Since the market’s collapse, there has been a lot of interest in Gold, and for good reason: Very real fears of inflation, deflation and currency devaluation. Investors are looking for a rock-solid way to protect their wealth. This article proposes an alternative to Gold.
If your goal is to maintain purchasing power, limit volatility and to earn a positive real return on your holdings, then you should invest as Central Bankers do the world over. In the past, Central Banks have chosen Gold because of its long history as a universal store of value. Gold has increasingly gone out of favor over the past half-century. Central Banks have reduced their gold holdings in favor of holding foreign currencies.
- High Volatility: Historically, Gold has been much more volatile than the SP500 index.
- Zero Yield / Zero Growth: Gold does not increase in intrinsic value. In biblical times 1 oz of gold bought a man a very nice suit. In modern times 1 oz of gold still buys a man a very nice suit.
- Waning Interest by Central Banks (major holders).
Central Banks chose assets that provide protection of principle, asset price stability, liquidity, and yield. Central Banks invest in a diversified basket of bonds denominated in several currencies. Currently, the US Dollar is the leading reserve currency, as 66% of all Central Bank reserves are held in dollar-denominated US nominal treasury bonds.
Risks of Nominal Sovereign Bonds (in Dollars or other currency):
- Rising Interest Rates (as rates rise, lower yielding bonds drop in value)
- Devaluation of the US Dollar
- Unexpected Inflation
- Government Default (unlikely in the US, but more likely in some euro-zone and emerging markets)
Solution: Holding a diversified basket of currencies helps to mitigate the risks of currency devaluation and default. Holding inflation-linked bonds mitigates the risk of high inflation.
Key Differences Between You and a Central Bank
- Because they can print as much of their own currencies as they want, they hold their reserves in other currencies. You, on the other hand, want to hold a majority of your assets in your own local currency.
- Because they are investing large sums, that would swamp the relatively small inflation-linked markets, it is impractical for them to put the majority on their holdings into inflation-linked bonds. A small investor, on the other hand could put all of his bond holdings into inflation-linked instruments with very little market impact.
Investment Vehicle - WIP
Name: State Street Global Advisors has a relatively new product called “SPDR DB International Government Inflation-Protected Bond ETF”, symbol WIP.
Description: WIP is a diversified basket of inflation-linked non-US government bonds. It is the non-US equivalent of the ETF TIP. WIP is a convenient way to diversify away from the US Dollar.
Holdings: The largest holdings in WIP are in the developed markets and in Euros and Pounds Sterling. The fund holds a wide basket of currencies including 31% in emerging markets (Brazil, Poland, Mexico, Turkey, South Africa, Chile, Korea, and Israel).
Default Risk: Even though developed country sovereign treasuries are generally considered safe, the funds holdings are at greater risk for default than the US. The riskiest assets in the fund are in Greece (4.33% of total fund assets) and Italy (4.84%) both are currently considered to be the Euro-area’s “sovereign debtors most likely to default.”
Yield & Expenses: The average real yield in the portfolio is 3.01% - double that of US TIPS. The only downside is the pricey expense ratio of 0.5%.
Fudging Risk: In an earlier article I said that US government is fudging the CPI to make inflation seem lower. The general consensus seems to be that the other currencies of the world for the most part, are much more accurate in calculating their respective CPIs.
A Hypothetical "Lower Risk" Portfolio
Of course, there is no such thing as a risk-free portfolio. Consider a following portfolio consisting of 50% TIP and 50% WIP. Consider the following scenarios, for a US-based investor:
- Should inflation rise either in the US, the rest of the world or globally, your principle is protected.
- If deflation occurs in the US, you are protected by the par value of your bond. CAVEAT: I am not sure how the individual bonds in WIP handle deflation.
- Interest rates could rise. Since TIPS are fairly new (1997) no one has seen how they react in a rising interest rate environment. Normally rising interest rates are due to rising inflation or rising inflation expectations. If so, inflation-protected bonds should maintain value due to their inflation-protection feature.
- The US Dollar could drop in value. You are protected two ways: 1) The WIP account would increase in terms of nominal dollars. 2) Since the US is highly dependent on imports, the decrease in the value of the dollar would cause the price of oil and other imports to rise. Inflation would pick up, and you would be protected by the inflation linked feature of TIP.
- The US Dollar could rise in value. The value of your WIP account in dollars would decrease, however the value of your dollars would increase. Your money would go further with imports.
A more sensible blend of TIP and WIP would be 70 TIP/30 WIP. The only thing that could destroy such a portfolio would be a default by one of the major reserve currencies (Euro, Yen, Dollar, Sterling), or a total world-wide financial collapse much more severe than the one that just occurred. The probability of either of these occurring is pretty slim. We’ve just been through a major financial upheaval and no major reserve currency has defaulted on their sovereign debt.
CONCLUSION: Given WIP’s juicy yield, which helps to counterbalance its high expense ratio, it offers a convenient way to hedge your bond holdings against a US dollar decline.
DISCLOSURE: Author is long individual US TIPS and WIP. You should consult with a professional investment advisor before investing.