THE BIGGER PICTURE
Markets hate uncertainty. Markets also reflect human endeavour and behaviour. As investors, we find ourselves in uncharted waters when it comes to the economic effect of the monetary policies set up by governments and central banks accentuated by the pandemic. Investing as opposed to speculating over the short term requires the investor to make a determination of probable outcomes over the long term. The inconvenient truth confronting investors is that economic outcomes over the short term are extremely difficult to evaluate with any certainty.
Opinions are divided as to whether we are likely to experience inflationary or deflationary pressures or perhaps stagflation (low growth and rising inflation) this year or next. In any event, a US index-linked Treasury Bond is a safe piece of paper issued in the deepest, most liquid market in the world, providing added protection against price inflation. In fact, the US 10-year Treasury Bond is the global benchmark for credit.
Sensible investors wishing to preserve the purchasing power of their capital over time should construct a well diversified portfolio of assets that will protect against the economic pressures we may encounter. Among suitable assets are Inflation Protected Treasury Bonds (TIPs). TIPs are often mischaracterised by institutions as pure treasury bonds. However, they deserve a class of their own.They exhibit the same characteristics as a Treasury Bond but they offer the added safety of a coupon (interest received from the nominal amount invested), which is index linked to rising price inflation.
The acclaimed Wall Street author Jim Grant said that US Treasuries give 'return-free risk', meaning the risk of the US Government defaulting on payment is not offset by the interest (coupon) that investors receive on their capital as a result of owning the bond. 'Return-free risk' also describes European sovereign debt. German Bunds and Swiss bonds have a negative real yield. A nominal yield is the interest paid to the investor based on their original capital for the duration of the bond. A negative real yield is a nominal yield minus inflation. Index-linked gilts and Index-linked European government bonds are available for sterling and euro investors who do not wish to take the currency risk of investing in USD-denominated TIPs.
For the investor wishing to preserve the purchasing power of their capital over the long term, TIPs provide protection against rising inflation. They also offer some protection in times of deflation (falling prices of goods and services), because at maturity the capital initially invested and the fixed coupon payments increase in purchasing power because prices of goods and services fall. Cash wins in a deflationary environment because purchasing power increases when prices of goods and services fall but loses with inflation when prices rise. It is our view that over the next 18 to 24 months interest rates in the US, UK and Europe are unlikely to rise. Equity market corrections in recessions tend to be around 20-40%. Risk-averse investors wishing to preserve capital over the long term would be well advised to consider TIPS as a hedge against risk assets, as part of a well diversified investment strategy.
The author is a member of the Society of Trustees and Estate Practitioners and an investment counsellor. The comments and observations by the author are a reflection of his opinion and do not constitute an offer to buy and hold securities, nor does he receive any remuneration of any kind from names referred to.