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Is it Time to Lift the Anchor on Government Bonds and Sail?

Government Bonds
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EDITOR NOTE: Perhaps it’s a human trait that under certain circumstances might also be considered a common yet often overlooked weakness. People avoid uncertainty. They find safety in numbers, seek comfort in popular opinion, and choose familiar rather than unfamiliar solutions. When it comes to financial matters, there are a number of socially-driven habits that form into what we call “herd mentality.” Take, for example, the notion of risk versus capital preservation. It’s either stocks or government bonds for many investors. Even when bond yields sit well below the rate of inflation, people still look to bonds for safety out of pure habit, bias, and perhaps fear--conscious or not. But there’s a dismal history behind such thinking, and the article below sums it up rather nicely. To further exemplify the point, gold is considered a “relic,” at least among most American investors. Central banks may be loading up on this “antiquated” currency, households abroad may be accumulating it in record amounts, and its price may be rising in anticipation of inflation and near-zero to negative zero bond yields, but still, for most investors in the US, it’s a relic. Not only is such thinking unintelligent, it simply doesn’t make sense. But the “herd” has never been known for “smart money” actions. And if you can’t tell where you stand, right now, as your purchasing power sinks amid the coming inflationary trend, then you may be in trouble.

In the late 1960s, many savers could see that the existing monetary framework, the Bretton Woods Agreement, was on the verge of collapse.

That system established the certainty that the U.S. dollar would be exchangeable for a fixed amount of gold and that other currencies would be exchangeable for a fixed amount of U.S. dollars. It was not difficult to forecast that the result from the collapse of the Bretton Woods system, the end of any link between paper currency and gold would be higher inflation.

Even armed with foresight of this structural change, most savers then witnessed a collapse in the purchasing power of their savings as inflation surged over the following decade and beyond.

We are now living through a similar structural shift and investors now face very similar challenges in preserving the purchasing power of their savings. Many investors in the late ’60s foresaw that the gold price would rise in U.S. dollar terms when the old regime ended but almost all still held more bonds than gold when the system did collapse. They took a bet that the gold price would no longer be fixed at $35 per ounce but they did not take a big enough bet.

Investors today are making the same mistake and the aim of this column is to explain why and what to do about it. The first step involves getting rid of our anchor.

Anchoring is an observable cognitive bias in which we subconsciously use available but irrelevant information to inform our decisions. Anchoring will result in many savers basing their asset allocation today on what has been the norm in the old regime. This was the same mistake made by investors in the later 1960s whose asset allocation remained anchored to the bond equity weightings that had pertained in the postwar period.

Shedding the anchor does not involve buying particularly risky assets but it does involve adopting asset weightings that would currently be considered risky. Risky, that is, if one is anchored in the allocation of savings by weightings considered low risk in the old regime.

So, the first currently radical step to shed your anchor and preserve the purchasing power of your savings is to hold as few bonds as possible.

It is dangerous to prepare your savings or your business on the basis that all that lies before us is just another economic cycle. In such a cycle, the rules learned in the last cycle are all that are necessary for a successful navigation.

However, a new financial structure is now in place. It is a financial repression in which interest rates are held below the rate of inflation, and it will last for at least a decade and probably longer if it is to achieve its aim of reducing debt to safe levels.

The result of bringing debt-to-GDP to manageable levels is a massive transfer of wealth from savers to debtors. A saver seeking to avoid the negative consequences of such a transfer must avoid investing in bonds.

The traditional approach to investment is to include bonds, particularly government bonds, as a key asset in any savings portfolio.

The reasoning behind such an allocation is based upon the observation that when times are bad the price of these bonds will usually rise. The ability of the government to meet its payments of interest and principal are almost beyond doubt as ultimately they control the supply of the money with which to meet their obligations.

With very limited risk of default on these payments, the price of government bonds usually rises in the bad times when inflation declines. Investors push the price of bonds higher as the real value of their interest payments, in a period of lower inflation, are rising.

In the market-oriented system that has pertained for several decades, government bonds are an asset and the price is expected to rise when the economy deteriorates. It has been a great boon to investors in these bonds that, through many business cycles now, the level of inflation has moved consistently lower. This structural decline in inflation is the key driver behind the long-term bull market in bonds.

We can track the inflation-adjusted returns from U.S. government bonds all the way back to 1800. Measured over 30 rolling periods, these bonds have just produced the highest returns ever recorded. They have provided such excellent returns as bond prices have risen and thus yields have fallen to record low levels. The result is that investors now receive very near record low yields for holding government bonds — just 1.5 per cent for owning the 10-year bonds of the Government of Canada.

If you are a long-term investor, you are betting that these record low yields will not just be sustained but can fall further — providing you with capital gains to push your total expected return above the meagre 1.5 per cent you will receive in interest.

That is an optimistic expectation given the record high returns over the past few decades and the move to a policy of financial repression. Capital losses are more likely than capital gains with bond prices just below record highs and yields just above record lows.

Worse than this, the rate of inflation is likely to rise and further reduce the purchasing power of your bond investments. Investors who held U.S. government bonds from 1951 to 1981, a previous period of financial repression, suffered an annual two per cent decline in the purchasing power of their savings even had they reinvested their interest. In the United Kingdom, returns from bonds were even worse and the investment was known as “certificates of confiscation.”

Today, with bond prices likely fixed through government and central bank intervention, the real losses to investors are more likely to occur due to high inflation rather than nominal declines in bond prices.

It is highly unlikely that the politicians or people of any country will chose policy settings in which no relief for debtors is forthcoming. The more policy settings change to alleviate the burden of debtors, the more the real value of your bond investments will decline. A world without inflation is a world where debtors will struggle to pay interest and principal on their bonds making bonds issued by the private sector a dangerous investment. A world where higher inflation boost debtors ability to service their debts, the greater the real and probably also nominal losses on bonds.

After exceptional long-term returns from bonds for several decades, many investors are anchored to the view that bonds play an important role in a diversified investment portfolio.

A more realistic perspective is that after exceptional returns, record low yields and record high levels of debt across the developed world economies, it is time to realize that a prolonged bear market in bonds has begun. It is time to stop anchoring and to set sail.

In forthcoming columns we shall focus on the appropriate direction of sail for those intent on preserving or enhancing the purchasing power of their savings. The first necessary decision, though, is to lift that anchor.

“To reach a port we must sail — sail, not tie at anchor — Sail, not drift.” — U.S. president Franklin D. Roosevelt, Broadcast to the Nation, April 14, 1938

Original post from TorontoStar

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