Beware Fixed Income

Share
Financial Planning perth : what is the value of a dollar of income?

Valuing a dollar of income in a sea of cash can be tricky. Image : Stuart Miles/FreeDigitalPhotos.net

While not usually given to hype-driven headlines and catchy bylines, it seems to me that investors are currently being led by some errant media ramping of fixed income products – which is wrapped up in the guise of genuine commentary, research and financial opportunity.

This is not a gloom and doom post, and not a recommendation to avoid fixed income investments, as there are a raft of very positive points to make in the current environment, and if i were a little less busy trying to help people take advantage of them then i’d have more time to spend talking about them. But back to the idea at hand…

Financial Planning – High Income, Guaranteed

These words have for many years now been magnets to money, capital and investor interest. In the lead-up to 2007, this was a result of the flood of low-cost money unleashed by the US Federal Reserve under Alan Greenspan post the “tech-wreck” stock market crash of the early 2000’s, which caused low interest rates, resulting in a search for higher income investments. Various better qualified and more redoubtable notaries would argue my point but few would argue against the premise that the US Federal Reserve (the “Fed”) kept interest rates too low, for too long.

This encouraged a host of bad things, from reckless lending to an ever-increasing mountain of “structured products” that took valuable, sustainable businesses and assets, repackaged them into hyper-leveraged black-boxes, and marketed them to all and sundry as “blue chip”.

There were lots of names for all this – securitised mortgages, CDO’s, listed infrastructure and property funds that paid income from debt. ABC Learning did it with the steady income of childcare centres, and Macquarie did it with toll roads, airports, infrastructure and just about anything that produced a steady income. The mathematics was compelling, and the process could be commoditised into a sausage machine profit-making factory.

Speculation doth beget speculation

The scale of this repackaging was at such a level that even those who recognised the issue were not able to forsee just how devastating the unwinding would be. Hedge Fund managers such as John Paulson made billions betting against these bubbles, and came to be seen as having some second sense. If they saw it once, they would see it next time is the logic that resulted in even more billions of dollars being funnelled into hedge fund coffers all over the world. What was glossed over was the role of hedge funds in stirring that whirlpool of excess. And so even more money has been pointed towards groups whose primary function is to take advantage of mispricing, rather than long term investing into productive and income producing assets. The result – even greater volatility. And a humbling dose of reality when it’s found that no-one really has a “second sense” when it comes to investment.

When the fire rages, add more fuel!

This only escalated when central governments decided that large debts were better than financial meltdowns. Global share market capitalisation (the sum total value of all the companies listed on all of the share markets of the world) fell from around US$57 trillion in 2008 to US$22 trillion in the depths of March 2009. That loss of US$35 trillion from global balance sheets was going to tear the world apart. Let’s spell that out – $35,000,000,000,000. Even one of those freight trains of zeros would have a large impact but we are talking about thirty-five thousand bundles of $1 billion.

Governments and central bankers have calcuators that deal with figures that big, so they knew just how big a tidal wave of grief was about to hit when company and household balance sheets started to reflect that lost money, and so suddenly the term “quantitative easing” was as well recognised as Coca-Cola. The United States, United Kingdom, and the European Union joined Japan in its rampant money-printing exercise. Governments decided it was better for them to have large amounts of debt than to try to teach a modern populace how to sell apples on street corners. All this printing of money had the obvious and intended result of reducing interest rates to pretty much nil for a large chunk of the financial world’s big players. And so the speculators who created the GFC trainwreck were now free to get back into the business of betting the Polish zloti against US corn and hog futures.

Financial Planning – Deflation is not a dirty word

Where the global financial crisis evaporated trillions of dollars of balance sheet asset valuations, the printing of money is an attempt to replace some of that cash, and keep the banking system afloat, so people have money to do the things they want to do. It is a “fingers-crossed” attempt to allow those previous high valuations to be unwound gradually, without wrecking the entire financial system in the process. This is a form of deflation – or consistent price reduction. Inflation is usually thought of as increases in the CPI (or “consumer price index) – but i am using “deflation” here in terms of a reduction in the pricing of assets. This gradual unwinding is not obvious when we have our faces pressed up against the window but after a number of years, we can see that not many assets  have actually increased in price over the last 5 years. This leads to the feeling of “getting nowhere” but it’s an essential component of letting the world’s finances settle down gradually.

Deflation in this sense is really just prices dropping to reflect the availability of funds, and the bursting of speculative bubbles.

1960’s – free love. 2010’s – free money!

What do you do when handed the internet password to access as much money as you want at an interest rate of less than 1%? You run off to find ways of taking as much of that money as you can, and earning as much as you can from it while taking the least possible amount of risk. In most cases, this means going out and buying up fixed income investments from banks and governments that pay a higher rate of interest than your cost of funds, while guaranteeing to give you your money back. A gilt-edged investment with cheap financing and a guaranteed way to make money. Central banks know it, private banks know it, and major trading groups know it. In effect, the general public are providing profits to banks so that they can eventually rebuild their strength and get back to doing what they are supposed to do – which is lend out money.

One of the darlings of the investment (speculation?) world in this environment has been Australia. Our interest rates remain higher than the rest of the developed world, and our currency has strength against all those economies that are devaluing their currency by printing money.

Financial Planning Perth : Comparing global interest rates March 2011

My chart of current rates from different major economies

So if you were a global money market dealer, which country would you invest into? given that overseas investors own the majority of Australia’s bonds, does that mean that our longer term rates are being kept even lower than they should be – something that would be quickly reversed should the Big4 decide to raise their central bank reference interest rates?

Stay with me – we are getting to the point

Those earlier paragraphs are a paraphrasing of 4 years of economic turmoil, political argument and global watershed moments, as these pre and post GFC imbalances have been worked through. Given the amount of commentary already passed on the Global Financial Crisis, it may seem unnecessary ground to cover but to my mind this rehashing of that which we all already know is essential, if we are to come to grips with the world of fixed income, and where it is today.

The world’s biggest pool of money

It ain’t a pool – it’s a veritable ocean of cash. The United States debt pile is so large that it has become one of the hotspots for larger investors in the global investment world.

This may seem counter-intuitive. After all, why would investors want to play in the debt playground of the most indebted nation on earth? Especially one whose economy is suffering distress at a multi-generational level?One that was recently downgraded from its pristine AAA status owing to its inability to get enough political agreement to even pay its debts? How can that make sense?

Well, it turns out that there aren’t a lot of places where you can invest a billion dollars today and take it out again tomorrow without impacting on price while doing so. This is what is called “liquidity” in financial terms. It means that you have greater certainty for your money simply because you have easier access to it. Therefore, when the world looks shaky, you can dump “risky” assets and buy into the US debt markets such as “Treasuries”, knowing that when things look good again, you’ll get your money back whenever you want it. In effect, this ocean of cash has become the “parking spot” for the world’s hot money.

Watching this pool of money is like watching a barometer of global financial market fear. There is an index that measures sharemarket volatility (called the “VIX”) but if you want to measure fear, watch the US debt markets.

If you want to see this fear in action, have a look at this chart of the United States 30 year bond yield. While looking at it, try to remember that it takes an awful lot of money to move yields in such a large ocean of fixed income assets.

 

Financial Planning Perth : A look at US 30 year bond yields

You can see that fear is a bigger motivator than risk ratings and central bank policy!

There are a few points to make about this chart. See the cliff-face fall late last year, when it looked as though the European Union was going to fall apart? That represents a flow of money into the US debt market. If you have the time and the interest, read this Bloomberg article from August 2011, http://www.bloomberg.com/news/2011-08-04/yen-slumps-after-japan-intervenes-to-curb-rise-most-asian-stocks-advance.html which points out that the flow of funds to cash had reached such a point that banks were, for the first time, charging a fee for overly large cash deposits!

It is also worth noting that the Federal Reserve’s Operation Twist was pumping money into longer dated securities from late September 2011, so this would have exacerbated the drop in yields.

To explain this a little – if there is a limited pool of available fixed income securities then when more people want to buy them, the price will be bid up. This higher face value price will reduce the relative percentage of whichever interest rate the investments pay. The flip side of this is that when interest rates rise for the same securities, it means the price paid for them has fallen – a capital loss on a fixed income product… it sounds quite silly here in the trough of interest rates but it’s actually happened a lot of times over the years. I remember the 1994 episode especially well – when a cash management trust in Australia was “locked up” owing to the failure of a major fixed income note in the portfolio, and all of a sudden – cash wasn’t just cash any more. Income funds stopped paying income and people who had adopted “conservative” strategies suddenly found themselves looking at losses that they didn’t think could actually happen.

And so the warning to be wary of fixed income investments in the current marketplace. The pricing of such instruments is being driven by extremely large and aggressive global imbalances – and all is not as it seems. Again, to put a bit of perspective on things, we need to peel our faces off the most recent interest rate screens, and consider the longer term cost of the United States debt.

Financial Planning Perth : US 30 year bond rates looked at long term

Where do US interest rates go from here?

If the USA suddenly has to start paying higher rates on that ocean of debt, they will have even more trouble bringing their budget into balance. That has not yet become an issue, as fear dominates global investment decisions and “smart money” thinks it’s better to hold a guarantee that you cannot make money unless the world gets worse than to actually invest for a more productive future – but at some stage it will, and the implications for money are not as obvious as Economics 101 would suggest.

Financial Planning – Bank and corporate income notes

There have been a lot of notes issued lately by banks and large companies. It’s worth remembering that all such issues have a commission built into them. That’s not a bad thing, as it costs companies money to raise capital, and commissions are pretty much just a marketing and distribution costs – or “access fee”. If a company were to raise a loan with a bank or a group of lenders then it would face very stiff costs and fees for that facility – so it doesn’t really matter to the company whether they pay the fee one way or another, so long as they get the money they need to operate efficiently and meet business objectives. The reason for mentioning the commission is simply to point out that this money has to be raised, and there are lots of people with a financial interest in it being raised, hence a lot of publicity and marketing effort to get these offers in front of people with money. It’s like the Telstra floats – you had to be in them, regardless of whether they were a good deal, simply because everyone said they were a good deal and everyone was doing it!

My interest in these issues goes back many years – to a note from National Australia Bank. I remember thinking at the time that being paid a set margin over the 90 day bank bill rate was a pretty good thing. It meant that you received a regular income and one that would keep up with interest rates if they were to get out of hand again, like they did back in the bad eighties. Having it backed by a major bank, and knowing that your capital was backed by the security of that bank make it appear as though your capital was secure as well. But it didn’t turn out that way. Here’s a long term look at the capital value of the NABHA security.

Financial Planning Perth : A look at an income security from National Australia Bank

If you bought this for income and security then maybe you’ve assumed a bit much?

Not necessarily what you would have expected, is it? Not exactly the sort of chart that you are going to see attached to any suggestion to invest into an income security, is it?

This doesn’t mean that such investments are bad investments. It simply means that you need to be careful of putting your own version or definition of “secure” on these type of investments. Just because they are promoted as income paying that doesn’t mean you can ignore what happens to your capital.

It means that you need to look through income securities particularly carefully, and especially given the larger issues at play. All is not as it seems, and it is my opinion that these instruments are being sold into a retail market ill prepared for their complexity and the nuances of risk management in the debt market.

Financial Planning – Global Impacts on fixed income

OK. So we’ve looked at a lot of background. Why is this important? It’s important because countries such as the United States, United Kingdom and the European Union know that they must eventually repay the debts that they have taken on in their efforts to stabilise banks and rebuild their economies. However, there are “crunch points” in the process, as any attempt to repay the debt will usually result in an increase in interest rates or higher inflation. That may seem a long way away right now, as central bankers are still worried about global banking stability and threats to growth rather than overall debt but it will eventually come into play – and when it does, people holding on to fixed income investments that only pay 2% or 3% for the next few decades are going to want to swap into higher yielding notes or other investments. And that means a capital loss on the bond you bought at a 2% or 3% yield. If the retreat becomes a rout then we can end up with interest rate shocks like that of 1994.

There are plenty of reasons why you would invest into fixed income securities. There are portfolio issues, duration issues, credit rating issues, margin issues and debt ranking issues. Most bond funds would seek to actively manage their holdings and duration to minimise any such ructions. However, there is plenty of room for strange outcomes right now – so it is worth remembering that not all cash is cash, and not all fixed income investments are equal. Some are definitely more equal than others.

 NOTE : Please remember the great disclaimer of this site – nothing in this post or on this site is to be taken as personal advice. You must not act on anything discussed or illustrated here without seeking personal, professional advice that takes into account your current financial position, aims, objectives and attitudes to risk. Please also remember the astoundingly obvious point that the past cannot be used to illustrate the future. That is, past performance should not be taken as an indicator of future performance. That may seem counter-intuitive, as how else can you measure anything today other than by using yesterday as a benchmark – but really what this statement is trying to say is that just because rates or returns have headed in one direction for a while, it doesn’t mean that this will continue, and so you should look at far more than past returns before even venturing on a conclusion.

Share

  2 comments for “Beware Fixed Income

  1. March 16, 2012 at 3:16 am

    Hi Michael, what a great run down of the risks around fixed interest. It seems, like most bubble activity, the “interest” in it increases just as the risk seems to. The lower yields go, more money follows… It is almost like global institutional investors are playing a game, “They have more treasuries, maybe I should too? What do they know that I don’t? Let’s not wait to find out, get more US$ now!”

    Thanks again Michael.

    Regards,

    Ryan David Grant

  2. March 16, 2012 at 7:06 am

    Hi Ryan,

    Yes, it is the bane of all long term strategists – performance tables. The moment anyone begins to question where their money should be, the first point of call is inevitably to ask “what are the results?” Naturally, share results look best after the greatest gains. Property returns looked spectucular by 2006 here in Perth, and fixed income investments look best after years of declining interest rates. This makes it inevitable that many people will make their biggest investment into markets just as the pricing in those markets nears a peak.

    The fixed income coverage in media of late is clearly a result of the returns looking good, and the marketing of bank and corporate debt issues.

    The substantial increase in margins that banks are now paying depositors, compared to pre-GFC periods simply exacerbates the issue, and makes it seem that commentary from advisors is somehow biased against cash products – which is probably why so many advisors are currently “going with the flow”, and recommending lots of cash and income products.

    1994 was a fascinating time – some income funds (i won’t name names) stopped paying income, and a large cash management trust had its units suspended because it couldn’t trade a Loy Yang note. Predicting the future is perilous but i struggle to see how the interest rate issue will be resolved without a few crunchy watershed moments.

    Regards
    michael

Leave a Reply