Investing Demystified

by Lars Kroijer

  The one-month bond declines a little in value to reflect an interest rate of 1%, while the 10-year bond declines to a value of around 90.5 to reflect the higher interest rate. Clearly something that can go from 100 to 90.5 fairly quickly (rate changes are rarely that dramatic) is riskier, even if your chance of eventually being paid in full has not changed.

  However, in reality the time horizon for most investors exceeds the maturity of the short-term bond. Someone who is interested in maintaining a position in the minimal risk asset for five years will be taking an interest rate risk over that five-year time horizon whether buying new three-month bonds every three months, or buying a five-year bond and keeping it to maturity.

  But if the time horizon is such that you think five-year bonds make sense, you shouldn’t necessarily just buy the five-year bond and hold it to maturity. A year hence, your bond would only have four years to maturity and therefore no longer match your time horizon.

  The best way to address this issue is not for you to constantly buy and sell bonds to get the right maturity profile (here you would sell the now four-year bond and buy another five-year bond), but to buy the bonds through a product like an exchange-traded fund or investment fund that trades the bonds for you. (These ‘access products’ will be discussed in detail later.) Such funds will offer products like ‘Germany 5–7 years (to maturity) government bonds’, ‘UK 10–12 year government bonds’, etc. Buying one or a couple of these products to match your desired minimal risk asset and maturity profile is a cheap and low-hassle way to ensure you have the right minimal risk asset in your profile.

  So investors with a longer time horizon should therefore buy longer-maturing minimal-risk bonds. As a reward for taking the interest rate risk associated with the longer-term bonds they typically yield more than the short-term bonds, as illustrated in Figure 4.1.2

  So if you need a product that will not lose money over the next year, pick short-term bonds to match that profile. However, if you – like most people – are after a product that will provide a secure investment further into the future, pick longer-term bonds and accept the attendant interest-rate risk.

  Figure 4.1 The typical bond yield curve

  You should therefore consider the time horizon of your portfolio and select the maturity of your minimal risk bonds accordingly. If you are matching needs far in the future (like your retirement spending) there is certainly merit in adding long-term bonds or even inflation-protected bonds (see below) to your portfolio. Long-term bonds compensate investors for interest-rate risks by offering higher yields and you have the further benefit of matching the timing of your assets and needs.

  Another good alternative is to mix the maturities of your minimal risk assets. You may have some assets that you won’t need for decades, and others you think will be needed in 5–7 years. In that case, there is nothing wrong with picking a couple of different products with different maturities to match that profile.

  Inflation-protected bonds

  Normally when people quote a bond yield they refer to the nominal yield. The nominal yield consists of the real yield plus inflation. (So if a bond offers a 2% yield then that simply means that you get £2 for a £100 bond; if you assume inflation at 1%, then the real yield would be 1%.) So as an investor, in most bonds you have an inflation risk on top of the interest rate risk. To address this inflation concern several governments have started issuing inflation-protected bonds where the buyer is promised a real return. The inflation-indexed bonds work by linking the principal to an inflation index like the consumer price index (in the US) or the retail price index (in the UK). As those indices go up with inflation, so does the amount you are owed by the government.

  The market has grown explosively since the British government started issuing these bonds in 1981, but are still not nearly as widespread as the regular bonds: there are currently about $1.5 trillion outstanding compared to world government bonds of over $40 trillion. These bonds are an interesting development and provide investors with a way to avoid the inflation risk inherent in the bond markets, and I would recommend UK and US investors in particular to consider them.

  The threat of inflation is a real concern for a lot of savers and these new bonds offer a good way to address that concern. While you still take an interest-rate risk and should match maturities to your maturity profile, at least your inflation risk is mitigated.

  In recent inflation-linked bond issues several issuers were able to issue bonds that had a negative real interest. Think about that. You lend someone money, potentially even for a very long time, and they promise to pay you back less than what you lent them in terms of what that money can buy. It may seem crazy, but that is the reality of the world we live in right now. This does not mean that these are not good bonds to own, just an illustration that interest rates are low now and the cost of owning a bond that will be extremely likely to repay you is high.

  What will the minimal risk bond earn you?

  Most people with even a peripheral interest in finance realise that at the time of writing, in spring 2013, interest rates are currently at or near a historical low. So investors should not expect to make a lot of money investing in the minimal risk asset in any currency. In fact, with nominal interest rates near zero, inflation means that investors in short-term government bonds will experience negative real returns. So while your £100 invested in a government bond may, with almost certainty, become £105 in five years’ time, the purchasing power of that £105 will be less than that of the £100 today. This is, of course, still better than if you had held the £100 in cash for five years – in that case the purchasing power would be even lower.

  Without putting too fine a point on it, that obviously isn’t great, but there is not a lot you can do about it. If you are after securities with minimal risk then the yields are just very low right now. Instruments that offer higher returns come with more risk of not getting paid and anyone who tells you otherwise is not telling you the whole story.

  Figures 4.2 and 4.3 show what UK and US government bonds (so in £ and $) will currently earn you, by maturity, both in real and nominal terms.

  Figure 4.2 Current UK government bond yields

  Based on data from www.bankofengland.co.uk

  Figure 4.3 Current US government bond yields

  Based on data from www.treasury.gov

  While the outlook for generating very low-risk real returns is thus fairly limited (at the time of writing), these are continuously moving markets and it is worth staying on top of them as rates change. What you can see from Figure 4.2, for example, is that if you wanted to buy UK government bonds now, you could expect to earn a just under 1% real return a year for a 20-year bond. Likewise, for a five-year bond you should expect a negative return of about 0.5% a year.

  What you can also see from Figures 4.2 and 4.3 is the current market expectation of future inflation (the difference between the lines). So, for example, the markets are assuming that there will be approximately 4% annual inflation in the UK for the next 25 years, but only around 2% for the next five years, suggesting higher inflation in the longer term. Inflation is bad for many things, one of which is tax. (While the benefits you get from your investments are based on real returns and the future purchasing power of your money, you pay taxes on the nominal return.)

  Suppose you invest £100 for a nominal return of 2% the following year, then you could be liable for tax on your £2 gain, even if 2% annual inflation had eroded the real gain (so the purchasing power a year hence would still be £100 in today’s money even if the nominal amount had become £102). Compare that to a zero inflation rate environment with a 0% nominal/real return and your £100 would still be £100, both in real terms and nominally, at the end of the year. There would be no gains to pay taxes on.

  If the charts above give you the sense that the returns you get in any one year from owning UK or US government bonds is stable, reconsider. Figure 4.4 shows the annual return from holding short-term (sub one year) and long
-term (more than 10 years) US bonds since around the Depression. What you can see is that the annual returns move around a fair deal for both, but far more for the long-term bonds. This is because those bonds will move in value far more as the interest rate or inflation fluctuates.

  It can be hard to do an objective, like-for-like comparison of historical and current returns as the market view of the creditworthiness of government credit has not been constant, but Figure 4.4 suggests that the returns from longer-maturity bonds are not without risk. If your investment horizon for the minimal risk asset was approximately 10 years and you had gained access to the government bonds through an ETF or index fund, your annual fluctuations would have looked roughly like Figure 4.4. It will probably be a surprise that something that is considered as safe as US government bonds can fluctuate as much as the chart suggests.

  Figure 4.4 Inflation-adjusted US government bond returns since 1928

  Based on Bureau of Labor Statistics and Federal Reserve St. Louis

  There are a few points to note from the charts above:

  Real return expectations from the minimal risk asset are currently near an historic low.

  Returns from these minimal risk assets have fluctuated quite a bit, because of changes in inflation and real interest rates, and can reasonably be expected to do so in the future.

  You can generally expect higher returns from investing in longer-dated bonds. If that matches your investment horizon then hold your minimum risk bond portfolio through a suggested access product like an ETF or index fund. But note that particularly for longer-dated bonds the yearly fluctuations in value can be significant.

  In the interest of keeping things simple in the following examples, I have assumed a real return of 0.5% a year from the minimal risk asset. As you can see in Figure 4.4 while that is too high for current short-term bonds, it is more reasonable for longer-term bonds and in line with historical returns from short-term bonds.

  Do not believe your cash is safe in the bank!

  Although interest rates are quite low, many investors still hold large deposits in cash at their financial institutions without considering the credit risk. I would caution against blindly doing this.

  About 120 countries in the world have a system whereby the state guarantees deposits with financial institutions up to a certain amount in cases of default. While this varies by country it means that the first £85,000 (in the UK) or €100,000 (in many EU countries) of deposits with a bank is guaranteed by the government. The guarantees are in place to lend confidence to the financial system and avoid runs on the banks. Without a bank guarantee we would be general creditors to the bank and have to gauge bank credit risk, something most depositors are not equipped to do. (Of course, if you have your money with a bank deemed ‘too big to fail’ the bank won’t fail without the government also failing.)

  If you hold cash deposits with one or more financial institutions in excess of the deposit insurance then you are a general creditor of that institution in the event that it fails. This means that if you have £200,000 in deposits with a bank and the credit insurance is only for £85,000, the last £115,000 is not covered.

  A good friend of mine sold his successful IT business a while ago for a very large cash amount. He was never really that interested in finance, and just left the money in an account with his financial institution while he took some time off. This was a large, double-digit, million-dollar amount and the financial institution was the insurance company AIG. He got concerned when one morning he read in the Financial Times about all the issues with AIG and how it could potentially go bust. When my friend contacted AIG there was initially some confusion about the kind of account he held and for a while my friend thought his money with AIG was going to be lost in the general abyss of a spectacular financial collapse. In the end, he along with all the other creditors of AIG kept his money, but the experience certainly put the statement that an investment is ‘as good as money in the bank’ in perspective.

  On a much smaller scale, I had some cash in a lesser-known bank in excess of the government credit guarantee. I had agreed to put most of the money on time deposits where I would get a slightly higher interest rate of 2.5%. Coincidentally I discovered that the bank bonds were trading in the market at a yield of approximately 5% a year. In simple terms, the market was telling me that I was taking a credit risk on the non-government guaranteed portion of my deposit that the market estimated at 5% a year, but getting paid 2.5% for it. Not a great idea!

  Who backs the deposit insurance?

  The deposit insurance scheme is only as good as the institution that has granted this guarantee. If you were holding cash with a Greek bank and relied on the deposit insurance protection from the Greek government you would clearly not be as secure as with the same guarantee from the German government.

  In the recent bailout of Cyprus, the restructuring that was initially suggested involved depositors both above and below the guaranteed amount taking a cut in their deposits (in the end, only larger depositors had part of their holdings confiscated), suggesting that bank depositors in that country were indirectly exposed to the creditworthiness of that government in addition to that of the bank holding their money.

  Local banks fare horribly if the government defaults; the banks are tied strongly to the local economy, which is suffering. On top of facing a poor economic climate, the banks will have lost a lot on their holding of government bonds. The correlation between the troubles of your government and your bank is thus very high, and the protection you were hoping for may be absent as a result. This is bad news, particularly as your bank and government default may well happen at the same time as other things in your life are being negatively affected by the same economic factors; you may have lost your job, your house may decline in value, and so on. It is exactly in that circumstance that you want the diversification of investments and assets that the rational portfolio provides.

  A way to address the potential lack of security of your cash in the bank is to buy securities like AAA/AA government bonds or other investment securities that closely resemble cash (such as money market funds, etc.). Importantly, securities like these still belong to you even in the case of a bank default, and while the process of moving that security to another financial institution could be cumbersome, you are no longer a creditor to a failed bank, which gives you far greater security in a calamity.

  While investments like stocks and bonds held in custody at a bank still belong to you if the bank goes bust, you should be careful about holding too many assets at risky banks. Once an institution defaults, the process of finding out who exactly owns what can take time. There have even been cases where the segregation between client assets and bank assets have been less firm than it legally should be, rendering it even harder to regain the investments that are legitimately yours, in the face of bank creditors claiming that the same assets belong to them.

  Also, in a future bailout like the ones we have seen in Southern Europe it may be that not only your cash is confiscated, but that institutions find a way to take some of your securities as well. It’s all a mess worth avoiding, so unless there is a compelling reason not to do so I would encourage you to place your cash and investment assets with very credible banks.

  Particularly pre–2008, some less-known banks offered very generous interest rates on deposits compared to the more conservative traditional banks (these turned out to not be so conservative either, but that’s another story). In the UK, the Icelandic banks in particular were guilty of this, but there were many others. (The rate differential provided the potential for profits from the perspective of the depositor at the expense of the soundness of the banking system.) If the depositor guarantee was indeed iron clad (i.e. the government would not try to get out of the depositor guarantee under any circumstances) then depositors were incentivised to withdraw cash deposits from the more conservative high street banks and deposit the money with the bank that offered higher deposit interest rates. If the gun
-slinging bank went bust (like some did later) the government would ensure the depositor would not suffer. If the gun-slinging bank stayed in business, the depositor would benefit from higher rates.

  A couple of years ago I was approached by someone who was planning to start a bank. His pitch did not involve great new markets or interesting products, but rather what he called an ‘arbitrage’ on the credit insurance of the government. His arbitrage involved offering customers extremely high deposit rates, but only up to the amount of the government deposit insurance, and thus attract sizeable deposits. He would use the deposits to offer loans to renewable energy investments that also had government guaranteed rates of return, while capturing a spread for the bank (and himself presumably) in the middle. He claimed that his scheme was entirely legal and within banking regulations (I suggested he double checked this). I don’t know if this man was able to start his bank, but it gives a good picture of the kind of thinking that can drive some of the more gun-slinging banks out there. Also, it shows how important it is for governments to get bank regulation right in the face of the many people who constantly try to game the system. It is not an easy task.

  I feel like a pessimist in writing about the dangers of cash deposits. It is certainly the case that in more than 99% of cases the thought behind the term ‘safe as money in the bank’ or ‘cash is king’ means exactly that; that it is entirely safe. My logic is based more on how things fit together and trying to avoid several bad things happening at the same time. If you consider the unlikely scenario of the bank where you hold most deposits going out of business, that scenario probably involves a lot of things that are also not good for your investing life. Regardless of what your risk profile is as an investor, you should be sure that you get properly compensated for the risks you are taking, and that you think about what happens in a calamity. The risk to your cash deposits in the case of a bank default is no different.