Be a Trader: Bills and Bonds

In the current risk adverse investing environment people have been flocking to government debt for safety. At times they have even been willing to earn a negative interest rate. This illustrates the misconception of risk. Just like share, bills and bonds go up and down in price. Buying these at very low yields exposes you to to three risks.

First there is inflation. The purchasing power of your money declines faster than cash if you are earning a negative yield. In essence cash is a zero coupon government bond. To give confidence that the government will not just print money, most governments issue index linked bonds. These have a coupon and principal that are increased with a price index, protected investors from inflation.

Secondly, and more importantly. For yields to return to their historic norm, 2% above inflation, the price of the government bonds will plunge and you will make a capital loss on your ’safe’ investment. If you hold cash there is no capital loss.

Finally, if you are a foreign investor their is the currency risk to consider. Although this can be eliminated through hedging. Currency risk acts as a multiplier to capital gains. If inflation rises bond prices and the currency will fall in value so foreign investors get a double hit on their investment. Of coarse it is a double gain if inflation falls.