Financial Education | 12 March, 2018

How to invest in an economic debt environment

Joaquín González Portfolio Manager

At present, most economies, both developed and also emerging market, are reporting excessive debt levels compared to the past. The amount of debt in the US economy, which in turn sets the pace of the world economy, stands at almost four time the wealth this country produces (measured by it gross domestic product).

This cycle of debt increases began in the 1980’s, after the financial deregulation promoted in 1982 by the president at that time Ronald Reagan, but more importantly, the start of this excessive debt cycle coincided with a new stage in which the growth rate of the labour force in the USA began to fall structurally, with a range of different effects, highlighting lower rates in inflation and economic growth increases in potential nominal terms.

How could this excessive debt level affect an investor in fixed income in dollars?

In our opinion, in order to reduce debt levels, the yield delivered by long-term US Treasury bonds must remain within a historically low range (0%-3%) for a prolonged period, as happened in the last debt reduction period experienced after the Great Depression (1929-1933) in the USA, which is illustrated on the accompanying graph.

Total US debt (public and private) over GDP (top) and 10-year US Treasury bond yield (bottom)

Therefore, if interest rates remain low for a long time, an investor could currently invest in high credit-rated long-term corporate bonds (10-30 years) to assure a reasonable annual carry, avoiding the risk of reinvesting the principal which they would face, were they to invest in a shorter-term bond portfolio.

Advantages and disadvantages for an investor buying a diversified high credit-rated corporate bond portfolio with maturities ranging from 10 to 30 years over an investor buying a 5-year bond portfolio of the same issuers:

Advantages:

 

  1. The current carry yield is almost double: The annual carry currently delivered by 10- and 30-year bonds stands at around 5%, vs. the 2.75% from 5-year bonds.
  2. There is no risk from reinvestment of the principal: If interest rates at the end of the 5-year period have fallen compared to today, investors in long-term bonds will continue collecting an annual carry of 5%, whilst the investor in 5-year bonds will invest the capital redeemed at maturity on the bonds bought today for another 5-year period at a rate below the 2.75% initially received.

Disadvantages:

 

  1. Volatility will be higher: The variation in prices of the bonds comprising the long-term bond portfolio may be as much as three times higher than the price variation in bonds comprising the 5-year portfolio. These variations may occur due to  increases/decreases in interest rates or in financial market volatility.
  2. Holding investments at a rate below what the market is delivering: If after 5 years the annual yield being delivered by 5-year corporate bonds is above 5%, investors in long-term bonds will continue receiving a 5% annual carry, whereas investors in 5-year bonds will reinvest the capital redeemed at maturity of the bonds bought today at a higher annual rate than the 5% received by the investor in long-term bonds.

This is a financial analysis and our expert’s opinion. Nevertheless it doesn’t represent and offer or any kind of recommendation. For any query please contact directly with your Relationship Manager.