Nothing stimulates the mind more than sharing your ideas with inquisitive and intelligent people.
This is what makes Port Phillip Publishing and its parent company Agora so interesting for me.
The global talent pool within Agora is very impressive. The ability to bounce ideas and concepts off people in different countries, with different investment philosophies and facing different economic and geopolitical situations is an enriching and enlightening experience.
The end beneficiary of this ability to ‘stress test’ our ideas is you…our readers and subscribers.
Looking at a situation from a number of perspectives — and remember nothing in life is one dimensional — enables us to bring to your attention risks or opportunities you may not be aware of.
One such example of this sharing of ideas is an email I received from Chris (based in the US) over the weekend.
The email was titled:
‘A quick question from Bill on bonds versus cash…’
Chris works with Bill Bonner on The Bill Bonner Letter.
Here’s the edited version of Chris’s email:
‘How are things?
‘I’m putting together a new letter, to accompany The Bill Bonner Letter that draws on the views of the international gurus…
‘I saw you wrote this recently in GFW [Gowdie Family Wealth]:
“The credit boom of the last 30 years is without precedent… so much money created without effort has built a world of unrealistic expectations.
“When the credit boom finally deflates, future generations will be talking about this period in history in the same tones as we refer to The Great Depression. Our defensive position in cash is the perfect place to ride out this one-in-one-hundred market even”
‘I’m writing about bonds…
‘Could you send me a couple of paras on why you buck the trend and don’t recommend bonds for a defensive asset?
‘Some questions I’d love to get your view on:
‘Didn’t bonds do well after the 1929 crash? Why does everyone hold bonds if they’re so dangerous?
‘Would you recommend cash for Yanks too, given interest rates there? What about Europeans?
‘If not, what’s the best defensive asset for someone living in the U.S.?
Here’s my edited reply:
‘Great to hear from you mate.
‘Not sure about the ‘guru’ bit though.
‘Why cash and not bonds?
‘I am not sure about the level of sophistication of US investors, but I know from experience Australian investors have a difficult time coming to grips with the concept of the inverse relationship between yield and capital value.
‘The higher the yield (and the longer the duration) the lower the capital value and vice versa.
‘In all my years in financial planning the one subject I had the greatest difficulty in explaining was the risk of rising interest rates posed to the capital value of fixed interest (bond) investments.
‘Client’s eyes would just glaze over. Trying to fathom “if interest rates go up, I lose money” was for most “a bridge too far”.
‘The investment industry markets bonds as ‘Fixed Interest’.
‘In Australia if you ask someone about “fixed interest”, 9.5 times out of 10 they equate this to a Term Deposit (the equivalent of a Certificate of Deposit in the US).
‘The belief from the person on the street is you put your money in for a fixed term at a guaranteed rate. Upon maturity receive your capital back.
‘In theory this is how bonds also work — you can buy a US 10 year bond and hold to maturity. But how many individuals physically buy a 10 year bond? Very few.
‘Most “fixed interest” exposure is via bond funds (PIMCO et al).
‘These funds are priced daily based on interest rate movement.
‘I recall distinctly in 1994 when Greenspan raised bond rates as a preemptor to an inflation scare — fixed interest funds (marketed by the industry as Capital Stable) were anything but stable. Portfolios lost around 25% in value.
‘Fortune Magazine ran this article in 1994. The by-line was:
“In a year of low inflation, bondholders have suffered more than $1 trillion in losses. Here’s why it happened, and could happen again.”
‘This was a trillion dollars in 1994. Imagine what it would be today?
‘You are correct in saying bonds did well after 1929.
‘In 1929 the 10 year rate was around 3.6%. A decade later — in 1941 — the 10 year rate bottomed out at 1.95%. Falling yield equals rising capital value.
‘But we are not in 1929. The US is starting with a 10 year rate around 2.3%. While Japan and Germany are well and truly sub-1%.
‘Why do so many people hold bonds if they are so dangerous? Simple. We are still in a world where the focus is Return ON Capital.
‘The prospect of picking up say 2% yield PLUS some capital gain (should rates fall further) is influencing investors investment allocation in a world of ZIRP.
‘My theory (and that’s all it is) is the next crisis — The BIG One — is going to come from one or more sovereign defaults. With over $200 trillion in debt out there some of it has to be at risk of never being repaid.
‘As the deflationary pressures build in the system and the income and expenditure gap in government budgets widens, someone is going to say enough.
‘The common misconception is that if very low inflation/deflation is in the system, then this will be reflected in lower bond yields. This is true. But as I said earlier, nothing in life is ever one-dimensional.
‘Interest rates are not determined by inflation expectations alone. Credit worthiness also determines bond rates.
‘Case in point is Greece. The country is in a depression (no inflation expectations) yet their bond rate is rising due to concerns over the country’s ability to repay its debt.
‘Most commentators I read are focused on analysing bond rates purely from a macro economic view on where inflation is headed.
‘Not one of them has considered what may happen to rates in a full blown debt crisis when panicked investors demand a higher return for the risk (perceived or real) of lending to a sovereign nation.
‘If for argument sake investors push rates up on UK Gilts, then this will domino onto US bond rates. Everything becomes relative.
‘If you subscribe to the theory the debt levels (and not to mention the projected growth of these debt levels) within the global system are simply too large to ever repay in full then the only logical outcome is for default and/or restructuring.
‘Depending on how deep into the debt pile these defaults go — and I think they’ll go a lot further than people think — then even in a deflationary world, bond rates would rise due the concerns over default..
‘Rising bond rates equals capital losses.
‘If the losses start to mount up, we may also see a lack of liquidity in bond funds as investors panic and head of the exit. This will only compound the losses as funds try to sell bonds at whatever cost to meet redemption requests.
‘My approach to the situation we are confronted with is different — it’s one of Return OF Capital.
‘A meagre interest rate is irrelevant. The important thing is having 100% of my capital safe and liquid to take advantage of what I believe will be “once-in-a-century” bargains.
‘In Australia we can still receive around 3% on our cash and term deposit money. Compared to northern hemisphere investors, our returns for safety are not all that meagre.
‘In answer to your question about where do US and European investors invest. Simple. Cash.
‘I know the push back will be “but I am only earning 0.25%”. This is a response from an investor functioning in ‘Return ON Capital’ mode.
‘I cannot stress enough that when the ‘proverbial’ hits the fan, people will not give two hoots about the return on their capital, they will want return OF their capital…all 100 cents in the dollar of it.
‘We’ve seen this movie play out before.
‘Investors all think they can have it both ways — stay in right to the top and then exit before everyone else. Perfect timing. Dream on.
‘When the “event” happens (whatever that trigger is going to be) no-one will see it coming.
They never do.
‘“Better to be a year early then a day late” is my motto.
‘Hope this helps you and Bill with the letter.’
The purpose of sharing these emails with you was to give you an insight into the discussions that we have internally.
This sharing of knowledge hopefully makes us all more astute investors. Ones who gain their wisdom before the event, rather than the majority who tend to be a little wiser and much poorer after the event.
Editor, Gowdie Family Wealth