Our Insights

About personal finance, investments and markets.
May 11, 2015

How safe is the „safe“ portion of your portfolio?

The traditional roles of bonds in a portfolio are income and stability. These days, government bonds offer very little of either: (1) after taking inflation into account, real returns are often negative and (2) at current yields, bond prices are very sensitive to changes in the interest rate which can lead to larger price swings than investors are used to. Don’t overpay for the perceived safety of bonds. Buying long-dated bonds at current levels is reminiscent of pickung up nickels in front of a steamroller.

Ugly bond math

10 year German government bonds (called ‚Bunds‘) lost 5% over the last two weeks. Does that move still qualify bonds as safe? On April 20th, Bunds offered a yield of 0.07% – two weeks on May 7th the yield has risen to 0.60%. Bond prices drop as yields rise so investors who bought then are sitting on a 5.1% loss. It takes 73 years of 0.07% yield to compensate (which is a bit problematic for a 10 year bond).

Safety is only a question of value

Why are we so cautious about government bonds, especially since they are generally considered as safe investments? As value investors, we think safety is only a matter of price, not a matter of which asset class an investment belongs to. Investors should maybe listen to what one of the architects of the current monetary policy has to say about QE. Bank of England’s Executive Director Andrew Haldane said in 2013: „Let’s be clear. We’ve intentionally blown the biggest government bond bubble in history”. We don’t disagree and prefer not to invest in bubbles.

Wealth management is not about making predictions

A wealth of research shows that, when it comes to the financial markets, there really aren’t any good forecasters. Predictions make for good headlines and can be quite entertaining but they should not be the basis for long-term financial planning. Investors need to ignore the various types of hype and noise and simply stick to their plans.

When it comes to bonds, our approach is not to make predictions where yields might be in the future. The right approch is to  think whether bonds are a suitable instrument to reach your goals. If you are looking to beat inflation and grow your wealth, then, unfortunately, at today’s yield levels, most government bonds are not the right asset class.

What this means for portfolio construction

The case for long-term government bonds today as an investment is a very thin one. In all probability they are safe against a loss of value under deflation, but in just about any other circumstance their expected real returns are somewhere between approximately zero to strongly negative.

 

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