Understandably many people are running scared of investments at present and many will be holding cash on deposit.
This post considers the longer term risk to savers presented by inflation and suggests some possible low risk alternative investments for consideration.
There is a widely held view that deposit accounts are a low-risk investment. In nominal terms, yes they are, your nominal savings are relatively safe. In real terms however, adjusted for inflation, it can be a very different story over the longer term.
Here is a simple logical argument for all savers to consider:
A simple definition of inflation is "too much money chasing too few goods"
Governments around the world are now printing money (quantitive easing).
The quantity of money in circulation is increasing, which all things being equal might be expected to result in higher inflation.
In the words of the economist Roger Bootle, ‘the umpteen billions of dollars which have been magicked out of nowhere must return whence they came"
For a more detailed explanation of the issues have a look at this:
[broken link removed]
Remember that real interest rates in the 1970s were negative. That is to say the net rate of interest paid to savers allowing for inflation was negative. Each and every year the value of their savings account declined in value.
So what? Inflation is low at present.
The value of money falls by a THIRD every decade with inflation averaging just 3%pa. This is not an investment risk for savers, it is an economic reality.
If real interest rates remain below inflation, the credit crisis will unwind as the burden of debt is reduced in the economy. Those with existing debts will see an improvement in their financial position whilst those with savings on deposit, will see the value of their savings reduce.
Low interest rates and high inflation will be terrible news for savers.
What should a cautious saver do to offset the risk of inflation?
Ideally, one needs a secure form of investment which offers the potential to appreciate as inflation feeds into the economy.
There are two simple options to consider:
1) Inflation linked government bonds
These offer a government-backed interest payment and inflation protection on the capital invested. However, there are two risks here:
i) Currency risk - movements in currency rates can swamp movements in bond returns so US$ or £ bonds which are un-hedged can create serious problems for a € investor.
ii) Maturity risk - most bonds are issued with very long durations typically 20 or 30 years. Small movements in interest rates can have a very large impact on the movement in prices. The price of bonds moves inverse to the movement in interest rates. So, a low interest yield purchased today, can spell a lot of trouble if interest rates increase.
2) The second option is therefore what was once described by Eugene Fama, Professor of Finance at Chicago University as an "inflation hedge fund"
Savers purchase a euro currency hedged, short-term government bond fund. This offers a high level of security for the cautious investor since they are buying government debt rather than corporate debts. Furthermore this actually offers very good protection against inflation.
The reason is that the bonds are held for a relatively short period of time (sometimes only a few months). They then mature and the proceeds are reinvested into new short-term bonds. Each time the bonds are reinvested, the investor gets to benefit from any changes in interest rates and inflation expectations.
Savers looking for a higher interest rate might be tempted to consider longer term government bonds or even corporate bonds as an alternative. Indeed this is what many active fund managers tend to do when faced with the hurdle of their high management fees. Chasing higher yields in order to offer a "better investment".
However, an analysis of bond returns from 1926-to now shows that by increasing the duration of a bond (longer terms) or reducing the credit (moving from AAA Government Bonds to Corporate Bonds or even to sub-investment grade bonds) increases the variability of the returns but does little to offer a higher expected return over time.
The numbers are as follows:
Jan 1926 to Feb 2009 in US$
Treasury Bills 3.7%pa Volatility 0.87%
5 Year Treasury Notes 5.38%pa Volatility 4.42%
Long Term Government Bonds 5.54%pa volatility 8.19%
Long Term Corporate Bonds 5.68%pa volatility 7.47%
Source: US long-term bonds, bills, inflation, and fixed income factor data Stocks, Bonds, Bills, and Inflation Yearbook, Ibbotson Associates
There is insignificant compensation in terms of return compared to the increase in risk by moving to longer term corporate bonds or longer term government bonds compared to short term government bonds.
Short term government bonds therefore result in less volatility in prices (the thing most cautious savers are trying to avoid) but with a higher expected return than a deposit account over time.
I am often asked why would we buy a fund rather than simply buying a bond on the German market? Two reasons diversification and tax.
Diversification is the closest thing that an investor has to a "free lunch" and a fund offers interest rates from many different countries.
In terms of tax, a government bond purchased directly is subject to marginal tax at up to 41% whereas a bond purchased through a fund is only subject to exit tax at 26%.
The solution?
I offer a high credit rated (mainly AAA government) euro currency-hedged, Irish Domiciled, Global Short-Dated Bond fund with an annual management charge of just 0.25%pa to my clients as a low risk means of hedging inflation risk and with a higher expected return than deposit accounts.
This post considers the longer term risk to savers presented by inflation and suggests some possible low risk alternative investments for consideration.
There is a widely held view that deposit accounts are a low-risk investment. In nominal terms, yes they are, your nominal savings are relatively safe. In real terms however, adjusted for inflation, it can be a very different story over the longer term.
Here is a simple logical argument for all savers to consider:
A simple definition of inflation is "too much money chasing too few goods"
Governments around the world are now printing money (quantitive easing).
The quantity of money in circulation is increasing, which all things being equal might be expected to result in higher inflation.
In the words of the economist Roger Bootle, ‘the umpteen billions of dollars which have been magicked out of nowhere must return whence they came"
For a more detailed explanation of the issues have a look at this:
[broken link removed]
Remember that real interest rates in the 1970s were negative. That is to say the net rate of interest paid to savers allowing for inflation was negative. Each and every year the value of their savings account declined in value.
So what? Inflation is low at present.
The value of money falls by a THIRD every decade with inflation averaging just 3%pa. This is not an investment risk for savers, it is an economic reality.
If real interest rates remain below inflation, the credit crisis will unwind as the burden of debt is reduced in the economy. Those with existing debts will see an improvement in their financial position whilst those with savings on deposit, will see the value of their savings reduce.
Low interest rates and high inflation will be terrible news for savers.
What should a cautious saver do to offset the risk of inflation?
Ideally, one needs a secure form of investment which offers the potential to appreciate as inflation feeds into the economy.
There are two simple options to consider:
1) Inflation linked government bonds
These offer a government-backed interest payment and inflation protection on the capital invested. However, there are two risks here:
i) Currency risk - movements in currency rates can swamp movements in bond returns so US$ or £ bonds which are un-hedged can create serious problems for a € investor.
ii) Maturity risk - most bonds are issued with very long durations typically 20 or 30 years. Small movements in interest rates can have a very large impact on the movement in prices. The price of bonds moves inverse to the movement in interest rates. So, a low interest yield purchased today, can spell a lot of trouble if interest rates increase.
2) The second option is therefore what was once described by Eugene Fama, Professor of Finance at Chicago University as an "inflation hedge fund"
Savers purchase a euro currency hedged, short-term government bond fund. This offers a high level of security for the cautious investor since they are buying government debt rather than corporate debts. Furthermore this actually offers very good protection against inflation.
The reason is that the bonds are held for a relatively short period of time (sometimes only a few months). They then mature and the proceeds are reinvested into new short-term bonds. Each time the bonds are reinvested, the investor gets to benefit from any changes in interest rates and inflation expectations.
Savers looking for a higher interest rate might be tempted to consider longer term government bonds or even corporate bonds as an alternative. Indeed this is what many active fund managers tend to do when faced with the hurdle of their high management fees. Chasing higher yields in order to offer a "better investment".
However, an analysis of bond returns from 1926-to now shows that by increasing the duration of a bond (longer terms) or reducing the credit (moving from AAA Government Bonds to Corporate Bonds or even to sub-investment grade bonds) increases the variability of the returns but does little to offer a higher expected return over time.
The numbers are as follows:
Jan 1926 to Feb 2009 in US$
Treasury Bills 3.7%pa Volatility 0.87%
5 Year Treasury Notes 5.38%pa Volatility 4.42%
Long Term Government Bonds 5.54%pa volatility 8.19%
Long Term Corporate Bonds 5.68%pa volatility 7.47%
Source: US long-term bonds, bills, inflation, and fixed income factor data Stocks, Bonds, Bills, and Inflation Yearbook, Ibbotson Associates
There is insignificant compensation in terms of return compared to the increase in risk by moving to longer term corporate bonds or longer term government bonds compared to short term government bonds.
Short term government bonds therefore result in less volatility in prices (the thing most cautious savers are trying to avoid) but with a higher expected return than a deposit account over time.
I am often asked why would we buy a fund rather than simply buying a bond on the German market? Two reasons diversification and tax.
Diversification is the closest thing that an investor has to a "free lunch" and a fund offers interest rates from many different countries.
In terms of tax, a government bond purchased directly is subject to marginal tax at up to 41% whereas a bond purchased through a fund is only subject to exit tax at 26%.
The solution?
I offer a high credit rated (mainly AAA government) euro currency-hedged, Irish Domiciled, Global Short-Dated Bond fund with an annual management charge of just 0.25%pa to my clients as a low risk means of hedging inflation risk and with a higher expected return than deposit accounts.