Image for How to survive the coming crash

First published August 7

This week, I’m giving you the chance to be a hero to an older person in your life.

Get this right, and one day you’ll be able to pop your grandchildren on your knee and tell them why your rellies didn’t lose their undies in the Great Bond Crash of 2018.

A bond crash? That’s right. Yes, it’s happened before - in 1994. A lot of you probably don’t remember it (or weren’t even born). Doesn’t mean it wasn’t painful.

Pensioners With Pitchforks

Back in those glory days of the early nineties I was a youngish financial advisor working for a stockbroking firm.

They were the best of times. Nirvana was still a band (just), Paul Keating was Prime Minister and interest rates were only 4.75 per cent.

So what was it that got so many retirees worked up? The oldies weren’t exactly storming head office with pitchforks, but it was a close call. The reason? Bond prices.

So let’s talk about bonds, the fixed interest ones, not the Y-Fronts.

Interest Rates Go Up, Bond Prices Go Down

Bond prices, like a lot of investments, are influenced by interest rates. Like I said, in ‘94 interest rates were 4.75 per cent.

Then the Reserve Bank popped the pensioner party and cranked rates up to 7.5 per cent in the space of four months.

Hang on, higher rates are good for retirees, aren’t they?

Yeah, nah.

You see, when interest rates rise, bond prices actually fall.

Doesn’t sound right, does it? It’s true though. Here’s why.

You’d be familiar with term deposits - you give the bank a wad of cash, and they reward you with regular interest for the term of the deposit. In short, you’re lending the bank money.

Bonds are much the same, except instead of the bank, you’re lending the government (or a big corporate) money.

Trust Me, I’m With the Government

Let’s suppose you invest in a ten-year Commonwealth Government bond paying 2.5 per cent interest.

Every six months you get an interest payment. After ten years you get your ten grand back. In total, you’ve pocketed $12,500 including interest. Safe as houses, right?

No, not really.

Okay, your $10,000 isn’t at risk (unless Barnaby, Morrison, Turnbull & Co default) but strange things happen when interest rates rise.

Let’s suppose just after you buy your bond, rates rise from 2.5 per cent to 5 per cent (stay with me here, it’s just an example. I’m not saying that’s going to happen). If you had the funds you’d be able to invest in another ten-year bond, this time paying 5 per cent.

Over the term of the bond, you’d get back $15,000 including interest.

So what’s your first bond worth now?

Yes, it’s Maths Time

If you’re keen, you could work out the value of your bond using this formula:

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If you couldn’t be bothered, then here’s the snapshot: all else being equal (sum invested, loan term), the bond paying the lower interest rate is worth less. A lot less.

Let’s look at it another way. If you were going to buy a $10,000 bond, would you prefer the one paying $250 per year, or the one paying $500? That’s a big difference over the life of the bond, and it’s why the first one is worth less.

You could argue if you hold them both until they mature it doesn’t matter because you still get your money back (not knowing how much your investment is actually worth isn’t clever though).

If you revalue them every single day, like your super fund does, the ugly truth comes out - bonds can lose money.

The Capital Stable Myth

Back in ‘94 if you’d invested in a fixed interest fund or your super was loaded up with bonds, chances are your super balance came tumbling down.

And in ‘94, a lot of retirees had money in bonds. That’s because they got burned in the ‘87 stock market crash, lost even more money in the ‘91 property crash, and wanted to invest their savings somewhere safe.

Their clever advisors usually talked them into ‘Capital Stable’ or ‘Capital Secure’ super funds.

What that means is most of their money was in bonds, with a bit in shares to provide some growth.

In 1994, they got screwed over twice. First, when interest rates rose from 4.75 per cent to 7.5 per cent, the bond market crashed. Then, the share market collapsed in sympathy.

Those Capital Stable funds got smashed, some of them losing more than 15 per cent. If you’re a share market type, you’ll know that shares can (and do) drop that much every year or two. If you’re a conservative type though, losing 15 per cent is scary stuff.

Avoiding the Coming Crash

You mightn’t be too fussed about investing in bonds personally. I’m certainly not - I’ve got better things to do with my money than lend it to the Government just so they can blow it on helicopter rides and business class flights.

Chances are you’ve got older friends and relatives though. People who might be retired, or heading that way.

If they think their money is ‘safe’, they might need to think again, so share this with them.

Here’s what you need to do. Ring your super fund (or wherever their money’s invested) and ask for the latest asset allocation pie chart. It’ll look something like this:

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That red bit? That’s what should have your dad or your Auntie Jenny worried.

Actually, it would worry me too. That’s because bonds are returning less than cash at the moment. And in the medium term, if you think interest rates will go up, then bond prices can only go down.

You don’t need to change super funds, take more risk or anything like that. You just need to turn the red bit into the green bit.

Which means making sure you’ve got bugger-all bonds, and lots of cash.

After all, cash is king. The time to have money in bonds is when interest rates are falling, not when they’re about to go up.

The Naked Takeaway

Suppose I’m wrong and rates fall, not rise. If the economy’s totally buggered we could end up with negative interest rates (yes, that’s a thing. Look at Switzerland).

There’s not much chance of that. And the risk of sitting in cash is far, far lower than what could happen if we get rapidly rising rates.

Got questions? Ask them on the blog or in the Facebook group and I’ll be happy to answer them. Just don’t get cranky if you ignore me and your dad loses his jocks next year.

You can follow*The Naked Investor at http://www.nakedinvestor.com.au , on Facebook and on Twitter @FinanceNaked.

The Naked Investor provides education, not advice. Do your own research, you know the drill.

*The Naked Investor is known to the Editor