S3E3: The Right Way To Use Bonds - Ramin Nakisa PensionCraft
Do you invest in bonds? You might not realise it but you probably do. If you have a workplace pension the default is to invest you in both stocks and bonds. But is this actually the right way to build long-term wealth? Ramin Nakisa from the PensionCraft YouTube channel, and friend of the podcast, is a fan of bonds. That doesn’t mean he thinks they’re always the right choice but he believes they can be more useful than you might think.
What you should remember from this episode
Heads up, this is complicated but Ramin thinks bonds are sexy so bear with.
• A bond is a tradeable chunk of debt.
• If you lend someone money that debt isn’t generally tradeable - you can’t sell the debt to someone else - but a bond is tradeable.
• How do bonds work?
- Let’s imagine a bond is issued by a company.
- The company wants to borrow £1m.
- There would be what’s called a coupon, which is the fixed rate of interest the issuer (the company} would pay on the bond - say 10%.
- The worse the credit of the issuer, the higher the coupon because it reflects the higher risk that the issuer won’t pay back the £1m.
- This riskiness is called a credit spread - the higher the risk, the wider the spread.
- The coupon will be based on the risk free rate of return plus the credit spread.
• Ramin suggests thinking about a bond over its whole lifetime, almost like a person. Let’s imagine a bond is worth £100:
- The day it’s born (it’s issued) it’s worth £100 and you pay £100 for it.
- The day it dies (matures) it’s worth £100. That’s when you get the redemption payment (your £100 back).
- In between those dates, the price of the bond can vary (and you can sell it).
- The coupon remains fixed throughout.
• As a bond investor, you’re trading off the chance you’ll get your money back versus the rate of return you’ll get.
• If you’re investing in say, Microsoft, you’re probably thinking the default risk (the risk that you don’t get paid back) is very low.
• If the credit is risky, you’re hoping it survives till maturity which is when you get paid back your investment.
• Who can issue bonds? A lot of corporate entities like companies and governments.
• Bonds are one of the few ways that governments can raise money - the other key lever of course is taxes.
• What are the ratings applied to bonds? You might have seen stuff in the press like a government's has had its credit rating downgraded to AA. Well, the key cut off is between BBB and BB, which is where a bond issuer goes from investment grade to junk.
• If you buy a bond fund, it’ll say IG (Investment Grade), or High Yield (Junk).
• Historically, it’s been generally advised to de-risk as you approach retirement by moving your investments from equities to bonds (and cash). This is to avoid sequencing risk, which is when a negative event happens early in retirement, like the market crashing, which wipes out a big chunk of your portfolio and can have a profound impact at that stage of life. Damo will consider bonds and how he de-risks as he approaches retirement, although there are some changing thoughts in this area, partly because we are living longer. More on that later.
• Ramin’s approach is broadly similar - to not worry too much about bonds until later in life - except in particular circumstances when he says bonds can be useful. For example, you might want to buy a house in two years. If you put your money into the stock market, it may crash in that period, hurting your house-hunting. If you don’t want to take that risk, and instead want a predictable return with a lot less risk, then a bond could be a good choice. You know exactly what you're going to get paid back in two years when the bond matures. This is for a single bond (not a bond fund).
• Basically, bonds are useful for de-risking and planning cashflows.
• Side note, Ramin still plays around with bonds for fun. What a legend.
• If you’re lending to say the UK government (by buying a UK government bond), you can do it for a year, two years etc. up to 30 years.
• You normally get paid a higher coupon (interest rate) if you buy a longer term bond because you’re taking risk by locking in a rate for longer. Of course you have to think hard about how long you want to have a bond for.
• Waiting till maturity of the bond to get paid back is often a good idea because that’s the only time you’ll get paid back exactly what you paid when you bought it (assuming the issuer doesn’t default).
• With bonds ‘you never have to face the market again’ - i.e. you don’t need to make a choice of when you sell (unlike stocks). You can just wait till it matures.
• However, that’s the other key thing about bonds, they are tradeable, so you can sell them before maturity if you want - for a loss or a gain.
• Let’s say you buy a bond today for £100 and then interest rates go down (set by the Bank of England). The price of the bond will increase because investors can get a better interest rate by buying your bond rather than buying a new one with the lower interest rate. The inverse is also true. If interest rates go up it means that the price of bonds bought before the rate rise will go down because there’s a lot less demand for a bond paying out say 2% rather than 5% which the new ones are offering.
• So the price of bonds and interest rates are inversely correlated - for bonds that were issued before the interest rate changes.
• For new bonds, the interest rate change will flow into them. When the Bank of England increases the base rate by 1% you’ll see that increase reflected in the coupons attached to bonds issued from then on. This is why a sharp increase in interest rates can really hurt the price of bonds issued before the rate increase.
• The longer dated the bond is, the more sensitive it is to interest rates.
• This is another reason there was a bond crisis in 2022, when interest rates surged upwards, they pushed down the price of older bonds massively.
• Plus, a lot of these bonds had long durations, known as duration risk. If interest rates move up and you need to sell the bond, you can lose a lot of money, and vice versa.
• Why would anyone have bought long duration bonds when we had record low interest rates until recently? Ramin says it’s because of convexity. Let’s say you buy a 2-year bond for £100, with a coupon of 5%. The next day, interest rates go up by 1%, so you’ll lose out on that extra 1% you could’ve got over the next 2 years. This means the price of the bond will go down by 2% (1% x 2 years). Now imagine it was a 10-year bond - the price of the bond would lose 10% (1% x 10 years).
• This percentage change (1% in this example) is called the yield curve movement. So the formula is the duration of the bond multiplied by the yield curve movement.
• Now what about convexity? Well what we’ve said above is the theory, but in practice it works slightly differently. A bit like when you were taught chemistry at school, then you moved into a new year and the teacher told you that what you’d learnt before wasn’t quite right. Cheers guys. What actually happens is if interest rates increase, the price of bonds doesn’t go down quite as much as you’d expect. And if interest rates go down, the price of bonds increases by a bit more than you’d expect. This means either outcome ends up slightly more in your favour than it should be the theory. The risk/reward goes in your favour, which is called positive convexity.
• A guilt is just a name for a bond issued by the UK government. A bond issued by the US government is called a US treasury. And each different maturity (like 10 years) has a different name. Beware of the dictionary on bonds, it’s a mini language.
• How do you buy a bond? On platforms like AJ Bell and Interactive Investor.
• Coupons on UK bonds are paid every 6 months.
• Bonds have two prices - a clean price and a dirty price. If you buy a bond part-way through its lifetime, you will pay any unpaid coupon that’s been accrued by the bondholder up to that point, as that’s effectively the unpaid interest they’re owed. The dirty price includes this unpaid coupon, as this is the price you will have to pay to buy it. You will only get the benefit of the coupon after you buy it, until it matures or you sell it.
• You will normally see a clean price but what you actually pay is the dirty price with the accrued coupon.
• We’ve just described an individual bond but you can invest in a bond fund, which invests in multiple bonds.
• How do they work? Let’s imagine a bond fund has a billion pounds to invest in bonds from customers. They then go buy a portfolio of bonds. But if more money/customers come in, they need to buy new bonds. And if money goes out (because customers want to sell) then they need to sell bonds. So buying and selling bonds is happening all the time in a bond fund. Plus bonds mature, and when that happens the fund needs to buy more too.
• This means you don’t know what the bond fund will be invested in, in the future. And because you don’t control when they sell (or buy), the value of the fund can decrease (if their bond value decreases) so if you need to sell then, you will make a loss.
• This is why Ramin thinks bond funds are not a particular good hedge, e.g. when interest rates rise, it could cause you problems.
• What’s the point of bond funds? Ramin says to some extent they’re less volatile than stocks. And if they’re really low duration they can be very safe.
• Bonds normally rally when stocks crash but in 2022, stocks crashed and interest rates increased massively (driven by inflation) which smashed the bond market, so it wasn’t a good hedge against stocks.
• One of the most popular approaches for an investing portfolio historically has been 60/40 which means 60% in stocks and 40% in bonds. The premise is that when stocks crash the bonds will support you. But this failed in 2022. Bonds are not such good diversifiers as we thought, says Ramin.
• Ramin thinks moving your allocation from stocks to bonds as you approach retirement, as has historically been the general wisdom, might not be the best bet. He cites a recent paper which found that being invested 100% in global equities in retirement rather than moving towards a higher bond allocation over time produces better results across all key metrics. This shocked Ramin because it goes against conventional wisdom/guidance - like target date funds for retirement which hedge with bonds like the classic 60/40.
• No one had done these simulations before - target date funds typically look at monthly returns rather than 10-year blocks. This suggests 60/40 might be the wrong general approach.
• Why would young people not be invested 100% in equities? Ramin thinks some of it might be cognitive/funds not wanting to lose customers. For example, if someone young puts money into their pension and it’s 100% equities and there’s a crash, they might think this isn’t working and pull out their money. Bonds should (in theory) stop that from happening (hedging against stock market crashes) but these bonds come at the expense of long term returns because stocks have always historically outperformed bonds over the long term. The pension providers generally want to keep customers in the funds, rather than give them the best returns.
• Ramin says the toxic point for debt to GDP (gross domestic product which is the country’s annual economic output) is often thought to be 100%, i.e. if the UK’s GDP is £2 trillion a year and the national dent is £2 trillion that would be 100%. We’re still slightly below 100% in the UK but the US is at about 120% and Japan is c. 250% mind.
• Ramin thinks municipal bonds could transform public project funding in the UK. This could fund stuff like your local library, potholes, your local university etc. It’s a bit like a voluntary tax. As a local resident you wouldn’t pay tax on your investment, you’d get to fund initiatives you want to support in the community - and should get a return on your money like with any bond (unless the bond issuer defaults). They’re very popular in the US.
• Ramin says a great way to access high interest rates on cash can be through money market funds. They invest in very safe stuff like 1-month guilts (UK government bonds which mature in a month so are very low risk). Right now (at the time of writing) money market funds are offering particularly high rates (better than most bank savings accounts). It’s very liquid, you can sell it any time you want (generally). And they reflect interest rates rises very quickly unlike some banks which don’t pass on the rate rises quickly.
• Damo buys his money market fund on Trading 212, you can find them on Vanguard and lots of platforms. Some are wrapped in ETFs.
• You can buy a money market fund inside an ISA or a SIPP.
• The big example of when a money market fund doesn’t work was in 2008 when one of the biggest US market funds went bust (The Prime Fund) because they were exposed to Lehman Brothers.
• For most governments defaulting on their debt is unthinkable because the impact would be so severe. Every asset would need to be repriced because it’s the bedrock of a national economy.
• The UK government gives a tax break on guilts, which are bonds the UK government issues. You don’t pay any capital gains on guilts, to give you an incentive to buy them and lend to the government. You still pay income tax on the coupon (interest rate) however.
