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How Low Can You Go?

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How Low Can You Go?

Bond yields continue to decline around the world and in many countries are actually negative. This is an indicator of the low return environment we are likely to experience in years to come. It should also serve as a warning to investors to protect the downside and build wealth through prudent stock selection.

This week the yield on 50-year Swiss government bonds turned negative. Based on the chart below, the interest rate being offered for investors looking to invest in the safety of the Swiss government for the next 50 years is minus 0.03 per cent. This means that an initial investment of 10,000 Swiss francs would actually cost an investor 3 francs per year or 150 francs for the life of the bond. Let me be clear, the Swiss government is providing a guaranteed return of just 9,850 Francs in 2066 for every 10,000 Francs invested today!

As crazy as this notion sounds it actually isn’t surprising given the trends. Bond yields in Switzerland have been falling for the last decade. The 50-year bond’s two, five and ten year siblings all turned negative a year and a half ago. Outside of Switzerland, 10-year government bond yields in Germany and Japan are now at sub-zero levels. In fact, the 20-year Japanese government bond also has a negative yield. In countries where the interest rate on government debt securities is still in positive territory, it isn’t there by much. The US 10-year yield is at record lows below 1.4 per cent. Australian government bonds only offer a tiny bit more return than this at 1.9 per cent – also a record low.

Swiss Government Bond Yields

07072016_graph1Such low and negative rates may be a reflection of broad-based investor concern around the outlook for global economic growth and the risk of deflation (you don’t need more money to buy the same goods and services if their prices keep going down). But it could point to more than this. As fear and uncertainty take hold in markets people (and their capital) gravitate towards the perceived least risky instruments. The Brexit vote may have been a catalyst, which has been sustained by property fund outflows in the UK and political posturing on the weakness of Europe’s banking system. At the same time private capital is competing with central bank buying in the market for government bonds, adding to upward pressure on bond prices and therefore downward pressure on yields.

With interest rates so low, investors in the least risky part of the investment spectrum will certainly earn negligible returns on their capital over decades. Yet as rates meander along the conceptual zero-bound, or some other practical limit just beneath it, the tailwind to equity valuations that has existed for the last 30 years has dissipated. Just being invested in the broad equity market won’t be a sure fire way to earn attractive returns if valuation multiples are swimming upstream and economic growth which drives sales and earnings is soft. Moreover, any economic, political or financial shocks could see a significant gap down in asset prices.

We believe the best way forward for investors is to be invested in a fund that is focussed on protecting the downside; adding value through individual stock selection – of high quality businesses on the long side and deteriorating businesses on the short side; and holding significant cash.

Christopher Demasi is a Portfolio Manager with Montgomery Global Investment Management. To invest with Montgomery domestically and globally, find out more.

Christopher is a Portfolio Manager at Montgomery Global Investment Management. Christopher joined Montgomery in January 2015 after spending more than four years at LFG, the private investment group of the Lowy family, where he was most recently a senior member of the research team based in New York. Prior to this Christopher worked as a research analyst at One East Partners, a hedge fund based in New York, and as an investment banker at Goldman Sachs in Sydney.

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This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564) and may contain general financial advice that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking advice from a financial advisor if necessary.

7 Comments

  1. So if governments take a long term view (as they should) that there will be some if not nominal growth, then should they increase debt to fund returning investments. The return hurdle, in effect, would be anything 0 or above. That’s a very low bar…

    Should governments, where bonds are 0 or negative, be massively increasing their debt to fund expansionary investment? It seems to be an extremely low risk proposition.

    Has there been a correlating increase in infrastructure investment?

    • Christopher Demasi
      :

      And yet governments should be wary of expanding capacity for the sake of it. With the highest debt loads of major nations, oversupplied industry and slowing growth, China has taken this low risk notion to the realms of high risk.

  2. Strange times we find ourselves in! Excessive debt, record low interest rates, company valuations stretched and property prices more expensive than ever. What happens next?

  3. Hi Chris,
    What is the end game here? Is it just a case of “until the music stops, you just have to get up an dance?”

    • Christopher Demasi
      :

      Richard, I think it is difficult to predict where and how these imbalances will ultimately manifest themselves. We never feel compelled to invest for the sake of it. Montaka runs a low net exposure and MGF holds significant cash. (We only get onto the dance floor when our song is playing and we’ve got the right moves). Regards, Chris

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