Rating

Bonds

Why are bonds the perfect crisis-proof asset?

Most people sleepwalk in life. Not sleepwalking in the usual sense (suddenly bolting out of the bed in the middle of the night and deciding to go on a cruise type), but something far more profound. They prefer spending their free time snoozing in front of trashy TV programs rather than investing it wisely to better their minds and bodies. This was why the majority of the population in the West were caught off guard when COVID-19 hit, even when the warning signs were all too abundant (Bill Gates’ warning in 2015, the outbreak in China in January, the classic exponential growth rate of an epidemic in the country).

Figure 1. Growth rate of COVID-19 across the world

Source: Our World in Data

 

Ask any historian and they will immediately tell you that crisis (man-made or otherwise) is an enduring part of humanity and they occurred on an alarmingly frequent basis. Taking pandemic as an example, without even needing to go too far into the past (whose occurrence was far too many to count), we have had at least 4 respiratory epidemics since 2003 (SARS, swine flu, H5N1 bird flu, MERS). So COVID-19 really should not have been a surprise. Yet it was.

unnamed

Figure 2. An outline of significant pandemics in human history; more than ⅓ of them happened after 2008.

Source: FastCompany

History also shows that preparation is the key to counter the effects of such disasters. When much of the world was still snoozing in curiosity about what COVID-19 is, a small group of prepared elites was already activating their contingency plans [1] and isolating themselves from the rest of the world. In the hindsight, it turned out to be a shrewd move. Preparation is, therefore, the key not only to survival but also it will help the prepared to thrive post-crisis as they will be the best resourced (and resource equates to power).

 

Preparation applies to all aspects of life and financial preparation should be on the number two priority (after physical security) of all investors. The best way to financially prepare your portfolio against crisis is by owning assets that are crisis-resistant or what we call “bulletproof assets”. These assets represent ownership in businesses with resilient models that perform equally well during bull and bear markets, garnering handsome returns for investors.

Why is cash trash?

Investors often retreat to cash during times of uncertainty. After all, cash is tangible, liquid and maintains its nominal value, thus providing a (false) sense of security that their net worth is safe and certain amidst an ocean of uncertainty. However, this is wrong. We strongly advocate the view that cash is trash and the only way to preserve your wealth during a crisis is through quality asset ownership.

 

The modern day cash is a fiat currency that simply represents a claim on value rather than value itself. As illustrated in the M1 supply in the US below, the total amount of money in circulation is increasing at a rate that far exceeds that of economic growth. This means that more cash is chasing after a finite amount of goods and services, thereby leading to inflation.

Figure 3. M1 supply in the US across the years

Source: EconomicGreenfield

 

This system generally works well during times of stability and prosperity. However, it comes under increasing strain when things get tough:

  • As governments are in control of the supply and denomination of cash, they can adjust them at will to suit their political objectives.
  • This is already evident in the Quantitative Easing programs in 2008 as well as the historic bailout since the outset of COVID-19 pandemic.
  • Given the total amount of goods and services in an economy is relatively fixed in the short-run, the massive glut of money supply will increase the amount of cash chasing after a unit of good/service, leading to inflation.
  • Consequently, people’s confidence in the currency will deteriorate, thus demanding a higher price for the provision of goods/services, leading to a vicious cycle of inflation. There are numerous historical examples, the most famous being the Weimar Republic in the 1920s.
  • As such, cash will simply lose the confidence of the population as we revert back to a bartering system.

 

What this has demonstrated is that paper money is inherently unstable as it relies on the goodwill of the people and competent economic management of the government (both of which are in short supply in today’s world). As a result, there is a clear and present case for diversifying away from cash into other safer alternatives. This is not to mention the fact that central banks around the world have universally adopted near-zero base rates in order to use lending to boost economic activity, thereby further impacting return earned on cash holding and thus eroding its purchasing power.

Why do bonds trump all others?

There are a few asset classes that can can contend to become “bulletproof” during the crisis, namely:

  • Equity (stocks)
  • Bonds
  • Gold

 We have compiled the table below to examine the various characteristics across each class.

 

Features Equity Bond Gold Cash
Overview Direct ownership of a business through the purchase of its outstanding share capital To become a creditor to a company/institution through the purchase of its debt instruments Direct ownership of physical gold or indirectly through the use of financial instruments (like ETFs) Direct holding of physical cash or through deposits in banks
Factors behind bulletproofing Ownership in a resilient company will ensure capital preservation and dividend continuity during times of crisis. Lending capital to a resilient company will minimise credit default risk during a crisis. Gold is a direct store of value and thus preserves value during a crisis. Not applicable
Return type Capital appreciation + Dividend payments Coupon payments + capital change if publicly traded Capital appreciation Interest payments
Typical capital gains up to 9% over a period of 20-year time horizon up to 6% Difficult to say – gold price is negatively correlated with market stability and therefore it acts as a hedge. Nil
Typical yield 1-4% 2-5% Nil 0-1%
Capital volatility High, typically +/- 20%  per year Low, since capital is usually redeemed in full upon maturity Medium, typically +/- 10% per year None
Income security Low as companies can cut dividends at will High, coupon payment is a contractual obligation Not applicable High
Liquidation preference Last First Not applicable Not applicable
Liquidity High, if publicly traded High, if publicly traded High, if publicly traded Medium to high, depending on account accessibility
Impact of 0% base rate Positive Positive Neutral Negative
Inflation protection Medium Medium to high * High Low
Management cost Nil Nil High Nil
Transaction cost Low Low Low Nil

*  Inflation index-linked bonds are particularly inflation-proof.

 

What we have seen from above is that bonds strike a balance between high security and relatively high safety across a multitude of different scenarios, thus proving to be a resilient asset class against future shocks. In particular, bonds have the following features that make them especially valuable in times of uncertainty:

  • Ability to deliver fixed and potentially inflation-linked income at regularly interval (quarterly)
  • High yield than equity and cash
  • High capital stability and safety due to its liquidation preference
  • Negatively correlated to the base rate, which is likely to stay at rock-bottom for the foreseeable future

 

Some may argue that gold is also a feasible bulletproof asset. However it possesses several adverse characteristics that make it ill-suited:

  • It is essentially a static store of value which does not generate any income
  • Gold needs to be stored one way or another, whether it is owned directly or indirectly (through ETFs), which will incur significant storage costs
  • Gold is ultimately a physical asset that can be easily seized by governments during times of needs as exemplified by Executive Order 6102

Higher return = higher risk? Invest where it’s not true

 

What is remarkable is that the contrary to conventional wisdom, the increase in return does not necessarily result in additional risk. This erroneous model comes from the “efficient market theory”, which proclaims that all the risks and future profits are already embedded into the price of any asset. If that would be true, there would be no profits to be made for investors, as the risks would always annihilate the profits in the long run. 

 

The practice shows that the markets are always inefficient. It means that there’s always some bargain deals available, as well as some ridiculously overpriced deals. Indeed, the prices may embed the expectations of the future growth and risks, but they only reflect the expectations of growth and risk, and not the reality. A good example is the rise and fall of WeWork – once a unicorn, now junk company. The company is still the same, but the investors took off the pink glasses.

 

Best investors also stick to the opinion that the markets are always inefficient.There are two kinds of inefficiencies available: the inefficiency in pricing, and inefficiency in the availability of capital.

 

Inefficiency in pricing


Warren Buffet and his teacher Ben Graham use the concept of Mr.Market to explain the pricing inefficiency in an anecdotal way: “Mr. Market’s mood changes like weather in the Atlantic; whenever he’s in a good mood, he buys most everything. You shall sell assets to him. If he’s in a bad mood, he sells worthy assets for a bargain price. You should buy from him”. George Soros, one of the most successful fund managers, starts from even a higher vantage point: the markets are always wrong, in his opinion.

 

Inefficiency in the access to capital


Second type of inefficiency is the uneven access to capital. For some companies, like for the large real estate companies, access for capital is farily easy: they have a lot of collateral and can accommodate vast amounts of capital, so they are interesting for the large funds even if they can derive only a mere 2% – 3%  returns. For the other companies (example), raising capital is difficult: either a business is too small to interest a large investor, or they don’t have enough collateral to provide to raise debt from banks (e.g. they don’t own real estate). This is why some companies are pushed to offer way above-the-market dividends in order to raise capital, and that is why high return is not always equal to high risk.

 

When constructing your bulletproof portfolio, make sure you:

 

  • look for the bargain deals that provide you with the necessary margin of safety – i.e. c/ompanies that are unduly overlooked by the market, or companies that are too small (or in other way not a fit) to raise the capital from large funds.
  • diversify your portfolio with uncorrelated assets, as it can enhance return whilst significantly reducing the downside risk.

 

Example: building an all-wealther bonds portfolio

 

We will review an example of such an all-weather bond portfolio, constructed out of bonds backed with various uncorrelated revenue streams, issued in the countries whose economies are considered to be low-correlated (USA, Switzerland and Japan), and have a viable reward to risk ratio.

 

However, a well-diversified portfolio should include as a conventional standard at least 10 to 15 assets. So we encourage you to finish this exercise by refining your own criteria and finding your own candidates to invest .

 

The bonds we included are:

 

 

Characteristics Le Bijou Bond US 10-year Treasury Bill Mitsubishi Medium Term Note
Overview To provide loan capital to Le Bijou, a leading luxury property-tech company in Switzerland to increase its footprint and expand the product offering across the country. To provide credit to the US Government in order to finance its capital and operating expenditures. To provide loan capital to Mitsubishi, a Japanese automotive manufacturer, in order to fund its capital and operating expenditures.
Prospects to benefit from the inefficiency in the access to capital High; as a mid-sized business, the company’s access to capital is hard, however it’s structured well enough to allow a private investor to invest and benefit None; US T-bills are considered one of the world’s safest and most traded assets, thus there’s never a shortage of investors money Low; Mitsubishi enjoys easy access to capital due to its size and being a publicly traded company
Prospects to benefit from the inefficiency in pricing Rare but significant; the company is not publicly traded, thus at times you might find bargain deals from investors who want to urgently sell their assets Mid; this asset is closely watched by thousands of analysts; buying it makes sense only at times where the market is temporarily underpriced Mid; the company is closely watched by thousands of analysts; buying the bonds makes sense only at times where the market is temporarily underpriced
Diversification contribution within

this portfolio

High; the company’s revenues are dependent on the global travel growth and are epidemic-proof High; the risks are related to the value of dollar and the sovereignty of the US, which are very different from the risk structure of the two other candidates High; the company’s revenues are tied to the consumer sentiment worldwide, almost evenly diversified across regions
Reward to risk High, uncorrelated with the rest High, uncorrelated with the rest High, uncorrelated with the rest
Why is it included Provides high returns that will spearhead the portfolio’s performance, while the risks are comparable with other corporate bonds Considered one of the safest bonds; the risks structure is very different from the two other bonds reviewed Relying mostly on the Japanese economy, it provides both a great diversification opportunity and good returns
Term 3 to 10 years depending on the issuance 5 years 5 years
Yield 3-6% depending on the issuance 0.5% coupon rate, currently trading at around 0.35% 2.6% coupon rate, currently trading at 2.35%
Capital gains None Theoretically none, although the bond is publicly traded and capital price does fluctuate (max 0.5%) Theoretically none, although the bond is publicly traded and capital price does fluctuate (max +2%)
Max drawdown (year to date, at the time of writing) N/A (is not publicly traded) -1% -6%
Liquidity Not publicly traded High High
Minimum investment amount CHF 10,000 $1,000 $1,000
Liquidation preference First Not possible as sovereign default requires bond restructuring First
How to invest Through Swiss brokers or directly from the company Via stockbroker like Interactive Brokers Via stockbroker like

Interactive Brokers

 

Consequently, investors might wish to consider constructing a portfolio that incorporates all 3 securities (or more). This will simultaneously expose the capital to 3 different low-risk geographies, sectors and business models, all of which are hugely crisis-resistant.

In conclusion

2020 has proven to be anything but ordinary. Yet great fortunes are often made during times of uncertainty as Warren Buffett famously declared to “be greedy when others are fearful”. However, being greedy does not mean being reckless and it is vital to ensure that you are achieving the greatest return for a given level of risk being taken. Bonds strike the ideal balance and thus should form an integral part of your portfolio.

 

 

Sources:

[1]Bloomberg: We Needed to Go’: Rich Americans Activate Pandemic Escape Plans

Thank you

x