Tasmanian Times

The individual has always had to struggle to keep from being overwhelmed by the tribe. If you try it, you will be lonely often, and sometimes frightened. No price is too high for the privilege of owning yourself. ~ Friedrich Nietzsche

The individual has always had to struggle to keep from being overwhelmed by the tribe. If you try it, you will be lonely often, and sometimes frightened. No price is too high for the privilege of owning yourself. ~ Friedrich Nietzsche

Economy

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:

image

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:

image

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

10 Comments

10 Comments

  1. lola moth

    August 6, 2017 at 12:54 pm

    I checked my super and it doesn’t mention bonds at all, it does show Australian Equities though. Can someone tell me what equities are?

  2. jhaswell

    August 6, 2017 at 1:22 pm

    Look here, forget the finance for a moment. Decent readers must express disgust at young Tuffin for posing in fruit-filled undies to illustrate a significant economic contribution.

    Ed: hahahahahahahahahahah!x blessyou mr h!x

  3. George Smiley

    August 6, 2017 at 1:49 pm

    It isn’t quite so simple as twiddling and collapsing the red allocation around by 40 degrees. Recall 2008 when the US Fed in concert with all the other G7 or 20 or however many central banks lowered interest rates to the zero bound to save the world’s vastly over-leveraged financial system. They bailed the too-big-to-fail with virtually free loans, encumbered only by acceptance of more responsible behaviour, and as usual the little guys were allowed to go under, most especially the no-longer-poor who had discovered no-doc loans and were flipping homes and condos and financing their nouveau riche lifestyles by borrowing on unrealized capital gains.

    But as usual we are wiser now, the Fed has finally pulled America from the following recession and even squeezed a percent or two of interest rate rises in the last 12 months, ammunition for the next disaster which Fed head Janet Yellen has dismissed.

    “There will not be another financial crisis in our lifetimes.”

    Connect the dots – when the CEO of the hottest company in your portfolio gets on the cover of Time Magazine you sell. When you hear words like the above; ‘peace in our time’ or somesuch you move to a desert island,dig a hole and fill it with imperishables like canned beans. The economic business cycle including the unhealthy PE of the share market is very long of tooth. When some young tyro you know has just bought into an ETF or cryptocurrencies it is another sign -you can’t tell him anything though – it yet may double again or his a**is mud and that is too close to a coin toss for my peace of mind.
    The US government is now paralyzed and Republican ideology isn’t always the best policy in hard times, in fact they have a knack of being there like a dirty shirt in the wrong time and place.

    Now if the feds lower their hard-won fed funds rate rise it is an admission the party is over. The govt. bond market, now inhabited mostly by lemmings will get a temporary boost BUT there is a spread with everything else which ought to grow if fear takes hold, wiping trillions off the value of portfolios of mortgages and commercial paper and consequently the book values of lenders, some with maybe 20-40 fold leverage on their outstanding loans. ‘Fractional reserves’ it is called. The ex governor of the Bank of Canada later admitted that according to accounting rules all the Canadian big banks were insolvent after the Lehmann fiasco.

    Cash (only under a mattress)might be the easiest and safest but better yet -a bolt-hole that no-one has ever considered – like Macquarie Island – if you bring along some goats and rabbits and a couple Adler shotguns it may be possible to survive if you really want to that badly.

  4. Paul Tapp

    August 6, 2017 at 1:59 pm

    “I saw a great onrushing wave and from it was no hiding.”

  5. Simon Warriner

    August 6, 2017 at 4:40 pm

    Just remember the US central bank is not a govt institution. It is owned by listed companies who happen to be banks and who have shareholders, and it makes it’s money by charging the US govt money on every single dollar it loans into existence. The money it printed in existence in QE1 thru 3 went straight to the owners of the fed, who promptly splurged it on equities, concentrating their ownership of productive, and not so productive assets. (Faang (facebook, apple, alphabet,netflix, google)stocks at PE ratios of over 50 are not really productive, especially if the music stops because, say, Proctor and Gamble stop spending $US 2 billion pa on digital advertising, and it’s competitors notice that sales did not drop. The resulting revenue fall is going to be interesting for some corporate high fliers)

    The US Dollar is backed by oil, via the need for US dollars to buy oil from a now rapidly shrinking pool of oil producers who will only take US dollars for their oil.

    From those two pillars of reality flow a pretty good understanding of global politics, US political posturing, and the fragility of the global financial system.

    This is why Russia welcomes sanctions, why Russia and China are buying gold, trading oil and related products for gold, and why the US has such a hard on for a big nasty war with Russia. And why it feels the need to meddle in oil producing nations politics.

    Look at who owns the banks that own the Federal reserve, and you will have a fair understanding of who is ultimately responsible.

  6. Doug Nichols

    August 6, 2017 at 5:52 pm

    #1 – shares

  7. Simon Warriner

    August 6, 2017 at 5:54 pm

    and right on time we have this:

    http://www.zerohedge.com/news/2017-08-06/chinas-minsky-moment-imminent

    The graph tells the story.

  8. George Smiley

    August 7, 2017 at 3:07 am

    From Simon’s Zero Hedge article

    “The evidence suggested that for over half of the infrastructure investments in China made in the last three decades, the costs were larger than the benefits they generated, which means the projects destroyed economic value.”

    So it’s always about ‘jobs, jobs, jobs” to keep those 1.4 billion little munchkins happily employed and thereby preserve the party which is why their peerless leader showed up here in little Tas with his retinue recently, to check out our own expertise at squandering the future for immediate political gain. Of course they have the military option; when things go pearshaped its always the fault of neighbours like Taiwan. How far south will they come? Will our subs and F35’s be ready by 2020? Do they already have a fifth column in place? Maybe Govnahs Lobb and Lolley in the nothin and southin plovinces.

  9. Lynne Newington

    August 7, 2017 at 11:31 pm

    If the rellies finances are as secure as depicetd it will be hard job losing them……

  10. Simon Warriner

    August 8, 2017 at 1:59 am

    It is fascinating watching what stories get traction in the media. Yesterday a company employed by our largest retail chain to process electronic payments was outed for reprocessing transactions with the retailer that were made back in March. It got a run on the ABC online, and a little bit of coverage on the commercial channels but it has since been ignored while gay marriage and a stupid Greens idea about ditching parliamentary prayers gets wall to wall coverage.

    Lets focus for a minute on what is being ignored here. Customers electronic access to their bank accounts is obviously being warehoused by a company that handles, apparently, every transaction Woolworths customers conduct. We know it is being warehoused because that information was required to repeat previous transactions. We know that criminal syndicates use this information to steal, launder proceeds of crime, and to spoof identities. We know the flaws in the system exposed by this incident make the global campaign to eliminate cash look very, very stupid. We know that such warehoused data is an extremely tempting target for the criminal element. Serious questions about risk management and security need to be answered.

    Surely this is far more important that a rather pointless and increasingly boring debate about the definition of marriage which has been done to death over the last two years, or whether our parliamentarians should pray for guidance they so obviously need.

    The campaign to get rid of cash imperils us all, placing us at the mercy of the processors of digital information, denying privacy, and providing an enabling vector for a tyranny on a scale not previously possible to contemplate, and it creates a massive opportunity for crime.

    That this story should fade so rapidly from view should give every single person who aspires to independent agency cause for considerable concern. Why do our media gate keepers choose to let it die?

Leave a Reply

Your email address will not be published. Required fields are marked *

To Top