- Yields are low and negative due to central banks’ efforts to spur on the economic growth
- There are still buyers of assets with negative yield, such as institutional investors
- Government bonds are a liquid asset held instead of cash or other assets with risk for decrease in value, such as stocks in a bear market
- Government Bonds make up 55% of the All Seasons Portfolio, and at the bottom, I summarize my ETFs
Hello again and happy holidays,
Hope you are really getting into a Christmas mood and that you will find a bit to relax. Will you have snow for Christmas where you live, or what will weather be like? In Stockholm, it seems it will be gray and rainy, but will find the holiday spirit anyway.
Soon, I have one full year’s history of the All Seasons Portfolio since starting in December last year with my first investment. Today, December 21st, also marks the 1 year anniversary of my first post on this blog. I will celebrate with small cake.
I have come a long way since with my portfolio, starting from zero and now having accumulated a portfolio valued at EUR 3,700 in only 11 months. The main takeaway, which you should adopt, is to be disciplined and to continuously set aside an amount every month to invest. That will quickly accumulate, and you will also have that money working for you with compound interest.
In case you missed it: November Portfolio Update
As I already mentioned in the relevant blog post, in November, my latest addition to my All Seasons Portfolio was in the Long-Term Government Bond part. This time, I purchased the iShares $ Treasury Bond 20+yr UCITS ETF USD (Dist) (EUR).
When posting about buying government bond ETFs during this first year, one particular question has always been brought up. It is a very valid question considering the current market conditions with low and negative interest rates. Why should you include government bonds in the portfolio, who in their right mind buys and holds bonds with negative interest and why do they do so?
Why are yields negative?
Firstly, both Long and Mid term government bonds are an important part of the All Seasons Portfolio mix and constitute 55% of the portfolio. The theory is that these assets do well in market environments of lower than expected economic growth and lower than expected inflation. Tnis is shown in the All Seasons quadrant here below:
If you look only on how the market looks, this would be an ideal asset to hold. Growth is slowing down in many major economies currently with many companies struggling to maintain growth. Inflation is also weak in many markets, especially in Europe, where the 2% annual target looks to be very far away.
Economic growth is now artificially being held at elevated levels by central bank interference through negative interest rates. The intention is to spurr growth by making companies’ investments cheap. In turn, this gives negative nominal yield on government bonds from the most secure borrowers in many strong economies.
So while governments are issuing these bonds to finance their spending, on the other side of the transaction, someone must be buying these bonds as an investment. But who are these buyers, and most importantly, why would you buy an asset that would guarantee you that you lose money when you hold it to maturity?
Institutional investors must buy and hold liquid treasury bonds
There are many potential buyers of bonds with negative interest rates. These, mainly bigger players, are institutional investors such as pension funds or insurance companies. These investors may have certain internal rules and guidelines that they must adhere to, that regulates that the fund must hold a certain amount of low-risk assets such as treasury bonds. The rules do not care about if the interest is positive or negative – it is the risk level of that asset which is important.
Many institutions, at least in several European countries, also have negative interest rates for their cash held at bank accounts. This is also true for some wealthy individuals in for example Denmark or Germany.
For these investors, it makes more sense to hold government bonds, which are a liquid asset that you can easily sell when you need to, with negative interest, if the alternative would be to hold the cash on an account with even lower interest.
It is well known, that American treasury bonds are among the most liquid assets in the world with a lot of holders across the world. And as late as in July, some short term treasury bills had negative interest rates in the US, even if they are mostly on the positive side.
Slightly negative yield is better than much negative yield – opportunity cost
You may also find speculators and hedge funds on the buyer side. Many believe that after the long period of growth on the stock market, what goes up eventually must come down. Here you have the opportunity cost theory to consider, meaning that by investing in something, you will not get the profits you would have gained by investing in something else.
There may also be investors who believe that central banks can be even more dovish and decrease the steering rates even further. In such a scenario, it is better to hold bonds with slightly less negative yield than the ones that are more recently issued. The same is true when comparing with a negative view on the stock market and if you believe a crash or downturn is coming.
Imagine if you are an asset manager or investor who has concluded after analysis, that the stock market should go down by 10 to 30 per cent over the next year. Being a sensible investor, you should then seek alternative investments that would perform better than the expected return of the stock market. In that case, a government bond yielding -0.5% is far better than an expected return on the stock market of -10%.
This way of thinking also goes hand in hand with the theory in the All Seasons Portfolio. Here, it is built in that in environments of weak economic growth, bonds will increase in value and thus offsetting some of the risk of the stock market. This will be true in the negative economic downturn as well, as money invested on a stock market with negative yield, will be moved to the bond market, which are not as affected by the economic downturn. This is regardless if the nominal yield is positive or negative, as it will be the lesser of two evils.
As investors will be seeking to buy more treasury bonds, i.e. when demand increases, also the prices of the traded bonds will increase. In this scenario, the value of the asset will go up. Potentially, buyers will purchase bonds above par, meaning that the effective yield of -0.5% may turn into -1.5% for the buyer.
For the investor who already previously held the treasury bonds, the asset’s value increases. Thus, in an All Seasons Portfolio, the bond part should go up when equity drops. When you then rebalance the portfolio by selling bonds at a high and buying stocks at a low, you will over time increase your profit and portfolio yield. This is a summary of how the All Seasons Portfolio works and how you get good risk adjusted yield.
Government bonds as a bet on currency FX
When investing in bonds issued by a foreign government, it is not only the stated yield that you have to consider. You should also consider how you think that the currenies will move when you invest in other currencies than your own.
An European investor, for example, you may have a belief that the US Dollar over the next 12 months will grow stronger then the Euro and wants to take a position for such movements in FX. This can for example be to hedge a portfolio for currency changes, for example if you are invested in the American stock market.
In that case, it is wise to invest in a very liquid asset, such as government bonds, where you have more buyers and sellers than in currency swaps or derivatives. By doing so, you have less counterparty risk in an economic crisis – it is more likely that the bank issuing the derivative will fail, than all potential buyers of government bonds. When buying government bonds for the purpose of currency hedging, a yield of 0 or just below, may not be negative for you in the long term.
Let’s say that at the end of the 12 month period, the value of USD has increased by 2% in comparison with EUR. In that case, a negative yield of -0.5% is not negative for your portfolio, but rather you would have had a positive outcome of +1.5%. That’s not bad during these market conditions for a safe investment.
Bonds as an indicator for economic recessions
As a parenthesis in the question of who invests in negative yielding assets, it is worth mentioning what such behaviour indicates. Inflows into bonds can therefore be used as an indicator for a contracting economy and turbulence ahead by the financial markets. The negative yield curve in the summer of 2019 (when short term bonds yielded higher than long term bonds) is seen by many that a recession is set to happen within 12 months from the inversion.
Therefore, it is uncertain in what direction the markets will move, as stocks are still going strong. When a phase one agreement of the American and Chinese trade war was declared in December 2019, both equities and bonds surged. If markets were to believe good times were ahead, money would be flowing into stocks and out from bonds, not into both.
Maybe this is an indicator that a recession may be on the horizon? Or at least that after stocks have been increasing in value due to macro economic events in the end of 2019, while profits haven’t improved, there may be a dip in the beginning of 2020? In either case, it may be wise to hold bonds when stocks tumble, and money starts pouring out from stocks and into the bond universe. In such a scenario, the All Seasons Portfolio will counter the falling stock prices and volatility by increasing bond prices.
Increase cash flow and risk with Emerging Market bonds
What about ongoing cash flow? One reason for investing in debt instruments is the interest received during the term of the loan. Well, there is not much of that when you invest in bonds with negative interest rates. However, there are ways around it, which I also have implemented in my portfolio, namely by increasing the risk.
This, I have achieved by investing in Emerging Markets government bonds. Here, you step away from the strong economies such as the US or Western European countries. Instead, you would be exposed to the economies of Asian, South American and Middle Eastern countries where volatility is higher. These carry more risk, but also higher potential return by way of higher interest rates.
To be fair, the behaviour of Emerging Markets government bonds is not the same as for developed markets. Instead, these more closely mimic the movements and risk of stocks, as they perform well in markets of strong economic growth and higher than expected inflation. So thread with caution when including Emerging Markets government bonds, as you would increase your portfolio’s exposure towards the risks associated with lower than expected economic growth and inflation, and also skewing the risk balance of the portfolio.
But don’t forget that cash flow from Emerging Market government bonds is not free money. As you may have seen in the news, many countries are experiencing mass demonstrations. These have been seen in for example Chile, Iran, Iraq and Argentina, with negative impact on the mood of investors of these countries’ debt. And now I haven’t even mentioned what has been going on in the highly regarded economies such as Hong Kong where demonstrations have been ongoing for several months.
Diversification is key, as always. That is why I like investing in ETFs, as these are combining a variety of assets in on easy to buy package. Even further, I diversify my portfolio with several ETFs by making my Long Term Government Bond part of my portfolio be built by bonds from both more secure economies like the EU and the US, but also with a smaller share of Emerging Markets bonds.
I am also trying to offset the increased risk of Emerging Market government bonds by decreasing my risk of other asset classes in the All Seasons Portfolio. For example, I have decreased the stock component from 30% to 25% and substituting the difference with 5% Corporate Bonds. Corporate bonds tend to follow similar movements as stocks, but the volatility is slightly lower.
What if economic growth and inflation do not decrease?
So, government bonds do well when economic growth and inflation are declining. Basically, investing in treasury bonds is a bet on weaker economic development. But what if that bet fails and the economy continues to grow?
That is the charm with the All Seasons Portfolio, that you are weather proofing your investment portfolio. You have a portfolio built by different kinds of assets that behave differently under different market conditions. If you and I would be wrong when we believe that stocks will tank next year, then we have stocks and commodities that thrive in such market conditions. All in all, our portfolio will continue to grow, but with less risk, as we are hedged if our beliefs are wrong.
With the All Seasons Portfolio Strategy, you may expect around 4-5% annual growth to start with. Then, by rebalancing periodically, by selling assets at their relative highs and buying them at their lows, you gain an additional 2-3% per year. This means, that your All Seasons Portfolio will see a yield of 7% per year, which is the statistically expected yearly yield from the stock market, but you do so with significantly less risk.
What Government Bonds do I have in my All Seasons Portfolio?
What about my portfolio – what government bonds do I hold? Currently, I hold four different government bonds ETFs with different maturities and differnet currencies and markets.
- Invesco US Treasury Bond 3-7 Year UCITS ETF USD Dist (EUR) (American Mid Term Bonds)
- iShares $ Treasury Bond 7-10yr UCITS ETF USD (Dist) (EUR) (American Long Term Bonds)
- iShares $ Treasury Bond 20+yr UCITS ETF USD (Dist) (EUR) (American Long Term Bonds)
- iShares J.P. Morgan EM Local Govt Bond UCITS ETF USD (Dist) (EUR) (Emerging Market Long Term Bonds)
In addition to the above, there are several treasury bond ETFs that I have identified and look to add to my portfolio in the future, such as:
- iShares € Govt Bond 3-5yr UCITS ETF EUR (Dist) (European Mid Term Bonds)
- iShares € Govt Bond 5-7yr UCITS ETF EUR (Dist) (EUR) (European Mid Term bonds)
- iShares € Govt Bond 7-10yr UCITS ETF EUR (Dist) (European Long Term Bonds)
EDIT, 16 April 2020: As of April 2020, I only own the iShares $ Treasury Bond 20+yr UCITS ETF for the Long-Term Government Bonds and Invesco US Treasury 3-7 Year UCITS ETF for the Mid-Term Bonds. Read more about my choice of Long-Term Government bonds in the March 2020 Portfolio Update.
What do you think?
Would you still not touch government bonds, regardless if they are negative yielding or just above zero, even if you wore protective gloves? I still believe that these assets can bring value in a portfolio in form of hedging, but I admit, hedge funds have had a tough decade behind them with stock markets only going up. But will that bull run remain going forward?
What do you think, and have you found other ETFs that work just as well? I know that I have a lot of different ETFs in my portfolio, but to me, it brings some control on how much exposure I want to different markets, in comparison to just owning one global ETF. And actually, in my portfolio, all my government bond holdings are up since purchase.
Government bonds with negative yield is a tough sell during current market conditions, but they still bring value to the table in seasons of lower economic growth and lower inflation. You could also use low-yielding bonds as a bet on currency exchange. There are still factors that would drive the asset prices during such a market environment.
To counter the absence of cash flow from such investments, I have personally chosen to include Emerging Market government bonds. This carries elevated risk, which I try to even out by dialing back on the equity portion of my portfolio. This is not investment advice, but you should do your own analysis and seek professional advice if needed when making your own decisions.
Thank you for your attention and for reading. I will be back again in January with the December update as usual. That will conclude my first year as a weathered All Seasons investor. Also in January, I will follow up with a special post about this first year in review, summarizing what I have done and what I have learned. I think that will be useful for both you and I to take a step back and consider what has been good and what could have been done better.
Make sure to subscribe to the newsletter for updates on new posts, so that you never miss a thing.
Thank you for 2019, now let’s look ahead for a prosperous 2020,
Reading tips for including bonds in your portfolio
This segment includes affiliate links for Amazon
The Intelligent Investor by Benjamin Graham
Are you interested in learning more about why you should include bonds in your portfolio, and not only be fully invested in stocks? Then I have a great tip for you, if you already haven’t read it. The Intelligent Investor by Benjamin Graham is a timeless classic on investment strategy and diversification between asset classes is a must read in every investor’s collection.
Written by one of the sharpest investment advisers of the 20th century, Benjamin Graham has taught and inspired people all over the world to become better investors.
Graham was the mentor for Warren Buffett, one of the world’s most famous and successful investors, and he builds this book on his idea of value investing, the strategy he is considered the father for and the same strategy as Buffett has adopted in his iconic Berkshire Hathaway. In this book, you will learn about the fundamentals of asset allocations among other topics, which will provide you with a firm base to stand on when diversifying your portfolio and when handling risk. Why this is important, has become increasingly clear with the Covid-19 coronavirus outbreak in 2020.
I’m sure that by absorbing these pages, you will learn valuable lessons to take the step towards becoming a better investor. Your future self will thank you dearly.
Annons från Nordnet
Nordnet är en perfekt nätmäklare för dig som vill bygga en allvädersportfölj. Med tillgång till Frankfurtbaserade börsen Xetra, finns ett brett utbud av billiga ETF:er. Här har du allt du behöver på hemmaplan. Starta ett ISK idag.