WTF are bonds? How and when to use them

23:45Yeah, all of them. And this saves businesses so much time and money. According to a recent IDC study, Vanta customers save over half a million dollars a year in costs. Not bad. And they also help you complete security questionnaires up to five times faster, which is great because everybody hates filling out forms. If you're a business that needs to prove security and compliance, visit Vanta.com forward slash making money to sign up for a completely free demo today. That's Vanta.com forward slash making money. There's a link in the description though, so you can just click that. Okay, so you talked about individual bonds and what you're saying now is I buy an A bond, one loan, and then you've got bond funds that exist.

24:24Can you explain the differences? I got so many questions about this and it's so hard to understand because if you buy a bond fund, what's in it? And the trouble is you don't know. You don't know. I mean, you know today what's in it. So let's say we've got a bond fund and what we're going to do, we've got a billion pounds from our customers and we're going to have to invest that in bonds. So what we do is we go out, we buy a portfolio of bonds. And then what's going to happen is if money comes into the fund, we're going to have to buy more bonds. and if money flows out, we're going to have to sell some.

24:57So continually what's going on is we're churning the contents of the portfolio. The other thing with bonds is they mature. So as they mature, we're going to have to buy new ones. So you never really know what's going to be in the fund one month from now or six months from now or even a year from now. There's going to be a lot of change in the contents. So the duration will be different. The coupon, the income, the average coupon will be different. There's no certainty then? None at all. So if interest rates go up, the price goes down. That still works. But the duration will change slightly. But it is true that it's interest rate sensitive.

25:30And if interest rates rise, its value falls. If interest rates fall, its value rises. But the income's kind of unknown. So if we're just coming off a long period of low interest rates, a lot of the bonds are going to have those low coupons built in. So the income will be low. But then gradually what happens is as those bonds mature, they're replaced with ones which have a higher coupon. and the income gradually picks up. So with the bond fund, approximately, if you think about it over your lifetime, let's say you buy a 10-year bond fund today and you just hold it for the rest of your life. What you'll earn roughly is just the income.

26:04The yields will rise and fall, but they never trend upwards and downwards forever. So long-term, you earn the income. Short-term, you've got an additional risk, which is the huge fluctuations from the yield curve, which drive the price up and down. And if you're unlucky and you have to sell at the point at which yield curves have risen, then you'll take the capital loss. So that's what I hate about bond funds. You don't have the control over when you sell them or what happens to the price. You don't know what you're going to get. And so I think as a hedge, they're not particularly good because you don't know what you're going to get.

26:38And if interest rates rise, then it's a problem. If the benefit of a bond is the certainty and the bond fund removes that certainty over income, what's the point in a bond fund? I think to some extent, they're less volatile than stocks. So that's one of the benefits. If they have a shorter duration, they're super low volatility. And if it's ultra low duration, it'll be a money market fund. And they're as safe as you can get. So funds like earns - People don't think that though. No. We'll talk about that in a sec. That's another bugbear. Anyway, so I think that, yeah, depending on the duration risk, you can control the risk to some extent.

27:12So if you go for a short term bond fund, it'll have less duration risk. If you go for longer term, it's a bit more speculative. But what's weird is in the past, when stocks crashed, the ones which gained the most value were the long duration funds, because they're more sensitive to interest rates. What didn't work, or we can talk about this, I guess, in 2022 was that inflation was high. So this negative correlation between bonds and stocks, they move in opposite directions. So if stocks crash, usually what happens is bonds rally. But if inflation is the cause of the crash, well, it's toxic for stocks and it's toxic for bonds.

27:49It's like they're kryptonite. If you've got a fixed rate of interest and inflation is higher than that, then you're earning negative coupons. So that's terrible. Yeah, because you're locked at this place and the value of currency is dropping. So it's just stripping the value out of that bond, essentially. Exactly. So what's interesting, there was a paper that was published recently which talked about this bond equity correlation for your entire lifetime. So for someone like you or T, where you've got a 30-year period, the times when bonds don't help is when inflation spikes. And of course, that's what's happened recently.

28:24It's what happened in the 70s. So if you really need an equity hedge, equities really struggle most when there's very high inflation, sometimes with other crises. But the bond equity correlation over long periods of time is actually quite high. So they're not such good diversifiers as we thought. So I think people might have to rethink things like target date funds, about 60-40 portfolios. Because over the long term, over the short term, yeah, they hedge stock market falls usually. But long term, over 10-year periods, not so good. So many people, if you're on a workplace pension, you'll be just plonked into one of these 60-40 funds.

29:03If you use one of these robo advisors, you'll answer some questions about risk, your appetite for risk, and they'll just plonk you into a portfolio, which is like, you know. Balanced, they call it. The balanced option is typically a 60-40, isn't it? And usually that'll be 60-40. Maybe it'll be 80-20 or whatever, but variations of that. So it's just the default option for so many different funds. Advisors, financial advisors, often they do a risk questionnaire and they put you into one of these funds. So I think it's just so pervasive, this idea that your risk is determined by your equity bond split.

29:40And that's just the most important thing. Whereas if that's not true, I mean, that's a really big deal. I mean, that's foundational for so much of people's understanding of investment. Vanguard was built on that kind of principle. They're very much a defender of the 60-40. And they're target date funds. So the way they work is they have something called a glide path, where you start off with 80 % stocks when you're a young lad. And then by the time you're 70, it's 30 % stocks. So that glide path is that de-risking over time. And that's built around the idea that bonds are less crashy and safer.

30:15Whereas what it actually means, if this paper's right, is underperformance, less money handed on to your kids, and having to invest more to get the same benefits in retirement. So it is a big deal. It's not just a theoretical thing. What do you think about... So I did some analysis recently of work-based auto-enrollment schemes, and I looked at the default fund options, and I was surprised at the bond allocations in those. So as an example, Nest, they have a grounding period or whatever they call, which is for the first five years, they de-risk. So the first five years you're in the fund in your 20s, basically because they...

30:48I think what they were saying was they didn't want any drops and people running away. And then they also de-risk 15 years before. So in an investing time horizon of 40 years is about 50, 20 years of like tapping the brakes. How do you see that style of like bond allocation? I think that would be a really bad way of doing it. And I think these target date funds do a very similar thing. You know, you gradually de-risk through your life and then you end up at age 70 with like only 30 % stocks. Whereas this recent paper that's been published, which actually looked at the back tests of how well does it do if you de-risk with a target date fund, is actually much better to just be internationally invested in equity.

31:31So 50 % domestic, 50 % international. And that actually does a better job of hedging than combining bonds with stocks. So they modeled their social security system and everything was US based. So for them, international means non-US. So 50-50 made sense for them. But for Europe, probably, because it's a smaller market, you tilt more towards US and elsewhere. But what was interesting was the US on its own was not very good because there's a kind of natural hedge built into your stock market via its currency. So let's say you have inflation spike in the UK, but not elsewhere. That devalues your currency.

32:09So when you convert your foreign stock value back into pounds, you get more pounds. And so that means that if inflation spikes, you've got this natural hedge to help you. So it's always good to have that foreign invested money because of that devaluation of your own currency if there's a bad time. So that's why international stocks did better, they think. But it's a really good hedge. And it actually had less ruin probability than combining stocks and bonds. So the risk of running out of money was lower. The terminal wealth when you die, hand over to cash to your kids, was higher by having international stocks.

32:48And the wealth of retirement as well. So on all the metrics, it came out better, which shocked me because all of these target date funds are built on this premise that hedging with bonds makes sense, but apparently not. Why do they do it then? I think the backtest they do use monthly returns, which seems completely logical, right? You just say, well, what I'll do is I'll look at monthly returns on stocks and bonds, and I'll look at the correlation, and does it diversify? And yes, it does. Whereas if you look at 10-year blocks, this higher correlation between bonds and stocks is what's toxic. And that's what you see if you look over longer periods of time.

33:27And no one had done these simulations with this approach. It was something called Bootstrap Monte Carlo. Just see if you're awake, mate. I was like, well, I understood all the words, but I was like, I don't know what they mean together. I'm like, I know what bootstrapping is. I know what Monte Carlo is. Get into the casino. I was thinking about the casino, didn't I? Let's bootstrap Monte Carlo. But the gist is you just look at like blocks of time, long blocks of time rather than short months. And I think Vanguard simulated it with like monthly returns. So they didn't see the kind of toxic effect, whereas it's the long-term relationship between returns of assets, which matters.

34:06So that's what was innovative about this paper, I think. I was really excited about it because I like things that kind of contradict what I believe. And that was very much contradictory to what I believe. Yeah. There's always this like the 60-40 is dead. And what you're saying is it might actually be dead. Yeah. Yeah. We'll link the paper so that people can read it. The target date thing, just for people that aren't sure what that is, you set a target date, right? Then it's in the name. So you might have one that's a 20-40. They normally have like the target date 2044 and 2050, 2060. And that's typically the date that you might retire, but the date that you think that you're going to need the money in the fund.

34:44And the ramp thing that you're talking about is the de-risking towards that date. So by the time you hit that date, you're typically all cash or all bonds or you're out of the market completely and you've just got a pot of money there. That's right. And the important thing to understand is they don't mature. So they carry on existing. So you can still buy the Vanguard 2015 retirement fund because it's just lots. it just contains lots of bonds. It doesn't have many stocks in it. So these things continue to exist and they continue to have value. And the idea is you just sell a little bit of it and live off the proceeds.

35:16Yeah. And it's important again to understand this because from the pension research that I did, most strategies are target date or they're de-risking. And a lot of them are decided by your employer, not the pension company. So the pension company sits down with your employer and probably says, we've got this option or this option, which one do you want? And they go, well, which is the cheapest for us? Which is the best? What do you recommend? We'll take that. And they've made a decision there about how much risk you're going to take, what bond allocation you'll have. And most importantly, what kind of product you might buy at retirement.

35:45You'll see them and it's like target date, 2040 annuity. And the fund is set up for someone that wants to buy an annuity at retirement. I don't think many people nowadays would be doing that. And they might take their 25 % and people really need to have this conversation with themselves and look at their pensions because that's their biggest exposure to bonds, even if they don't like it. I think the problem is that most people just don't care. They don't care. They don't want to understand it and they don't want to understand the bonds in particular. And so explaining something like a target date retirement fund is just not going to make any sense to them.

36:17So that's why these default options exist. So I think from the point of view of the fund managers, the job is to find something which is going to work pretty well for most people most of the time. But what this paper shows is that that's not 60-40. Yeah. So I read a really good paper on this. It's called Death by Default. And it looks at this point of, so with NEST, 99 % of people are in their default fund. So what you have is a broad range of 18 to 60-year-olds with varying degrees of risk profile. So they skew balanced. But when you do an individual test with someone, they go a little bit more adventurous.

36:55and they modeled the difference in returns between balanced and slightly more adventurous. We're talking 20 % more risk, you know, so not like balls to the wall, just a little bit more risk. They balanced like bear market, normal market and bull. And the only case where the more risk lost was in the bear market, like in the worst case. And in retirement, they talked about how much income you would have. And the difference in income was about 800 pounds a year between like in this. But in the bull case, the difference in income between the standard default fund and this slightly more risky was£15 ,000 a year.

37:31A year. A year. It's a big difference. So you're talking like hundreds of thousands of pounds of value. And only out of the nine modeled examples, only in one example did this default fund actually perform better than the rest. So if the market just performed as average, you're talking an extra five to six grand a year in income by going, no, I don't want to be balanced. I just want the slightly more risky." And it was a difference between 60-40 and 80-20. It wasn't even 100 % equity. I think the stat that surprised me was that ruined probability. It's actually not that high for stocks because stocks, although they do crash, they bounce back fast.

38:05You just look at 2020, that was an unusual one, but it returned. Within a few months. Yeah. I mean, it just completely turned around. Same in 2008. It turned around pretty quickly. that was probably, you know, I think it was around seven years for that to recover, which was painful at the time. But you carry on investing through those periods. So you get really chunky returns after it's crashed. So it's only if you're in retirement that these crashes really are a huge problem. What's the reasoning behind people in their 20s having 80-20, for example, or not being 100 % inequities? Why do they think that you should have some bonds in your 20s in their 60-40 fund?

38:43I think some of it is cognitive. So if you see that, okay, you put the money in first month and you see it crash by 20%, you stop paying it. Yeah. I think that's the worry. And people have got to stick with these things. So I think for people who don't understand markets and that they do recover, that can be a problem. Yeah, that's true. I think what people need to realize is these pension providers are in the business of charging you a fee over your lifetime. So they've got a very vested interest in making sure that you're in their funds. they also would like you to perform very well because they get a bigger share than percentage wise.

39:13But I think for a nest, it's like, let's just make sure the 20 year old stays in the fund rather than burns it. So they'll just dial the risk right down. So you see, oh, the thousand pounds I paid in over the year has gone up by 50 quid. That's great. Like you don't realize that's a massive underperformance versus the rest of it. That's actually kind of clever. Yeah, I think. It is clever, but it's also - It's going to hurt their wealth. Yeah, like because - It's going to hurt your personal wealth when you're coming to retirement. It's like second order thinking, because if they just stop paying in, that'll be much worse.

39:42You want to have them for their whole life. Psychological nudging. They use nudges. What they should actually say to them is, you know, in their 20s, they should sit them down and go, you need to take as much risk as possible right now. Because if you look at someone in your position, if they do 100 % equity, this is where they end up. Whereas if they do this conservative approach, this is where they end up. They should educate and inform, rather than go, let's manipulate them into stake and into the public. They don't understand it and the pledge don't need to know. we'll take our 1.8 % contribution fee for the admin cost and then half a percent a year, which is what I think they charge, which is ludicrous fees.

40:16Do you know what I mean? Yeah, but enough of that. I had a massive rant on my channel. I'm not happy. I expect an email from Nest at some point going, oh, we'd like you to come in and have a chat.

40:29Can we talk about 2022 in more detail? Because I think the narrative that most people would have is like bonds are more secure than equities. They're like safer, less risky. But then people just got wiped out, didn't they, in 2022? And I don't really know why. I don't think people understand why. And I don't think they understand why Liz Truss and Kwarteng had to do with that, if that makes sense. Yeah, I got pretty angry about that. And I don't usually get angry. I'm not an angry man. No, I remember your rant video. I was a bit ranty. But I think the reason was because governments, when they issue debt, they have to be responsible.

41:06So think of it like issuing pieces of paper which have a value which you force people to create for them. And if you issue too many of those pieces of paper and you don't warn the market it's coming, well, the value of those pieces of paper will go down. That's effectively what they did. They telegraphed their plans very poorly. Plus, it was at a time of really high inflation. So issuing lots of debt at a time of high inflation in order to stimulate the economy was itself inflationary. And they didn't listen to experts. And essentially, over one week period, we had the biggest sell-off, the biggest increase in yields ever for the UK market.

41:46And this is one which has been around for centuries. So I think that was so irresponsible. They paid the price politically. They're seen as incompetent now, I think, by many people. You just look at the polls. And I think governments have to be responsible. And to a certain extent, people still need to buy gilts. People still like gilts. I like them. If they do crash, I'll buy more. So I kind of like these crashes. But I think that was incredibly irresponsible because we're still paying the price today. People are paying more on their mortgages today. People are paying more for any kind of borrowing.

42:21So I think it was very irresponsible. What sort of impact, like in percentage-wise, did it have? How much extra are people paying on their mortgage as a result of that mini budget? Well, if you look at the yields themselves, I think they increased by about, I mean, this doesn't sound like much, but by about two percentage points. That's a lot. Over the course of a very short period of time. So if you think about, if you have a 30-year bond, that's going to have a duration of about 20 years. So 20 times two is 40%. So over a very short period of time, you get these huge sell-offs in these long maturity bonds.

42:55And if you imagine that you're a pension fund and you've got certain hedges in place, You price in a certain worst case scenario, assuming the government's not an idiot. But that didn't work. And a lot of them became insolvent due to something called LDI. This is a way of hedging the interest rate risk. But those assumptions didn't work because they were so incompetent. I mean, if you talk about 2 % on your mortgage, people know how much that extra that would cost them. You're talking like hundreds a month in extra cost on your mortgage. There's so many millions of people. And so I think that's why politically they're seen as incompetent now because they were the party of business.

43:33The economically sensible party, right? In theory. And they destroyed that reputation. I think so. And it's going to take a generation, I think, for them to reclaim that mantle of being a kind of safe party. Let's flip it onto Labour then because I'd be interested. I heard that obviously Labour have a reputation of spending, right? And I heard that they would fund that through bond issuance. So can you explain what that would do and why wouldn't that cause inflation? Well, to a certain extent, inflation is now coming down. So we've got a bit more wiggle room. We're not at the kind of peaks that we were at.

44:05And the prints are coming down. Recently, we had a print that went up a bit, but I think that was just a blip. So inflation is not as bad as it was. So there's more wiggle room in terms of issuance and stimulating the economy. Now, the conservative government is going to be stimulating as well. So I don't think that makes much difference between the parties. But you're right. Typically, labor spend more on services, education, and that has to be paid for somehow. And if they haven't got more growth, then what can they do? They can only plug the difference with debt. So if they issue a lot of debt, that's going to be a problem because it increases our debt to GDP ratio.

44:42So if you think the GDP is a country's income, the amount of debt relative to GDP, the toxic point usually, I mean, people argue about this, is about 100%. We're currently, I think, well below that. The US is well above its 120. Japan's at something crazy like 250 % of GDP. So, you know, people - Go on Japan. Yeah, slap it on the Alex, they'll give a shit and pay it in the morning. But everyone, when they say that debt to GDP is really worrying, you always give them the example of Japan, which is okay, basically, at the moment. And people like it there. Like, you know, it's seen as a nice place.

45:20They've got the toilets that sing songs to you and do all sorts of things. I mean, they always seem to me to be the guys like experimenting with policy the most, you know, like doing the wild things. Like when it was like we were talking about quantitative easing and tightening, it was like there are no examples of this, apart from in Japan. Like they were always like the people that lead from the front in terms of crazy manoeuvres. Yeah, they bought stocks. Crazy, right? I mean, you wouldn't have thought the central bank would end up doing that. But then the US central bank, the Fed, they ended up buying junk bonds.

45:52So this time around in 2020, when we had the big crash. So I think other banks are taking on some of their ideas rather than the other way around. But yeah, no one seems to be in big trouble yet. But to be fair, they haven't raised interest rates there yet. They're still at their zero bound. You look at any other central bank and rates have just chugged upwards really aggressively. Japan, no. What's the inflation like there? I think they're just getting back to inflation, which is what they were trying to do for 20 years. But, you know, the demographics there are just appalling. It's like a 50 % dependency ratio, which is the proportion of people in work relative to people who've retired.

46:30So much higher than other places. So they have an aging population. Aging population. Immigration, I think, is about zero, literally, over the last - Net migration, kind of. Net migration is very small. so they have very few people being added to their population you know like there's a lot of stuff there about like the men not engaging and not having babies basically the younger generations there you know they're a lot more in the computers aren't they basically yeah they'd rather play a video game than have babies which you know in retrospect I mean that's not true it's a lot cheaper I play video games with my baby now so we've got a full circle me and my son.

47:10Absolutely smirkily. My son did all the boss battles and I'm grateful to him for that. Yeah, that's it. Okay, so it's interesting though how the bonds intersect with the politics. And you could have a little piece of an IOU, but you also need to look at the bonds from a political perspective. They move the country in a certain direction through the issuance of these bonds. They make the world go round, as I think you said. I think they do. And I think certain bond markets, which we don't have in the UK, could transform the UK's economy. Is this your municipal bonds that you talked about? Municipal bonds.

47:43Because let's imagine that all the government has to do here is say, let's say that you buy a municipal bond. It would fund things like your local library, your local fire service, your ambulance service, your universities, whatever, locally, your potholes in the road. And the idea is it's kind of like a voluntary tax. What's the benefit to you as a local resident? Well, firstly, you don't have to pay tax on it. That's the bit the government does. They ensure that the tax laws favor it. And then secondly, you have a kind of feel-good factor that you're funding your local community. And you know what you're funding as well.

48:19Usually these are tied to a particular project, maybe some infrastructure. So I think that could really transform the UK. And it requires very little effort from the UK government. All they've got to do is just do this tax thing where reduced taxes or even better, no taxes on those bonds would be all you'd need to set it up. If you could salary sacrifice into local projects, because you would effectively skill up the whole... It would be like that investment through that, but you just basically say to people, you either pay it as tax or you can direct it into municipal bonds. For me, I would direct money into a fund that put fast internet where I live.

48:58Yeah. Because it's just not there. Why wouldn't you? And potholes. If you feel strongly about potholes, well, buy the municipal bond. And you can actually get people maybe to lobby for these things to be done. And then the funding's there. Are these municipal bonds currently active? Oh, in America, yeah. In America, but I was going to say, where in the world are they available? Well, I know the US has them. I know that Canada has them as well. And they use these for public projects all the time. So I think from that point of view, they're quite a transformative bond market, which we just don't have.

49:34Would you get your money back as well? Oh, yeah. So it's a standard bond. So let's say on day one, you want to build a library. Well, you have to break ground on the site. You have to have the cash up front. So they issue a bond. They get, I don't know, 20 million, 30 million to build it. And then you get a coupon, which is then paid off over some period of time. So the bond would mature in 10 years and you get a fat coupon because it is not risk-free. I mean, you can have these local authorities going bust. We've seen it in the UK. Yeah, Birmingham's gone bust. And so they can default on the debt.

50:05So I want to bring us back to investing now again. There's the bond in terms of like a savings account and you use it. But you talked about long-term, short-term, et cetera. I want to have the conversation around the ultra short, which is what I do, ERNS. Can we talk about the risks there, the perceived risks and the benefits? So for you, Tomein, this is a great way to access high interest rates on cash savings, much better than the banks offer typically. Yeah. So at the moment, with short-term interest rates being super high, these money market funds, what they invest in is really, really safe stuff.

50:44So if you can think of boring, it's like boring squared. That's what you get with one of these money market funds. So the deal is, if it's one of these ones that pays an income like yours earns, it's always worth a quid. So you might be thinking, why would you ever invest in something which is always worth one pound? It seems crazy. It does fluctuate slightly, but it's worth a pound. The idea is that it pays you this regular interest, which is based on this kind of short-term interest rate. So you can milk that short-term interest rate with zero volatility. So if you put a pound in, you can always take a pound out.

51:17So if you've got your kids' university money, it'll always be there. If you have to buy a house in a year's time and you need the deposit - It's my tax money I put in it. It'll always be there. Or if you're a company, good example, corporate tax. It's a great place to park your money. So companies use these all the time as a temporary place to park their money. So what do you earn with it? Well, you earn the ultra short interest rate. That's roughly what you'd get with like one month UK gilts. They also invest in things like commercial paper. This is like a short-term IOU from a company. So let's say a company wants to borrow for 180 days.

51:54They'll issue one of these commercial paper notes. And so very short maturity, very little interest rate risk, very little credit risk. They're often very high quality issuers. So very low risk, short-term investment. And you'll get some kind of credit spread on those, not much. But those are higher risk and give you a slightly higher income. and also things like deposits with banks. They can do that in a structured form called certificates of deposit. So those are the kinds of investments, all ultra safe, low credit risk, low duration risk, boring, boring, boring, low interest rate, but at the moment, very high interest rate because you'll get more interest on that money market fund than you would for a one year, two year, all the way up to 30 year UK gilt.

52:39So big income, almost no risk. so it's kind of like a no-brainer at the moment yeah you're being paid to take less risk which is very weird um so like i think it's about 5.6 percent it works out to at the minute that i get and they you know it like you just see it ratchet up in price and then it pays that to you as an income and every time the central bank rate went up the rate went up instantly how often does it pay you um i think it's every six months i get for that one which i think is a lousy design yeah The Vanguard one pays you monthly. Yeah. And there's another one which is popular with the pension crafters, which is called CSH2.

53:18And that's issued by a Mundi. And that pays you via capital gain. So you just see its price steadily increase, which I think is more understandable than something which kind of ramps up and down and pays you coupons. Just love that notification though. And, you know, when you're talking, let's say my tax bill might be like, because I put my income tax in there, And that could be like, you know, 20K, say. And I've got to build that up for a whole year. And I'm getting 5.6 % on that. Do the math. It's a chunky amount of just extra money, you know. And it helps you get there. But when does that narrative change then?

53:52So when would I be going, this is no longer worth it for me? Well, the big example was what happened in 2008. And one of the biggest US money market funds went bust. And it was called the Prime Fund. And what actually happened was - Doesn't sound very low risk, Roman. Wasn't my tax millionaire. What happened is they bought commercial paper, a chunky amount of it, but from a bank you can probably guess the name of. Lehman? Yes. Unfortunately, they said - I was thinking, there's a lot of banks. Oh yeah, 2008 makes sense. So all of that paper essentially became worthless overnight. So they were left holding worthless paper.

54:33The people were putting their money out of the fund. So they had huge redemptions. And of course, if people are pulling their money out, they have to sell the stuff they've bought. So they sell the liquid stuff, the usual kind of liquidity spiral that you'd expect. And the commercial paper market effectively froze up because people, money market funds, couldn't sell this stuff fast enough. So you can have the commercial paper market run into these liquidity problems. But central banks know this. And if they see the first sign of that market freezing up, my guess is that they'll probably do something.

55:07They'll do something to ensure that the liquidity is there. Maybe not direct loans, but indirect loans like the - Or just reassure it. Yeah. Like they just say, we are here and we will foot the bill. We're a borrower of last resort. We'll buy that paper off you temporarily. Yeah. And that way, they'll get their money back because they don't really care anyway. But it's all made up money from their point of view. but that way it puts confidence back into the market. So I think to restore confidence in that market would be fairly easy for the central bank. I think to do the kind of kamikaze approach, which is to say, no, we're going to let it burn.

55:44That's not going to happen. I don't think even Andrew Bailey would do that. No, because when we did our live, I said my only exposure to bonds is through that fund and people were like, whoa, that's too risky that. And then I saw you make the video of our money market funds risky. So is that the risk that people are talking about, that 2008 risk? That's what people worry about. And it's the commercial paper part of it that people worry about. It's not the government bonds. I think a government, you know, we're still paying the moron premium in UK guilt, but no government would be so moronic as to actually default on UK debt.

56:15What's the moron premium? The moron premium is that huge spike we got in UK guilt. Oh, okay. So that's what you call it. They call it the moron premium. Okay, okay. So we're still paying that to some extent. But I think any government, they're going to be paying that moron premium for generations. Like if the UK government defaulted on its debt, because that's the kind of bedrock, you know, like if you build a Lego model, you've got the kind of base plates that you build everything on and then you kind of layer everything on top of that. Well, the kind of government bonds are like the base plate for the Lego model.

56:45If you take that away, the whole thing's going to collapse. And so every other asset has to be repriced because interest rates are now higher, which is what happened in the UK. It didn't just affect the UK market, sent shockwaves through the entire fixed income market, into the equity market, because everything has to reprice if rates are higher, those risk-free rates. So making that mistake would be, it would get a party out of power for a generation if they did that. So I think most governments are aware of that and they wouldn't do it unless they are bonkers. And it was interesting, Donald Trump was actually talking about defaulting on US debt and saying it would be kind of okay.

57:25And I was thinking, no, it really won't be okay. That's probably the safest and biggest debt market on the planet. So shaking that one up would have just been catastrophic. So let's just hope the sanity stays in place. I mean, he looks like he might get back in, so maybe he'll have another shot. Well, let's hope that the debt ceiling debates don't get too close to the wire because that's when they usually threaten to say, oh, fine, just let it default. Forget it. Yeah, it'll be okay. So we talked about money market bonds earlier. Money market funds earlier. Are they just essentially really short-term bonds?

58:02And how do they work? And when I say short-term, how long is that short-term? So on average, let's take the Vanguard UK money market fund, for example. If you look at the average lifetime of the debt, which is inside that fund, it's 30 days. So let's say that lots of people started pulling out their money and the fund got gated because you couldn't pull your money out because they couldn't sell the stuff fast enough. All you've got to do is wait a month and the stuff's going to mature. So it's very, very short term. An ultra short term means almost no interest rate risk. It's almost cash-like.

58:33So their returns are, it's annual return? Well, I know it's monthly, but is it 5 % per annum? Yeah, well, at the minute. And then you get it. Roughly attracts something which has a rather cute name. It's called the SONIA rate. So it stands for Sterling Overnight Index Average. Not so cute, but nice name, right? But that's roughly the rate at which banks lend to one another. And that's roughly what you earn, which itself is very closely linked to the Bank of England's bank rate. So if that's 5.25, then SONIA will be about 5.25, and so will the return on your money market funds. So just by watching SONIA, you know what you're going to earn roughly.

59:11And the benefit of the money market fund is that you get the rate adjustments quickly. So when the Bank of England were increasing the rate, you saw that reflected in the fund straight away. Whereas your bank were like, we'll still give you 2%, you know, on a savings account. And they were benefiting from that rate by lending your money out. And there's that big controversy really about them not passing the rates on. So with the money market fund, you get that quick access. So in a time of inflation, when you know rates are ratcheting off, it's quite useful to have that because you're going to get access to that rate immediately.

59:41And then they give you all your capital back at the end of the month and then you can reinvest or do they just give you your return? So it depends on the makeup of the fund. But with the one I get, you almost get like a dividend. So you see the price of the fund raise like this, which is the interest building up as such. And then it drops in value and then you get a cash chunk in your bank. And then same thing. You can then reinvest that if you want. And it's very liquid, so you can sell it anytime you want. unlike a fixed term deposit with your bank where you're locked in for two years or whatever and you get a penalty if you have to sell it beforehand or if you can even sell it.

1:00:13And because it's set, let's say if it pays out once every month for ease of example, and it starts at a pound and it's going to end at£1.05p, but you sell 15 days in, you'll sell them get£1.25 because the price will have risen to that point. So you still get your money even if you sell out, you don't have to wait for maturity. Do you know what I mean? Just like our crude coupon example. Yeah, while I was paying you what you were earning. Exactly. So it's rising in value to basically represent the money you would have earned. It's the dirty price. Yeah, the dirty price. Yeah, yeah, the dirty price.

1:00:43But it feels so good. You see, bonds are sexy. There's all sorts of things. Dirty price. Sonia. Sonia's dirty price. Yeah, so I buy my money market fund on Trading212. You can buy them on, most brokers have their own versions. Like you say, Vanguard have a specific one. But yeah, like most brokers have them. Would they be called money market funds? Some of them are wrapped as ETFs. So you can buy that on any ETF platform. CSH2 is a popular one. This is the one issued by Amundi. And there are others which have a fund form. So it's an open-ended investment company. And you can buy them inside of an ISA and things like this.

1:01:20Yeah, inside an ISA, inside a SIP. So it's really useful from that point of view, because if you want to switch out quickly, if stocks look like they're about to rally, you can do that so fast, because you can sell the thing and switch into something else almost immediately. So for me, my cash comes in spurts. I want to fill out my ISA, but I want to, you know, pound cost average into the market on a consistent basis. I can stick that money inside my ISA, you know, the big chunk, have it inside one of these money market funds generating a return and then just sell off each month and invest a fixed percentage.

1:01:51So I'm not, I mean, I know that markets on term trundle up, but I just like investing on a consistent basis each month, you know. So rather than just slapping, say, 20K into the market in one day, I can like spread it out, but still generate a return inside of the ISA and not lose the ISA allowance. And then tax, which brings on, there's obviously no tax inside of an ISA, but is the tax, is it capital gains? Is it income tax? Is it a dividend? How are tax on bonds? So bonds are kind of special if you look at gilts in the UK. And this isn't true for other countries. It's special about the UK. The government gives you a kind of break for voluntarily giving them money, which is that you don't pay tax on the capital gain.

1:02:34Okay, so that's the way it works. You do pay tax as a kind of savings income on the coupon of the bond. So throwing our minds back to what you get with the bond, if you buy it at£95 today, and matures at 100 in a year's time, then that 5 % is capital gain. You are not taxed on that, even if it's outside an ISA or a SIP, and you can buy in unlimited amounts. So we've got bonds in terms of as a vehicle for saving for something. I want a car in two years, here's a bond. We've got the short-term ones, which are like ER and S and these kinds of things that I use, the money market funds for access to basically the central bank rate at a quick rate.

1:03:18What about, you talked about de-risking and approaching retirement. Can you talk about how someone that's listening now thinking, I'm five years off retirement, how would they use bonds there? Yeah. So what I'm planning to do, and this is something I shared with my community in fair amount of detail, but what I'm planning to do is to start something called a bond ladder. And it sounds fancy, but really the only idea behind it is that instead of just buying one bond, which matures in a year, you buy two bonds, one that matures in a year, one that matures in two years. And that way, the rungs of the ladder are the maturity dates.

1:03:50So that's got two rungs, but you can have 10 rungs, 20 rungs, however many you want. And then when one of the bonds matures, you just buy another one. So it's like a conveyor belt where you're just buying another one. And I'll probably run that for five years before retirement and carry on running it for like five years after retirement. And then when I'm thinking how much money to put into it, I'll take my annual living expenses, multiply by three, and that's how much I'll put into my ladder. So it'll be like a three-year ladder. Five years before I retire, I'll set it up. And then gradually after two years into retirement, I'll just stop reinvesting when one matures.

1:04:28And then if there is a crash, I can always sell one of those bonds and use that to live off and let stocks recover while I'm living off the bonds. So that's the plan. So that's one way you can do it. Another way is simply to have a constant allocation to bonds for some period of time through your retirement. If you can't weather 100 % equity, which is what I'm going to have for most of my retirement, if you're not comfortable with that, then having, I don't know, 20 % in bonds or whatever it is you want through single gilts is pretty easy to do. The bond ladder, you only have to do things when it matures and just buy another one.

1:05:06So I think to maintain them is pretty easy. So that's probably what most people could do in retirement. Not many people do do that in the UK because we're just not very fixed income savvy here. In America, they're all over it. So they build their bond ladders with municipal bonds, of course, because they're so tax efficient, but also US treasuries. And there are tools they've got on Fidelity's platform, which let them build the bond ladders, work out the yield, all of that. So I think there'll be more online platforms that let you do that in an automated way in future because it's just a really useful thing to do.

1:05:43So can we just sum up like where bonds would be useful for people at different age groups? Sure. So let's say you're 20, right? So at this point in life, you're probably thinking about saving up for a house, maybe a car in order to get around. So if you've got those big expenses, then you could put money maybe into a money market fund if interest rates are fairly high at the short end of the curve like they are now. If they're not, then you could think about say, saving up for a year or so and buying a one-year gilt, for example. Then in your 30s, maybe you're thinking now you've got a partner, you've got children, you're thinking about those children's big expenses.

1:06:22For example, you could be paying for their lavish presents. You could have to save up for that for some period of time. So again, money market funds and gilts might be another way of doing that. Or if they're going to university, when you're in your 40s, you're probably thinking the kids are going to have to have a wad of cash to pay for it rather than getting into debt. So why not buy debt in order to get them out of debt? So all of these things, retirement, when you're in your 60s, you'll be thinking about de-risking. And I talked about having a bond ladder at that point. So all through life, I think there are events when these bonds become really useful.

1:07:02And of course, they've got the kind of transformative aspect, which is things like municipal bonds, which can really change society, community and local settings. Absolutely. You should make a video on this, like how to use bonds to get rich at every age, by age, 20s, 30s, 40s, 50s. You're never going to get rich with them, but I think you can use them. I'm joking. We don't do that.

1:07:28We've got cameras here so they can see you.

1:07:34If you want a bullet point summary of this episode, you can sign up to our newsletter using the link in the description. And don't forget to subscribe to the podcast and leave us a review. It really makes a difference and lets us know that we're doing a good job. And remember, this is not financial advice. Like we say a lot on the podcast, investments can fall and rise. In fact, it's almost a guarantee. Remember, past performance is no guarantee of future results. So your money is at risk with investing. Also, remember, other fees may apply. I'm Damo. I'm T. This episode was recorded by Jack Hobbs.

1:08:06Music is by Felix Taylor. It was produced and edited by Ruth Edwards. Johnny Hunter is in charge of marketing. And it's all brought together by Will Stollerman.