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Investment Risk Guide – Part 1: Government Credit

 

The thing about investing in government bonds is the sheer size of the asset class. Trillions of Dollars, Euros, Yen, Reals or Sterling are raised every year by countries that need debt to balance their budgets. For the most part, the risk is quite low that a government would default on their loans as that would imply that the whole country has failed. Before that happens, governments can always print more money to pay old debts, and there are various mechanisms in place, including the world bank (IMF) that will lend a helping hand if politicians can’t balance their spending. 

 

So, lesson number one, when investing in government bonds: they are relatively safe. As such they also offer lower yields than, say, buying non-investment grade corporate bonds (junk bonds). Lesson two, seems rather obvious, but you also have to decide for how long you want to hold the bonds, because only then are you guaranteed the yield as promised. In other words, if you buy a 10-year US government bond, your current yield is 2.5%. However, if interest rates were to rise and you decide to sell the bond after only 2 years, then your yield would be lower, and you could even incur losses on your capital. Many people think there is a free lunch, because you can get a yield commensurate with 10 years in duration, but you can get out whenever you want by selling the bonds in the market. Unfortunately life is not that great, and you get what you pay for. Hence the yields are also much lower than for loans that are made to term.

 

The next lesson has to do with currencies, and as many of our avid readers know, there is nothing more complicated than exchanging money from one country to another. Say, you want to buy a globally diversified portfolio of government bonds, how much are you going to put into Dollars or Euros? If you are a UK investor and you buy non-Sterling denominated bonds, you run the risk that the currency price at the time that you bought the bond could have changed when you decide to sell. To eliminate this risk, we could hedge the currency exposure. But there is a reason that we simply don’t all buy high yielding US bonds rather than Euro bonds with negative yield. That is because of a financial concept called “interest rate parity”, which basically means that the cost of hedging your currency is equal to the difference in yield.

 

Finally, we need to decide how much risk we are going to take on. Clearly, there are many things one would need to take into account in choosing debt from one issuer over another. But the point is this: If the only real worry of holding government bonds is default, then the easy way to mitigate that risk is to buy bonds from many different borrowers without overweighting any one by too much. This can be done most efficiently by buying so called ETFs (Exchange Traded Funds), which allow us to hold thousands of bonds from dozens of countries with various durations, for very low cost. Beyond that, it really all comes down to the efficient allocation of time, energy and resources.

 

To put this into numbers: a globally diversified basket of government bonds with a duration of 7 years would currently yield about 1.75% (after costs in real terms). The other investments we make have much higher returns (because we are taking more risk) and are currently yielding more than 7% on average. Considering further, the relatively small allocation of our total capital to government bonds versus everything else, and it becomes quite clear where the focus of our efforts should lie. Moving on, and please look out for our next post on Corporate Credit in this six part series, as we look into all the core risk categories.

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