Monday, June 23, 2014

Should you still be invested in bonds?

Now that the interest rates are going up globally, should you continue to invest in bonds? The answer depends not only on what bond yields you are getting and where you live, but also on whether you own your property or not. How? Read on...


Beating inflation

The point of investing is to make your money to work for you. At a bare minimum, you want to ensure that the value of your capital does not erode over time. I hope to achieve that for my savings by investing primarily in stocks. However, I also have a smallish bond portfolio.

By above logic, I should be buying bonds only if I believe that the returns on my bond portfolio will beat inflation. Since I live in Hong Kong, I will elaborate using Hong Kong as an example.

Since 1981 (earliest the data is publicly available), inflation in Hong Kong has averaged 4.6% (year-on-year basis, monthly data). So I should be happy if the current yield on my bond portfolio is well above this average. (in US$. There's an underlying assumption that HK$ will maintain its peg to US$, at least for the near future).

Okay. Simple enough? Hardly. There are obvious holes in the thesis.

Illusion of averages

4.6% average does not guarantee that the inflation in the near future will not exceed the returns I am getting from my bonds. Hong Kong has a history of very volatile inflation rates, reaching a high of +16% in October'81 and a low of -6.1% in  August'99. It stayed above 4.6% for prolonged periods from 1981 to 1984, and then again in the pre-handover euphoric years of 1988 to 1996, falling below 4.6% only after the Asian crisis, as the chart below shows.


And when averages fail...

The statistical measure that can help us understand how far a typical monthly inflation data can be from the long term average, is called Standard Deviation. In other words, Standard Deviation indicates the volatility of inflation. Higher the standard deviation, higher the volatility.  

Most economic forecasting models assume that inflation follows a normal distribution. We know from statistical science that about 68% of "normally distributed" data lies within 1 standard deviation (SD) either side of the mean, and about 95% of "normally distributed" data lies within 2 SDs either side of the mean.

The standard deviation of inflation in Hong Kong is 4.7%. This means that 68% of the time, Hong Kong inflation was in the range -0.1% to 9.3%, and 95% of the time, Hong Kong inflation was in the range -4.8% to 14%.

Volatility in inflation

The table below summarizes average inflation and standard deviation for various countries (monthly data since Jan 1981).

Hong Kong's inflation has the highest standard deviation, even higher than a developing market like India. Why is Hong Kong's inflation is more volatile?

The reason is Hong Kong's currency peg: HK$ is pegged to US$. Exchange rate is not available as a monetary tool to its authorities (even the other tool, interest rates, is also blunted because of the peg, but that is a separate discussion). The result is that asset prices have to do the job that exchange rate can not -- i.e., property prices and rents have to rise more when the economy is strong, and fall more when the economy is weak, because currency cannot appreciate or depreciate.

Because of high volatility of Hong Kong's inflation, Hong Kong investors need yields exceeding 9.3% in order to comfortably beat inflation. Do we find any bonds yielding 9.3% in today's low interest rate environment? Not unless we look in the 'distressed' territory. Investors living in other countries are more fortunate; they require much lower yields in order to beat inflation. These are post-tax and local currency yields by the way, which for Hong Kong means US$ yields because of the peg.

Does this mean that I should sell my bonds? Well, not yet.

Property owners vs. rent payers

I take comfort from the fact that I own my place of residence in Hong Kong and do not pay rent. How does that affect the inflation that I face?

Property rents comprise almost a third of the CPI basket in Hong Kong (31.6%, to be precise). Apart from a cause of volatility in the inflation, property has also been the largest contributor of high inflation in the past. While separate data for property component of CPI basket is not available, one could have a general idea after looking at this government data that goes back to the early eighties. Apartment owners like me are immune to inflation in property rents. Even if you carry mortgage on the property you own, the proportional change in your EMI from rising interest rates (of a variable interest rate mortgage) is going to be lower than the inflation on your rent.

(It works the other way also: owners do not benefit from a fall in rents. During period following the Asian crisis, falling rents and real estate prices was the biggest cause of deflation in Hong Kong, in part because Hong Kong could not devalue its currency.)

Property owners' inflation

I use a bit of simplification and take out the property component of the inflation, and arrive at 3.2% as the "Property owner's inflation rate" for Hong Kong, with a standard deviation of 3.3%. 66% of the time, this has stayed within the band of -1% to 6.5%.

The current yield on my bond portfolio is comfortably above 6.5% (I buy Asian bonds, and most of them are lowest investment grade and many in the non-investment grade category); I'm not rushing out of bonds.  

Bonds versus bond fund

There is another issue. As interest rates rise, bond prices go down. What is the guarantee that what I earn from the coupon will not be offset by the decline in bond prices?

I have a simple solution for this problem: I buy bonds rather than investing in a bond fund, and I buy with the intention of holding to maturity. That way, I am locked into the yield, and what I see is what I get -- that won't be the case if I owned a bond fund instead. 

Two things I have to ensure: one, that I am not going to need the capital in the interim, and that the company I invest in will not default. Therefore when buying a bond, my focus is mostly on analyzing the default risk. In addition, I have to ensure that my bond portfolio is well diversified. Once I have achieved this, I do not care too much about the 'bond duration,' or maturity (though constructing a 'ladder' - straddling the maturities is something I am mindful of).

Holding power is key to my strategy. And it was tested during the financial crisis, when the prices of my bond holdings plummeted, but eventually all of my investments came whole.  

So, should you still be invested in bonds? Well, that depends not only on where you live and whether you pay rent or not, but also on whether you can create a diversified portfolio of bonds (as opposed to a bond fund.)

Happy investing!

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