{ "version": "1.0.0", "segments": [ { "speaker": "Kyle Caldwell", "startTime": "0.0", "endTime": "47.205", "body": "Hello, and welcome to our latest On The Money podcast episodes, a weekly show that aims to help you make the most out of your savings and investments. So the topic for this episode came from one of our listeners who pointed out that while we do mention bonds on the podcast, it's not an area that is a regular focus. And due to this, the listener asked if we could have an episode dedicated to how bonds work, how they fit into a broad income focused portfolio, and there was an additional request to cover both individual bonds and bond funds. Joining me to tackle this topic, I've brought in a bond for manager who is called Damian Hill, who manages the BNY Mellon responsible Horizons UK corporate bonds fund. Damian, thanks for coming in today." }, { "speaker": "Damien Hill", "startTime": "47.205", "endTime": "51.525", "body": "Thanks so much for having me on today to talk about all things bonds. I'm looking forward to it." }, { "speaker": "Kyle Caldwell", "startTime": "52.085", "endTime": "88.44", "body": "So Damian, when you strip everything back, a bond, it's essentially an IOU or a loan that investors make to governments or companies. In exchange, bonds offers a fixed amount of income throughout its life. And the income element, it's known as the coupon, which is paid twice a year. And if the government or company that issues that bond proves to be credit worthy and does not run into financial difficulties, then the amount you invest, known as the principal, is paid back to you when the bond matures. And it's very important to bear in mind that you don't have to buy a bond when it's issued." }, { "speaker": "Kyle Caldwell", "startTime": "88.52", "endTime": "108.565", "body": "You don't have to hold on to it until it matures. You can buy and sell in the secondary market. So, Damian, I've just given a very brief overview. Could you unpeel the onion further and talk about the relationship bonds have in terms of having a price and a yield and how that is an inverse relationship?" }, { "speaker": "Damien Hill", "startTime": "109.71", "endTime": "125.545006", "body": "Yeah. No. That's a really good summary to start. Clearly, there's a lot of complexity in bond markets, but you've summarized it in in the most simple way there that you get effectively a contractual amount of income every period, and you get your money back that you've lent to the borrower. There's clearly a lot of variety in there." }, { "speaker": "Damien Hill", "startTime": "125.545006", "endTime": "158.485", "body": "You can have bonds that are linked to inflation where you the extra income you get, the coupon, every period goes up or down linked to the inflation rate or occasionally, you know, you can buy bonds called floating rate bonds where, again, the amount of income you get each period will adjust with underlying interest rates. But for most of the bonds, that characterization is correct. You get a fixed income or a coupon every period. Some pay annually, some pay semi annually. Those floating rate ones I talked about can pay quarterly because the coupons, that income is reset every quarter." }, { "speaker": "Damien Hill", "startTime": "159.685", "endTime": "207.905", "body": "In terms of the the interaction between yield and price, because a lot of those bonds as you as you summarize, the income is fixed and you get a fixed amount back, the amount you've lent to the borrower. Clearly, the creditworthiness of companies can change through time, interest rate environment can change, inflation rates can change. So the amounts a borrower or a bond investor might require to lend to a company or a government shifts through time. And that required rate of return through time is what we call the yield. So a bond, when you look at the maths, is effectively a collection of cash flows, and you do what we call a discounted cash flow analysis where effectively you bring the value of that income, those coupons, and that redemption that you get back, the payment at the end, back to today's value." }, { "speaker": "Damien Hill", "startTime": "208.06499", "endTime": "234.395", "body": "And the rate you use to do that is the yield. So that's the required rate that shifts through time. So if the required rate goes up, the value of those cash flows and that redemption pay payment today falls in value because the the kind of hurdle rate, that yield has gone up. So then the price falls. So you have an inverse correlation between the yield or rate of return required and the price." }, { "speaker": "Damien Hill", "startTime": "234.555", "endTime": "245.595", "body": "Because effectively, those that income stream is locked and fixed. So essentially, the the price shifts around depending on how much return people require at any point in time." }, { "speaker": "Kyle Caldwell", "startTime": "246.06001", "endTime": "278.78", "body": "Let's now move on to risk. So bonds are given a credit rating that determines the risk level of a bond. If I was to try and explain it in sort of in a way that people might hopefully sort of understand in a quick way, it It's a bit like how GCSEs used to be grazers. So in the bond world, a bond with a rating of triple a is considered the best, the highest quality, and it goes all the way down to, well, u for unraises, on on race of bonds. Could you talk us through how bonds are rated?" }, { "speaker": "Kyle Caldwell", "startTime": "278.78", "endTime": "283.58002", "body": "And could you also also explain what the terms investment grade and high yield mean?" }, { "speaker": "Damien Hill", "startTime": "283.98", "endTime": "299.14502", "body": "Yeah. I think you summarized that really well there. So there's three main racing agencies. Clearly, there's a variety across the globe, but the three largest we tend to rely on are Standard and Poor's, Moody's and Fitch. So combined, they have similar notations." }, { "speaker": "Damien Hill", "startTime": "299.14502", "endTime": "345.77", "body": "You say triple a down to d or u, d being an event, you know, default. Use an interesting one because sometimes, you know, that might mean they've not been rated by those agencies, but, you know, if you've got a a strong team of analysts, you can actually rate them yourselves internally. Yeah. So it doesn't always mean it's terrible, a terrible credit, because there's quite a lot of companies that are choose to be unrated for a variety of reasons. In terms of what they actually mean and how racing agencies assess this, and we might come up with our own internal ratings, The rating really looks at what the probability of default or the credit worthiness score, going back to your GCC analogy, you know, a score of how credit worthy a company is, and that risk of bankruptcy or default over a certain time period." }, { "speaker": "Damien Hill", "startTime": "346.225", "endTime": "373.96", "body": "Now depending that's somewhere between a year or five years. There's ways you can kinda translate what the probability default is. Obviously, a one year horizon from an implied credit rating, but typically, it goes up in an exponential way. So when you get down to d, you know, you're already kind of in an event of default, but the lowest rungs just above that in that junk or high yield area, you know, you might be 50 to 75% chance of default over the next year. When you get to triple a, it's minimal." }, { "speaker": "Damien Hill", "startTime": "373.96", "endTime": "395.88004", "body": "You're looking at decimal decimal points. In terms of that investment grade, high yield or sometimes people call it junk, there's different tiers as you go down. The broad categories, triple a, double a, single a, triple b. When you get to the bottom end of triple b, the delineation is triple b minus or b double a three if you're if you're Moody's. And that delineates where investment grade ends." }, { "speaker": "Damien Hill", "startTime": "396.6", "endTime": "434.08", "body": "In terms of how a lot of bond fund managers like us manage money, they tend to split kind of risk in indices or benchmarks they manage money against into investment grade and high yield, and then combinations thereof depending on what the strategy is looking to do. And then really, it's it's junk or high yield from there. But as I say, the probability default over that time period going up reasonably exponentially. In terms of how those ratings are built up, ourselves and the rating agencies will look effectively at the the operational strength of a company, the industry it's in, combined with the financial health of that company as well on a forward looking at point in time in a forward looking basis." }, { "speaker": "Kyle Caldwell", "startTime": "434.585", "endTime": "447.70502", "body": "And how does the income on offer, the bond yield, fees into those credit ratings? Those are bonds with the highest quality ratings, does that mean it's gonna have a lower yield than say a bond that's considered riskier and and in the high yield category?" }, { "speaker": "Damien Hill", "startTime": "447.97998", "endTime": "471.435", "body": "Absolutely. In generally, that's that's that's correct. Right. I mean, you will get anomalies where you get certain issuers of governments trade particularly cheap for their particular racing category, and there's a lot of potential reasons for that in terms of what they might be doing through time, their track record, management, other potential concerns of ESG or other kind of technical factors. But in general, yes." }, { "speaker": "Damien Hill", "startTime": "471.435", "endTime": "499.825", "body": "That's right. Clearly, you've got different asset types that command kind of different risk premia or extra yield from investors. So if you get into the world of emerging markets, for instance, it's not only thinking about the risk of default and credit worthiness. There's aspects that go into there in terms of things like country risk. Because when you get down into a particular company, you might think it's brilliant, but you often get a lot more political volatility, certainly historically in certain emerging markets that you need to take into consideration." }, { "speaker": "Damien Hill", "startTime": "499.98502", "endTime": "526.665", "body": "So often, a triple b rated company might yield quite a considerable amount more in an EM jurisdiction relative to the same rating in in an investment grade developed market. So we've covered off the basics. Let's now move on to two big factors that hugely influence the bond market, interest rates and inflation. Mhmm. Could you firstly explain why they are so influential?" }, { "speaker": "Damien Hill", "startTime": "526.665", "endTime": "570.06", "body": "Yeah. So if you look at interest rates to start with, and that dovetails with something I said earlier, that if interest rates go up, clearly the return on savings and the cost of borrowing goes up. You can always question with your bank in terms of how much that savings gets transmitted to you as the consumer, but ultimately, you have a higher interest rate environment, the Bank of England set their the base rate, Off the back of that, banks will generally put up the return on savings. So when you think about then bonds with those fixed rate coupons and that fixed payment you get at maturity, the requirements to actually own a bond, again, the yield, the required yield to compensate goes up in general. So again, the bond price will fall." }, { "speaker": "Damien Hill", "startTime": "570.06", "endTime": "617.145", "body": "And conversely, when often, you know, interest rates fall, you know, that return on savings, the cost of borrowing falls, then bonds are worth more because again, you're getting a fixed amount amount of income through time. Clearly, it depends on the type of bond, the type of coupon. But as I say, when it's fixed, that's generally the correlation that, you know, yield and rates up, price down, and vice versa. In terms of inflation, again, when you think about those fixed rate coupons again, if they don't vary with inflation, clearly, if they're fixed rate, they don't, because you can get bonds called inflation linked bonds, where the coupons go up or down with inflation rates. Again, inflation up, generally that has a depressing factor on the price because then the compensation again, the required yield will generally go up to compensate for that inflation out out in out in the economy." }, { "speaker": "Kyle Caldwell", "startTime": "617.48004", "endTime": "640.765", "body": "And a key metric that investors can see on like a fun fact sheet is called duration, which measures measures the sensitivity of bonds to changes in interest rates. Could you talk us through what you and duration is heavily influenced by the life of a bond. But there's more that goes into it than that. Could you explain further?" }, { "speaker": "Damien Hill", "startTime": "640.765", "endTime": "679.06", "body": "Yeah. So the duration number you see will often be expressed a number of years and what that means in aggregate for all the bonds in a particular fund or portfolio, that is the weighted average time to cash flows effectively. So when you take an individual bonds, you do your discounted cash flow analysis, you say, on average, what is the weighted average of the cash flows I'm getting? So you clearly have your annual amount of income you get, that coupon, getting paid semi annual, but you might turn it to an annual number and combine it with the maturity payment that you get at the end. And you say, what is the average time to receiving those cash flows?" }, { "speaker": "Damien Hill", "startTime": "679.06", "endTime": "713.48", "body": "Clearly, that will shift around a little bit depending on the yield in the market, the return that investors require, but that might be getting a bit too technical, so it can shift a little bit up or down. But generally, when a bond, you know, it doesn't it doesn't shift a huge amount with that, but that's really the interaction of that income versus the redemption payment. But as you said, what it is, if you've got a bond say with five years average time to its cash flows, you say, well, if the yield goes up or down by 5% to 1%, then the bond will go up or down by 5%. If that makes sense. Often we express it in smaller increments than that." }, { "speaker": "Damien Hill", "startTime": "713.48", "endTime": "733.63", "body": "We might say point 01% and it goes up by point 05%, but that's the gist that effectively that duration, let's say, remains fixed for simplicity sake, that's the sensitivity. So that's what that number will translate to. Interest rate or yields up a percent, bond falls by 5%, or bond a fund falls by 5%, and vice versa the other way." }, { "speaker": "Kyle Caldwell", "startTime": "733.95", "endTime": "764.74005", "body": "Let's move on to the outlook for bonds today. Now you might tell me otherwise in a moment, but on the surface, it looks like a very good time to be a bond for manager given the the level of yields, the amount of income that you can find in the market is much higher than it has been for most of the past fifteen years. Because during that period, interest rates were mainly at rock bottom levels. So at the moment, as you know, UK interest rates were 3.75%. UK inflation is running at 2.8%." }, { "speaker": "Kyle Caldwell", "startTime": "764.98004", "endTime": "771.79504", "body": "You can find lots of bond opportunities, governments and companies, that yield them above 4%." }, { "speaker": "Damien Hill", "startTime": "772.115", "endTime": "789.94", "body": "Absolutely. So that's a great characterization. So for a long period, as you say, income in year was pretty low in the post great financial crisis era where, you know, there was a lot of quantitative easing from central banks. And, you know, The UK was, you know, case in point that that happened here as well. So absolutely." }, { "speaker": "Damien Hill", "startTime": "789.94", "endTime": "824.875", "body": "So you've got kind of five year UK government bonds giving you say four, four and a half percent yield. So that's if nothing happens, the rate of return you would expect to generate annually, as we've said from, you know, those yield calculations. And all the corporate bonds in The UK and in other jurisdictions, you know, hedge back to sterling will give you sort of five, five and a half percent depending on the credit worthiness in investment grade arena. Clearly, if you then go down to high yield, you can earn more, but then the credit risk goes up, say 7% depending on how far you want to go. And as a reminder, what bonds are giving you is a contractual income." }, { "speaker": "Damien Hill", "startTime": "824.875", "endTime": "852.615", "body": "So if a company or government does not pay that income, they are in an event of default. So in a company's for a company, that means effectively the equity could be worthless. You rank behind bonds in a bankruptcy scenario. So there are contractual payments, that income you're getting through time. And that really is quite compelling at this point, at least as a diversifier, because that income cushions you for further volatility in interest rates." }, { "speaker": "Damien Hill", "startTime": "852.615", "endTime": "880.685", "body": "You know, you have to have quite large backups in yields to start losing money on a one year look forward basis. So you've a positive return asymmetry, higher credit worthiness than what you have in equity markets without the concentration. And clearly, you can look further beyond The UK. So in our, you know, UK strategies as well, we're able to look globally and take advantage of opportunities to add performance by that active trading. It's not just about income harnessing and fixed income." }, { "speaker": "Damien Hill", "startTime": "880.685", "endTime": "917.14996", "body": "As you said earlier, you can buy and sell bonds for capital gains as well depending if, you know, you do your underlying analysis, you know, you have can up your risk, reduce your risk to take a bunch of directional moves, you get asset allocate between different parts of the bond market, whereas between governments and corporate bonds or up and down the rating scale, different countries, different currencies. I mean, again, that's before you start looking at sectors and individual company credit worthiness. So there's a huge amount of levers you can pull to add value. But the bread and butter is there's a lot more income, a lot more yield, and it's contractual income. Because remember, companies don't need to pay dividends." }, { "speaker": "Kyle Caldwell", "startTime": "917.55", "endTime": "962.925", "body": "And in terms of the role that bonds play in a well diversified portfolio, they are considered to be the defenders in a portfolio. And a popular strategy that has worked very well historically is the so called sixty forty approach of holding 60% in shares, 40% in bonds. However, in 2022, the relationship between shares and bonds broke down. And there have been some commentators that have suggested that going forward, the sixty forty strategy may not be as effective as it has been in the past. However, I've then seen other commentators point out that because of the good level of income now on offer in the bond market, that strategy has potentially been reborn." }, { "speaker": "Kyle Caldwell", "startTime": "962.925", "endTime": "965.645", "body": "So where do you sit on this side of the debate?" }, { "speaker": "Damien Hill", "startTime": "965.645", "endTime": "991.97504", "body": "Well, it's kind of glass half full, glass half empty, rear view, forward looking. But absolutely, you really need to think about where we're going from here. And given there's a lot more income, a lot more yield, if you have been holding a sixty forty and being patient with it, then you wouldn't shift from that. If anything, you might up your bond allocation depending on your investment goals. But absolutely, 2022 was a bit of an Armageddon for bond markets and risk in general." }, { "speaker": "Damien Hill", "startTime": "991.97504", "endTime": "1020.045", "body": "Mean, you know, equities weren't totally immune, you know, they would have fallen at different points through the year as well. But, you know, inflation and rampant inflation is not good for bonds unless you have those inflation linked bonds. So clearly, you can allocate to those. But as a simple sixty forty, there's a lot more compelling income, You know, ranks higher in a in a bankruptcy scenario if some if a if a company or a government does get into well, some of company gets into trouble, and it's contractual. Right?" }, { "speaker": "Damien Hill", "startTime": "1020.045", "endTime": "1039.8551", "body": "So, yeah, absolutely. On a forward look, you know, there's a lot of compelling reasons to add more to bonds if you haven't had any. And if you had a sixty forty, I would probably advise to stay with it. What really on a go forward really get bonds moving relatively is if you have growth start to wane. Clearly, there's a lot of tailwinds for growth and there has been." }, { "speaker": "Damien Hill", "startTime": "1039.8551", "endTime": "1052.45", "body": "We've seen a bit of disruption out of The Middle East, but broadly, the impetus has been relatively strong. You'd say more out yeah. Emanating out of The US and emerging markets. The UK has been a bit anemic. Growth wise, kind of that 1% area." }, { "speaker": "Damien Hill", "startTime": "1052.85", "endTime": "1084.42", "body": "But, you know, we're still forecasting at least moderate growth. It's if you do do start to see more of a moderation there where bonds can come back into their own and without that pickup in inflation. So I think, you know, you've seen that through time, you know, instances, say, the COVID era 2020 or back to the great financial crisis where bonds really can play a part when you've got higher yield and you do get a growth shock. And it's very hard to necessarily predict something that come from left field and shock you. And if it's always after the event, you would kick yourself for not having enough bonds." }, { "speaker": "Damien Hill", "startTime": "1084.66", "endTime": "1143.5499", "body": "So, I can see both sides of the base, but ultimately, at these levels of income and yield, you're insulated from a lot more market shocks by owning bonds relative to history. And 2022 was a a real, you know, anomalous event, certainly on the inflation side of things, and you get a lot more compensation now. Wanted to next ask you about UK government bonds as the listener who wrote in asked for some thoughts on UK gilts. For DIY investors considering buying gilts directly, what would you say are the the main considerations? Well, I would say, you know, think about the actual yield you're getting because I know there's been a lot of popularity to own lower coupon or income delivering gilts relative to high because the capital gains treatment, and think about whether the tax efficiency argument holds between the two of them." }, { "speaker": "Damien Hill", "startTime": "1143.63", "endTime": "1188.0748", "body": "Think about transaction costs, holding periods, whether actually it makes sense to be buying these when you could buy broader bond funds that deliver more active returns by, you know, taking advantage of all the dislocations through different bond markets, different asset classes that you could be leaving on the table. But clearly, there is a draw there for that tax efficiency argument. But I would take into account all those kind of factors because they could be a bit too concentrated as well. You do need to think about concentrations. And clearly, with government bonds themselves, you know, the fiscal direction of a lot of governments in terms of kind of the debt sustainability has been called into question at times." }, { "speaker": "Damien Hill", "startTime": "1188.1549", "endTime": "1214.665", "body": "I think The UK actually isn't as bad a position as sometimes is written in the press that we have quite a long maturity profile in terms of when the average time that, you know, governments need to pay back their bonds for The UK is quite long. So if you compare it to The US, a lot of bonds are coming from maturity, probably double the amount over the next eighteen months. So actually, gilts aren't bad. But think about those concentrations. Think about are you leaving anything on the table here?" }, { "speaker": "Damien Hill", "startTime": "1214.665", "endTime": "1227.54", "body": "Think about the transaction cost holding periods and whether it makes sense depending on what you're buying them for because I think a lot of people are buying from that tax advantage. Then you got to think what is the opportunity cost as well of what I I could also be buying." }, { "speaker": "Kyle Caldwell", "startTime": "1228.02", "endTime": "1239.6249", "body": "And could you run through this the the outlook for bonds within the fund that you manage? Where do you see in the best opportunities and what are the biggest risks that sort of face your strategy?" }, { "speaker": "Damien Hill", "startTime": "1239.705", "endTime": "1268.5149", "body": "Yeah. I mean, I think at this point in time, we so if if if you translate it back to The UK, in terms of our forecast for yields in one year's time, we are expecting moderately lower yields. There's quite a lot in the price in terms of political risk. Some of that's come out in recent weeks, and we'll have to see who ends up, you know, in number 10 and number 11, etcetera, and the and the fiscal policy going down the line. But we are expecting a little bit of capital gain, but it more of the return should come from income." }, { "speaker": "Damien Hill", "startTime": "1268.6749", "endTime": "1300.145", "body": "So broad stability in yields, whilst growth holds up, we think corporate bonds will be well supported as well. And then it's really a game of flexing all the active levers we have to better add, you know, add alpha or outperformance. Whether that's directional risk, that's allocation between comparing bonds in The UK, in Europe, in The US, and further afield. And then on a sector basis, is there anything we can be doing there? And generally in sectors, we don't think there's enough cyclical risk premium priced in." }, { "speaker": "Damien Hill", "startTime": "1300.145", "endTime": "1348.4149", "body": "You know, you've had a consumer which has had to deal with quite a lot of headwinds over a number of years, whether it's inflation, the higher interest rates, and we're starting to see a few cracks come through in some sectors within cyclicals. You've seen some of the reporting forecasting from some of the auto manufacturers, for instance, over the last few weeks and months that are coming under pressure from competition from further afield. And we do favor in that sense kind of more traditional bond market sectors, say harder asset sectors that clearly have low obsolescence in a an AI world and are probably more immune to some extent from from trade war risks as well. So thinking here in The UK, things like utilities and even things like social housing, which again, we think work and the relative valuation is relatively compelling versus history." }, { "speaker": "Kyle Caldwell", "startTime": "1348.735", "endTime": "1361.95", "body": "And do you have any final thoughts on the bond market and bonds and where they can sit in a portfolio? I mean, what would your sort of elevator pitch be to try and convince a DIY investor to have some exposure to bonds?" }, { "speaker": "Damien Hill", "startTime": "1362.35", "endTime": "1380.455", "body": "Yeah. I think it's really that contractual income and yield now is so compelling versus where it's been over the last ten to fifteen years. You think about contractual income relative to equities where they don't necessarily have to pay an income. It's no contractual obligation. And really, you think about bond markets." }, { "speaker": "Damien Hill", "startTime": "1380.455", "endTime": "1406.955", "body": "They don't have the same concentrations like you have in equity markets as well where, you know, clearly tech has had a great run. I'm not saying that can't continue, but the concentration levels that you've got in those markets relative to history and certain other booms we've seen is getting pretty elevated. And you might might want a bit of extra ballast in your portfolio to possibly present a hedge if that goes wrong and growth starts to go in a negative direction." }, { "speaker": "Kyle Caldwell", "startTime": "1407.115", "endTime": "1425.73", "body": "Damien, thanks for your time today and coming on to talk all things bonds. Pleasure. And that's it for our latest episode of our On The Money podcast. We'd love to hear from listeners. If you've got an idea for a future episode or you have a question that you'd like one of the team to tackle, then do a email us on otm@ii.co.uk." }, { "speaker": "Kyle Caldwell", "startTime": "1426.005", "endTime": "1437.685", "body": "In the meantime, you can find plenty of analysis related to funds, investment trusts, ETFs on the Interactive Investor website, ii.co.uk, and I'll hopefully see you again next Thursday." } ] }