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Not Bonds Now

By Roger Montgomery

Not Bonds Now

If you are retiring soon or have already retired, the mantra you recite each morning is, or will soon be, 'cash flow, cash flow, cash flow'. Of course as you no longer have a job to produce that income your savings and investments must now be relied upon to produce the cash flow you require to satisfy your lifestyle and future healthcare needs.

No wonder then that investments offering immediate cash flow, such as (relatively) high-yielding shares and even low-yielding bonds start to look more attractive than those investments promising possible long-term capital gains.

And as any salesman will tell you, if you understand and appeal to a customer’s most immediate needs, the job of selling is that much easier. It is no surprise then that many retires have been told to invest in fixed interest bonds; start receiving regular income immediately and avoid the volatility or risk that comes with gambling for capital gains that might never accrue. With less years to recover any losses, you don’t want to be gambling with what what you have left.

The only problem of course is that with long-term bond rates only just up off the floor of multi-century lows, retiring today is not as enjoyable as it once was.

If you were retiring back in the 1980's you could earn between 12 and 16 per cent on a ten-year Australian Commonwealth Government Bond. The only thing that would stop you from living the life of Larry was the government defaulting. And to put that in context, retiring in the 1980's would earn you $120,000 to $160,000, for a decade, on a million-dollar investment.

By contrast, retire today and historic low interest rates mean you are earning just $27,000 interest on your million-dollar nest egg invested in a ten-year Commonwealth Government bond. That's less than the poverty line of $31,087.68 today for a couple.

Another way of comparing the staggering difference in returns is to look at how much capital is required to produce the same income. Back in the 1980's a million dollars gave you all the income you needed for a decade. Today you need $5.9 million invested in a ten year government bond to produce the same $160,000 of income per year. In other words you need six times as much money squirrelled away, or you would have had to work for six times as long, to produce the same income.

As you already know from reading my previous columns here, and our blogs at rogermontgomery.com, we don't think rates are destined to stay low forever. While many commentators are calling this era of low interest rates 'the new normal' I believe they are unwittingly conceding 'this time is different' – the four most dangerous words in investing.

As I have been saying for many months now, these low rates are artificially engineered by central bank buying and I prefer to take a leaf out of economist Herb Stein’s book, who said “If something cannot go on forever, it will stop.”

And even though Trump's victory has given the run up in bond yields since June, a short-term shot in the arm, there are three good reasons to think that bond rates will eventually rise even more.

First, low rates and flat yield curves are not having the desired effect on investment and spending. Where rates have been negative for the longest period, such as in Denmark, consumption as a percentage of GDP is falling and savings is rising – the opposite of what central banks were trying to achieve.

Second, corporate investment has declined materially because low long-term rates provide no incentive to accept longevity risk. As a result, companies representing the S&P500 have acquiesced to shareholder demands for more dividends and increased their payout ratios from 25 per cent in 2011 to almost 40% today. In Australia that payout ratio has risen from 57 per cent in 2010 to over 80 per cent. High payout ratios leave less capital available for future growth, limiting the effectiveness of extreme monetary policy.

Third, ultra low rates aren’t justified on an economic basis. US 10yr bond rates were recently lower than at any time since the late 1700s – that's when one Captain James Cook crossed the Antarctic Circle for the first time. Rates were also lower than during the great depression and back then the US had 25 per cent unemployment. Economic conditions simply don’t justify the outcomes of the greatest monetary experiment in history.

Additionally, low rates corrupted investors' sense of risk. By way of example, buyers of Italian bonds are today willing to lend money to the Italian Government at lower rates than when times were good, even though the banking system today holds €360bn of loans (25 per cent of GDP) which are unlikely to be repaid in full.

So it should be no surprise that rates were beginning to rise even before trump was elected. Just as we have warned, US ten year yields began rising from 1.36% on July 8 this year to 1.8% before the Trump victory. And since then rates on US 10yr bonds have risen to 2.35%. In Australia ten year bonds have risen from 1.8% to 2.7% since mid 2016. In both cases a circa-100 basis point move.

Nevertheless, traditional financial advice was authored at a time when bonds offered a valid alternative to shares for income-hungry investors. Today they don't, and committing yourself to a decade of hard labour (returns of circa 2% per annum) when rates could rise in that time, might produce not only envy if rates do rise further, but also capital losses in the interim.

Property investors in particular should be very careful. With record levels of mortgage and household debt in Australia (you can ignore the argument that households also have record cash balances because the people with the debt aren’t the same people with the cash), and with record high property prices required to be paid to ‘get in’ to the property market, rising bond rates will come at a time when newly-minted and highly-geared property owners can least afford it.

Your investment strategy needs to be fit for the era in which you are investing. The lowest rates since the 1700's is not the new normal. It is entirely abnormal. Now is the time to be selling property - as John Symonds, Soul Pattinson and John Gandel have recently been reported doing – and now is the time to be reducing debt. Now is the time to be reducing duration. Cash is producing the same returns as ten year bonds so why commit to ten years of 2.7% when you can get the same rate for 90 days and retain the flexibility to take advantage of lower asset prices that will inevitably transpire as bond rates continue to rise?

 
Roger Montgomery
Roger Montgomery

Roger shares his stock market insights at his Insights blog, blog.rogermontogmery.com. Investors can also follow Roger on Facebook and watch media interviews at his YouTube channel. Grab your Second Edition copy of Value.able and learn how Roger Montgomery values the best stocks and buys them for less than they're worth. Grab the book now at special price!