from two percent to five percent.

So on a hundred pound Bond, the interest shortfall is five percent.

That's the market rate.

You can now get minus two percent.

That's the rate on the bond that we've bought Times by nine years remaining on the bond, so 27 pounds.

So the bond needs to fall at by most 27 pounds to equalize the returns between existing bonds and the current bonds issued at the higher interest rate and so the longer the duration of the bond, the more volatile its price will be.

Bond prices could take a long time to recover.

So here we've got Vanguard UK government bonds and when the interest rate was 0.1, percent price was about 26 pounds.

Now the base rate is five percent and the price is around about 16 pounds, so they've Fallen value quite quickly, but I'm, not so sure how long it will take for them to fully recover bonds can, in theory, have negative correlation with equities during a recession, provided that interest rates are being cut and hence bond prices will rise and the interest rate cut is being done to boost the economy.

However, if inflation is high and Rising, then bonds could fall at the same time as equities as interest rates rise to try to reduce inflation.

So a lot of the things you've read about Bonds in the past aren't really applying at the moment and that's why bonds are currently quite a risky thing to have here are some different types of bonds and their one-year return and five-year returns.

These are exchange traded funds, I've got the data from justetf.com, so the largest ETF is a corporate bond fund, a negative eight percent.

Over five years, seven percent.

Over one year, some UK guilts negative, nearly 20 over five years 14 over one year, some shorter duration, UK guilts, where a guilt is a government born or to five years minus five percent over five years minus four percent over one year, um short duration, bonds, Ultra, short bonds.

These tend to be quite similar to a cash account, so they're, maybe like three months on the duration, so those have had positive returns and rather bizarrely index linked.

So they're they're linked to inflation, ideally have lost 22 over five years and 18 over one year.

So my Mantra is, if you don't understand, it, don't buy it, and here are the prices of some index linked UK government bonds and when inflation Rises, you would kind of think.

Well, it's going to pay out more money, so it's potentially something worth having, but actually the price Falls um.

So that's a bit odd and when I read the fact sheet, I still couldn't really quite understand what was going on so for me, I'm just going to give UK indexing guilds a pass.

So all this has got me thinking who does actually buy bonds? Sometimes it's workplace pensions.

Sometimes it's people advised to do so by financial advisors because they've been told they're risk-averse.

But the problem is that economic relationships and correlations can break down over time and don't be stuck looking in the rear view, mirror so with corporate bonds.

There's an asymmetric risk.

If the bond issuer defaults, you could potentially get nothing.

So there's a hundred percent downsize side.

But if everything goes to plan you get what the contract stipulates.

So there's a naught percent upside.

So, unlike equities, where, if the business innovates sells into new markets, there's all kinds of ways, you can capture quite a lot of upside with bonds.

That really just does not occur so as a long-term hold they're, not really a very good proposition for me, so how much of my portfolio should be in bonds? Well, people used to talk about the 60, 40, Equity, Bond split portfolio and how that had quite smooth returns over time, but that was the historic relationships.

People have even said.

Well, you should be more like your age in bonds.

So, if you're in your 30s, you have more like 30 percent in bonds, but I think that that's maybe a bit too much exposure.

All you really need is the duration of a market downturn, so maybe like three four years, so you've got this kind of ballast in your portfolio.

If equities do badly for a few years in succession, you've got some bonds that you can sell and use that to finance your retirement, should I hold bonds separately or within a multi-asset fund.

So examples of multi-asset funds include Vanguard life strategy, where it's got anything from I, suppose no bonds to 80 bonds, wrapped up within the fund and I think that can be quite confusing because when the fund doesn't do very well, you've got to unpick.

What's going on with bonds and what's going on with equities, so you can decide what you want to do about it.

The advantage of these funds is that they automatically rebalance for you, so you don't really have to do anything.

You can just hold the fund, but you need to before you've actually bought.

It do a lot of detail research to understand whether that is really what you want to buy, including the quite large UK exposure that Vanguard life strategy has there's also things like Capital gearing trust that can have quite a lot of exposure to bonds, and this can pivot between value, equities, gold and different types of bonds, including index linked bonds as it sees fit.

So it can be quite a good strategy, but recently even Capital gearing trust has come under pressure, and so its idea of being a very defensive fund is starting to be questioned.

Should I hold active bond funds or Emerging Market bond funds, or maybe neither well returns on bonds are low and they don't really justify the active manager fees of a strategic.

That's.

What I would like to call them bond funds, so my preference would really be a bond ETF rather than an actively managed bond fund, an Emerging Market bond funds, even if the bonds are ultimately generated in US, Dollars can potentially carry too much risk that could wipe out returns because in the time between buying it and selling it, you might find that it's actually had no Capital Growth due to what's been going on in these Emerging Markets.

So it wasn't such a safe haven for you.

After all, what about an individual Bond versus a bond fund that held several bonds within it? Well, individual government bonds can be difficult to buy.

They can have load liquidity, so much volume traded and a wide bid offer spread.

But at least you've got the certainty of exactly what's going to happen, because you've only got the one Bond bond funds don't have a specific maturity date.

They keep buying and selling, so they may actually never get back to their par value, and that's really the problem with bond funds that they're just rotating around all these different bonds and that, ultimately, they could be selling at prices that are lower than what they have to buy to keep the bond fund going.

So here's an individual corporate bond issued by Vodafone 5.9 maturing 2032 price is about a pound, but this quite a big gap between the buying price and the selling price, which is almost um a Year's worth of Interest.

So it has fallen quite a lot in recent times and I mean if you did want some money in 2032, then maybe this is an optional one way to get it but you're taking a bit of corporate risk against Vodafone, but hey at least it's not Thames.

Water are stocks expensive compared to bonds.

Well, they say what you need to do is compare the 10-year bond yield to the earnings yield of the stock market So.

Currently, the 10-year government bond yield is 4.3 percent and the earnings yield, which is just the inverse of the price to earnings ratio for the ftse all share it's about 6.9 percent.

So there is an equity risk premium in place.

So I would argue that the markets are quite fairly priced really between stocks and bonds, so I don't think there are Bargains to be had on either side.

What is the outlook for interest rates? Well, who knows really I mean we could be at the peak of the cycle, in which case it would be quite a good time to buy bonds, but it is difficult to know- and you shouldn't really try and front run things and anticipate.

What's going to happen in the future, interest rates could fall, but, although recently we've seen a discount from the interest rate of the inflation rate that might not persist.

So that's what's meant by negative real interest rates and who would lend out money at two percent if the inflation rate is five percent, just doesn't make sense, so interest rates might stay high for quite some time.

So my conclusion is it's difficult to buy bonds, anticipating a meaningful interest rate decline, so my conclusion is that bonds come in many different guises and some have more default risk in terms of junk bonds from corporates and volatility than others, but there's really not much difference in returns between a Government Bond and having 85 000 pounds, which is going to let the government protected limit in a really decent savings account and changing inflation and interest rate expectations mean, in my opinion, there's no Bargains to be had so stick with your stocks.

Put some money into a savings.

Account would be my suggestion, but it really depends on your risk profile and the research that you've done.

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