Jun 1

Financial Repression: Taking a Bite Out of Our Portfolio Yield


Back in the 1980s, we were introduced to a crime fighting dog named McGruff, who famously used the tag line ‘take a bite out of crime.’

What has that got to do with investing?  Consider…

The yield on the US 10 Year Treasury has sunk below 1.5% for the first time, as one wag put it, since 1789.  Thus, it is time to fully consider how to invest while Chairman Ben maintains low rates for longer through the end of 2014.  This coupled with his counterpart at the ECB, Mario Draghi, who is orchestrating an ongoing ‘flight to quality’ that results in US Treasury rates (as well as rates on bonds from Germany, Finland and Holland) well below inflation.  Thus Mario and Ben are basically taking a bite out of our portfolio yield.

How much of a bite depends upon factors like the current book yield of the portfolio versus the reinvestment rate, and how often securities within it will be repricing.  Ongoing overall portfolio yield declines of 20-40 bps per year are expected to be commonplace if new investment rates don’t change.

Meanwhile, we all know how this movie has played previously.  When Chairman Alan kept rates too low for too long, we eventually had a bubble somewhere and it played out in the residential real estate market.  This time, we are all on the look out for where the bubble may be next.  Some say the bubble will be in long treasuries, or the value of the dollar and/or ugly inflation at some point in the future.

One thing we are certain of:  Current interest rates in no way compensate us for inflation, let alone term, credit or liquidity risk premiums.

But, we live in this world, far from a perfect one.  And when those dollars come across the transom, they have to be invested somewhere, awaiting payment of claims, etc.  With that in mind, we ask a rather simple question:  Is waiting for more ‘normal’ interest rates worth it?

We have taken a rather simple mathematical example to help answer that question.  We have assumed a cash yield of 0.10% and a ten year portfolio yield of 3.5% (a healthy 200+ bps spread of Treasuries, so we are taking on some credit risk).  The following table shows how the average yield on a new investment today would be greater (in black) or less (in red) than just holding our nose and buying the ten year portfolio at 3.5%.

You will notice all the red numbers, which tell us how much yield we would be losing, annualized, over the 10 year period if we stayed in cash.  However, those red numbers start moving into the black, if rates start ‘normalizing’.  For example, if our ten year available rates rise by 50bps by the end of one year to 4%, we would have made the correct decision (by 11 bps per year) by just waiting for the rate increase.  But, if it takes two years to get that 50bps increase, we would have made the wrong decision by staying in cash.

Obviously, the longer you wait, the higher rates must rise to make the ‘stay in cash’ decision worthwhile.  And, note that most of the numbers above are red, once again underlying Chairman Ben’s push to get investors out of cash and into risk assets (although the ‘risk off’ behavior of the markets in the last month, certainly has pushed against the Chairman’s desires).

Of course, as this is a simplistic spreadsheet, we can easily change the variables (cash or similar rate, today’s new investment rate, etc.) to allow a quick look at the risk/reward of waiting versus investing now.  Feel free to contact me or another Principal at Strategic Asset Alliance to discuss.

Meanwhile, like the FED Chair, McGruff has raised his profile over the years. He has advice for kids of all ages on how to handle difficult situations in school, out of school, etc.

But, there is perhaps one bit of advice that we all could use from the Crime Dog:  “If another kid, even a friend, asks you to do something you don’t want to, don’t do it.”  As we have seen, this certainly might apply, as Financial Repression is taking a bite out of our portfolio yield.