What is the least risky home for part of a portfolio?

Brendan Burgess

Brendan Burgess

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A friend of mine has thought through his investment strategy. He has around €1m in financial assets and owns his own home.

He has €900k in worldwide equities

But what surprised me was that he was planning to put €100k in the NTMA 10 year bond as "it is safe" and he will get a tax free return of 30% after 10 years.

I think that there is a very good chance that he will get back €130k after ten years. But, apart from inflation, he is exposed to two significant risks

  • Ireland might leave the euro
  • Ireland might default
Ireland leaving the euro wouldn't be too much of a problem as his shares are well diversified outside the euro.

But if there is such economic turmoil that his portfolio crashes in the longer term, then it's likely that the Irish state would not remain solvent. So I don't think that state savings bonds will achieve what he wants. He wants absolute safety - that is not achievable.

But if he wants something which can weather almost all storms, short-term German government bonds? He may get a negative return, but he will get his money back.
 
Well he is in line with many Swiss advisers... they have been pushing this line for several years now.
 
Brendan,

This is a very good question.

We used to use Government bonds as the "risk free rate" but the last few years has questioned this approach.

You also have to factor in where you are starting from. Interest rates are at their lowest level for around 300 years. Bonds move in the opposite direction to interest rates and the bond market has been going up for the last 30 years.

So as you correctly identify his risks are

Inflation/Interest rate risk
Default
Financial Repression (capital controls etc)

I currently recommend a global basket of around 5,955 bonds all Euro Hedged to reduce currency risk with a bias towards short duration (3.45 years) and high credit (60% AA+). This basket also includes Inflation linked bonds which offer a near perfect hedge against these risks.
 
Marc

I don't understand the advantage of a basket of bonds over a single German bond?

A short term bond protects to a large extent against prices falling as a result of rate increases.

If the German bond is the safest bond, why would one diversify any further?
 
Brendan

The first point is probably to do with tax. If you buy a bond on the market the income is taxed at marginal rates of tax so that could be up to 55%.

Whereas a fund is "only" taxed at 41%/45%

The main problem with a short duration German gvt bond is that everyone knows it's safe and therefore you are not going to get any return. In fact you may get a negative real return. Hardly a good capital preservation strategy.

By investing internationally you get to benefit from higher yields from equivalent bonds.
So for example a US company might be rated the same as a German gvt bond ( Johnson & Johnson, Exxon-Mobil and Microsoft) but might offer a higher yield.

By mixing bonds of different durations you are maximising your expected return and managing interest rate risk. By holding thousands of bonds you mitigate against default risk.

So you end up maximising your risk return trade off.
 
What's the return on German bonds now? 1.5%?

And what price are you buying it at?

The 10 year Solidarity Bond pays 2.66% AER.

Neither are that attractive though. If he wants a long term cash deposit, he is better off waiting. Rates will go up at some stage and more attractive rates will come along.


Steven
www.bluewaterfp.ie
 
He does not want a long term cash deposit as such.

He wants to put 10% of his portfolio in an asset which will weather almost any storm.
 
Marc said:
By investing internationally you get to benefit from higher yields from equivalent bonds.
So for example a US company might be rated the same as a German gvt bond ( Johnson & Johnson, Exxon-Mobil and Microsoft) but might offer a higher yield.
Click to expand...

OK, I would not have thought of any commercial bond as the same as a German government bond. Big safe companies do default. But maybe big safe countries default as well.

By mixing bonds of different durations you are maximising your expected return and managing interest rate risk.
Click to expand...
He is not trying to maximise his return.

He wants to take as little interest rate as possible, so short term bonds do this.

By holding thousands of bonds you mitigate against default risk.
Click to expand...

Even if you accept this argument, you don't need thousands of bonds. If you feel that German bonds may default, would holding Microsoft offer diversification? Maybe so, but by taking on exchange rate risk, which he does not want to do.
 
Stick it on deposit. PTSB pay 2.15% for 12 month fixed. There's not much money to be made from secure investing at the moment. Just look for the best short term rate available, put it there and look at it again when it matures.

According to Bllomberg, the yield on a 2 year German bond is 0.02%. Not worth it.


Steven
www.bluewaterfp.ie
 
You are missing the point entirely. He does not want to be taking any risk with this money. There is a risk that the state will go bust and ptsb with it.

Brendan
 
Brendan Burgess said:
You are missing the point entirely. He does not want to be taking any risk with this money. There is a risk that the state will go bust and ptsb with it.
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I won't pretend to understand any of this, but it does convince one that if the experts cannot agree, how on earth would anybody trust a financial advisor to get it right.

On the wanting total security, the issue seems to be a country could go bust. So why not split the 100K into 10K in government bonds in the 10 safest countries.
 
Bronte said:
On the wanting total security, the issue seems to be a country could go bust. So why not split the 100K into 10K in government bonds in the 10 safest countries.
Click to expand...

In a sense, that is what Marc is proposing, but over 5,955 safe bonds, rather than just 10.

Your suggestion of 10 makes more sense to me.
 
Marc said:
Brendan

The first point is probably to do with tax. If you buy a bond on the market the income is taxed at marginal rates of tax so that could be up to 55%.

Whereas a fund is "only" taxed at 41%/45%
Click to expand...

1) As the income is so low anyway, the 10% difference is insignificant
2) I am sure that the management charges exceed any tax savings
 
Brendan Burgess said:
You are missing the point entirely. He does not want to be taking any risk with this money. There is a risk that the state will go bust and ptsb with it.

Brendan
Click to expand...

That's because I don't believe the Irish State nor PTSB will go bust and bondholders will be burnt.

After what we have just been through and are still paying for, all bondholders were paid in full.

Anglo and Nationwide BS were not allowed go to the wall and the ECB declared that no European bank will fail. I don't see a reversal of that.
 
Hi Stephen

I don't expect it to happen. But there is a risk that it will happen. So it is right to allocate a part of one's portfolio to an asset class which is even safer than the Irish government.

Brendan
 
Investing in German bonds at 0.02% exposes him to a much greater risk of inflation. Last year CPI was a mere 0.28% but your pal would still have seen the real value of his money decrease. CPI to date this year is 0.85%, another loss in the real value of his money.

And I don't recommend that he invest in a 10 year bond when rates are so low. I recommend he places it on a short term deposit. So what would the risk be that an Irish bank goes bust in the next 12 months?


Steven
www.bluewaterfp.ie
 
Hi Steven

Again, you are missing the point completely.

He wants a rock solid investment for 10% of his portfolio. This is not about return on his money, it's the return of his money.

Inflation will apply whether it is in deposits, bonds or shares.

I have been the biggest advocate of investing in shares and not having money on deposit. I don't regard any investment as risk-free. But Irish deposits are riskier than German bonds. The key point of this thread is - which is the least risky asset for 10% of his portfolio.

Brendan
 
Whilst it may be a very low probability the risks as I see it are as follows;

1) The Deposit Guarantee Scheme (DGS) which protects amounts up to €100k per person per institution is not fully funded in Ireland unlike in other countries. Therefore in extremis if called upon would the Govt. of the day have the capacity to fully meet those claims?

2) The new European bank resolution mechanism has depositors at risk before tax payers - and many would say that this is a good thing. Depositors, we suggest, need to at least take this into account

As I said these are remote risks but high impact if they occur. PTSB and Ulster bank in my opinion both have huge structural issues with their business model, which even a recovering economy/rising house prices cant solve. Therefore as per the OP bank deposits may not be the optimal safe haven unless you are in a very sound bank in a country where the DGS is fully funded or the state will be able to easily meet those potential claims.

One small observation Bronte:
I
won't pretend to understand any of this, but it does convince one that if the experts cannot agree how on earth would anybody trust a financial advisor to get it right.
Click to expand...
- whilst it may be defending the indefensible, I think you are being unfairly hard on financial advisers. In many fields there can be different opinions and positions on best practice. It doesnt meant that they are all invalid
 
A bit off the wall but: Convert to cash (€100k) and store in safety deposit box (insured up to €150k).
 
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