Illusory returns and very real risks

The UK Gilt market has been manipulated by the Bank of England’s purchases of such bonds via quantitative easing, to an extent that it now owns approximately 30% of the entire outstanding quantity of UK government bonds.

The new rules for capital adequacy, and perhaps the beginnings of financial repression, have also seen the UK banking sector’s ownership of Government bonds increase to 10% of the outstanding debt.

Such demand, combined with the fact that the cost of money is basically free for the above entities, has inevitably driven down yields on UK government debt to the following historical low levels.

Correct as of 21/01/2015, Source www.ft.com

Would you really be comfortable lending your savings to the UK government for a period of 15 years in return for 1.83% each year in interest?

These low yields are despite the fact government finances are in disarray, and this is only the transparent government debt. When you include the future transfers of wealth necessary to make good on state promises through future pension and welfare liabilities as a consequence of an ageing population, a century long enforced use of pension ponzi schemes and the increasing costs of a welfare state, it is clear that a larger portion of government taxes will go on paying for historical promises made and official debts, rather than infrastructure and essential services, which will inevitably increase political and economic pressures on government finances. Even today this issue is apparent and it is likely to only become worse.

For example, we currently spend approximately £115billion on State Pensions and Credits (or 6.8% of GDP), which is broadly equivalent to the combined expenditures on Defence (£38billion), Transport (£23billion), Public Order and Safety (£32billion) and Housing and Environment (£25billion).

Additionally, even at such manipulated and suppressed debt repayment levels, we are still paying out £53billion a year in interest on our existing debts. Even more concerning is our ability to get a grip on the situation. With all the austerity posture, you would be right to feel confused by the fact that we have borrowed £107.7billion in the 2013/14 tax year alone.

(Source: www.theguardian.com/news/datablog/2014/mar/21/budget-2014-tax-spending-visualised)

Despite this mess, I accept that an outright default is highly unlikely, as we can in theory pay these debts by fraudulently creating additional numbers out of thin air, however all other factors being equal, that will inevitably lead to a reduction in worth of prevailing money and inflation of prices.

Even putting aside the very large real risk of not actually being able to purchase the same value of goods in the future if these bonds are fully repaid, there is a significant risk of depreciation in price if we ever decide it’s time to stop the manipulation and increase interest rates.

I have included a table below which highlights the implied loss indicated by modified duration, if the Bank of England base rate increased to a reasonable 4%.

Note: This is anything but a true reflection of what will actually happen as MD is imperfect and a quick look at the Bank of England’s historical rates indicate that 4% is still actually quite a low rate of interest. The table should, however, prove useful in highlighting the risks inherent within these markets.

Financial professionals have been taught in financial textbooks and classes that government bonds offer a risk free return and yet history proves this to be false.

Investec Fund Manager Max King pointed out in 2009 that “An investor who bought the 3.5% War Loan for £18 in 1974 could have sold it for £88 in early 2009 generating a compound return of 24% pa. However it was originally issued at par and in 1932 was trading so far above par that the government was able to force through a cut in the coupon from 5%. Bond markets have not always been safe and low risk.” (Own emphasis added)

Bond Fund Manager Stewart Cowley of Old Mutual Wealth also noted that “If you look back on the history, bond yields have fallen from about 14pc in the early Eighties to eye-wateringly low levels today; a five-year maturity bond now yields about 0.7pc.

“This should be a sobering thought for investors in government bonds. At the very least nobody should be messing around with government bonds with maturities greater than about five years.” (Own emphasis added)

An over reliance upon financial theory without consideration of price has led, at a retail level, to owners of government bonds tending to be ‘low risk’ investors and therefore financial advisers who follow the prevailing financial theory, will invest their client’s funds into this asset class today and expose them to serious risks, without any conceivable return provided to make these risks remotely worth taking. An investor today is clearly taking a very different risk to an investor in the seventies.

You must review your portfolio to ascertain how much government debt you own and whether you are happy with this.

Whilst I concede that one of the ‘best performing’ asset classes in 2014 was government bonds with the Vanguard UK Government Bond Index Fund providing a ‘return’ of 17.8% for the year, in light of the pitiful yields on offer at the start of 2014, that ‘return’ was mostly an escalation in the prevailing government bond price, and only a limited number of investors will be able to obtain this ‘return’, as any attempts to sell in a large quantity will inevitably drive down the price, unless of course greater fools can be found, or the Bank of England embarks on ever greater amounts of monetary lunacy.

I expect only nimble speculators to benefit from the escalation in bond prices, investors are likely to only experience temporary paper profits which will make their investment statements look impressive and reassuring, yet my belief is this is merely an illusion of increasing wealth and the return to reality will prove painful.