Bringing the Evidence Home

Almost daily we discuss the current Yield Curve, or more specifically, the low interest rates being offered to folks desirous of generating a reasonable rate of return from their savings.  I find this discussion to be interesting for several reasons.

First of all interest rates on savings are highly correlated to inflation. (In the following examples I utilize 30-Day T-Bills as a proxy for ‘safety’ investing in savings accounts)  For example, in 1980 inflation was measured at 12.4% and ‘safe’ 30 Day T-Bills returned 11.2% – ‘safety’ investors got about 1.2% less than inflation.  In 1990 inflation was measured at 6.1% and ‘safe’ 30 Day T-Bills returned 7.8% – ‘safety’ investors got about 1.7% more than inflation.  Today, inflation is debated (depends on how you measure it) to be between negative to flat and ‘safe’ 30-Day T-Bills yield close to 0% – ‘safety’ investors get about 0% over inflation.  In each example ‘safety’ investors received a return at or near inflation.  (We urge ‘safety’ investors to note that the return on ‘safe’ investments is similar to and moves in correlation with the rising and ebbing tide of inflation.)

We could look at more data, but, it really isn’t different this time.  Short term ‘safe returns’ and inflation are highly correlated.  Things really haven’t changed relatively between inflation and interest rates.  The delta is near zero.  I advise that “it’s important to have a sufficient quantity of very ‘safe’ assets on your personal balance sheet for currency needs in the future and – if your very ‘safe’ fixed income provides returns at or near inflation – that’s about all that is realistic!”

So, what if you are determined to pursue an enhanced rate of return?  There are two Conventional ways to achieve this – one is to bear Duration Risk (time to maturity of fixed income) and the second is to bear Credit Risk (investing in Fixed Income issued by Corporations).  There is ample evidence that if you are willing to be a little less ‘safe’ and bear the risk of longer duration instruments and/or you are willing to bear the risk of exposure to Corporate instruments – AND YOU ARE PATIENT…you have historically been paid for bearing those risks.  (Impatience = Crap Shoot)

The aforementioned focuses on fixed income within the borders of the United States.  Academic evidence suggests Global Diversification may be another tool for enhancing expected returns.

So…Global Diversification might make sense – Let’s explore yields around the world.

We are all bludgeoned with news about the Yield on 10-Year Government Bonds in the United States.  As I write this letter the inter-day yield is vacillating around 2.14%.  That sounds pretty good compared to Switzerland at -0.21%, Japan at 0.38% and Germany at 0.63%.  (I wonder what their citizen investors are getting on their savings account…can’t be good?  These numbers also serve as fodder for a future discussion about the ‘imminent’ rise of interest rates in the USA.)

What happens if we cast our net a little more broadly?  We discover Singapore at 2.56%, Australia at 2.77%, New Zealand at 3.34% and Mexico at 3.62%.  Those numbers sound a little better!  Of course, other risks may be looming…default risk…inflation risk…currency exchange rate risk.

What happens if we expand our universe to the out-sized returns offered on 10-Year Government Bonds issued by the riskiest sovereigns?  Brazil at 5.23%, India at 7.80% or Greece at a whopping 9.91%!  Clearly the inventory of risks being born by investors in these markets is enormous – default risk…inflation risk…currency exchange rate risk…even, heaven forbid, nationalization.

Knowing that Risk And Return Are Related – the aforementioned data makes that case – might we not benefit by thinking of our fixed income investments like unto our equity investments and consider building a Globally Diversified fixed income portfolio?

In the words of the father of Modern Portfolio Theory and Nobel laureate in Economics, Professor Harry M. Markowitz:

“A Good Portfolio Is More Than A Long List Of Good Stocks And Good Bonds.

  It Is A Balanced Whole, Providing Investors With Protections And Opportunities

 With Respect To A Wide Range Of Contingencies.”

We embrace the rationale of Professor Markowitz and recommend – Investors Should Consider A Globally Diversified Fixed Income Portfolio.  Of course, besides the enhanced returns, there’s a lot more to talk about here, not the least of which are the importance and trade-offs of Currency Hedging.  (If you want to discuss that further, please feel free to call or email – it’s a cool topic.)

Enclosed please find a chart that views the world in terms of the capital mass of Bond Markets as opposed to landmass, population, gross domestic product or even stocks markets.  This enclosure simply reveals the value of the investment grade fixed income opportunities around the world with the size of each countries graphic adjusted to reflect the relative size of its fixed income markets.  Further differentiation is provided between the government issuance and corporate issuance within each country.  (This last point gets conversation worthy when one notes that most of the countries around the world are characterized by ‘primarily government debt’, however, the United States has a much higher proportion of ‘corporate debt to total debt’ than most countries.)

Click the hyperlink to view our insert, “A World Of Fixed income Opportunities” for a graphical representation of the global fixed income market!

Hoping you will find this missive to be interesting and useful as you pursue the achievement of your wealth management goals, we remain

Yours Truly,

Warburton Capital Management

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