Gold Is The New Fixed Income

Aug. 28, 2019 1:07 PM ETSPDR Gold Trust ETF (GLD), IEF, IEI, SGOL, SHY, TLH, TLTFNV, FNV:CA216 Comments
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Oyat
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Summary

  • Fixed income usually provides the defensive component to balanced portfolios.
  • We suggest investors consider replacing fixed income with gold.
  • For many, the opportunity cost of owning gold no longer exists, especially outside of the US.
  • Gold is competitive as a hedge and lowers inflation and default risk.

Investors considering an investment in gold are often told to limit exposure to between 2% and 10% of their portfolios. It’s argued that this allocation provides an optimal hedge without sacrificing too much of more desired asset classes such as equities and fixed income. We suggest that investors rethink their asset allocation with an eye on replacing some of their fixed income (NASDAQ:TLT, NYSEARCA:TLH, NASDAQ:IEF, NASDAQ:IEI, NASDAQ:SHY) exposure with gold. For many, that could mean an allocation to gold of 30% or more.

The concept of investing in fixed income instead of gold is often based on bonds providing yield versus gold, which essentially yields nothing. But for many investors, especially European investors, that historic reality no longer exists. Government and even corporate bonds in much of Europe and Japan no longer provide investors with the yield they crave. In fact, there are now over $15 trillion of negative yielding bonds outstanding.

It therefore follows that one of the core reasons for owning fixed income over gold often no longer exists (or is even reversed), and investors may want to consider ditching some fixed income in favor of the shiny metal. Yet essentially no investors, bar a few, are applying this common-sense logic and ramping up gold exposure. We attempt to explain the lack of action in this article, and invite asset allocators to consider whether it’s time for a change.

Opportunity cost of owning gold is gone, but investors are stuck in their ways

An allocation to gold of 30% or more sounds extreme and controversial. It represents a break from the long-held view that 2%-10% in gold is surely enough for most investors. The premise has long been that owning gold represents too large of an opportunity cost versus owning equities or fixed income. We generally agree that there is still an opportunity cost to owning gold instead of equities. Equities continue to provide attractive dividend yields and represent ownership of productive assets that should continue to grow in value over the long-run. We can recall a quote to this effect from October 2010 when Warren Buffett told Ben Stein:

You could take all the gold that’s ever been mined, and it would fill a cube 67 feet in each direction. For what it’s worth at current gold prices, you could buy — not some — all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?

We agree. It simply makes sense to be invested in productive assets. But fixed income doesn’t usually provide investors with ownership of productive assets. And for many investors, it no longer provides the yield that would help make it more attractive than gold, even after storage and related costs. There is now over $15 trillion of negative yielding debt in the world with corporate debt representing more than $1 trillion of the total (some of which is even junk).

The is over $15 trillion of negative yielding debt.

Source: Deutsche Bank, August 2019

It may well be that US investors want to hold onto some fixed income with US 10-year treasuries still yielding about 1.5%, but even that represents a negative real yield by most measurements. For European investors who don’t want to take substantial US dollar risk, even US bonds may not be a viable option. The new reality is that fixed income yield no longer provides an opportunity cost to owning gold, and investors may want to consider an adjustment. With perhaps the core argument for owning fixed income over gold now eliminated, let’s examine other potential reasons for preferring fixed income to gold, or rather, for preferring gold to fixed income.

Country

10-Year Yield

CPI

10-Year Real Yield

US

1.51%

2.56%

-1.05%

UK

0.54%

1.08%

-0.54%

Japan

-0.26%

1.01%

-1.27%

Germany

-0.68%

1.06%

-1.74%

France

-0.39%

1.04%

-1.43%

Canada

1.18%

1.37%

-0.19%

Netherlands

-0.55%

1.07%

-1.62%

Switzerland

-0.96%

1.02%

-1.98%

Source: Trading Economics, August 27th, 2019

Fixed income offsets weak equity performance in tough times

Fixed income has generally provided an offset to weak equity returns in times of strong stock price losses, such as in a crisis or recession. It has made sense for financial advisors to put their clients into products balancing equity holdings with a healthy dose of fixed income.

But an argument for fixed income as an equity hedge does not mean it is any better than gold in that respect. Gold has done as well or perhaps better than fixed income in periods of extreme stock price weakness. The chart below expresses the comparable success of both fixed income and gold in troubled times for equities.

Bond fixed income and gold act as equity hedges in times of trouble.

Source: Federal Reserve St. Louis, investing.com, Incrementum AG

Our conclusion is that gold is more than capable of taking over fixed income’s role as an offset to weak equity performance or, at least, should be seen as complementary. We therefore see no hurdle from this angle to replacing a large amount of fixed income with gold, especially with bonds providing no yield.

Past performance does not predict future returns

It’s important to point out that the analysis in the previous section is based on history. What’s really important is what will happen going forward. Times have changed regarding monetary and fiscal policy as well as the bond market. Historic analysis of fixed income’s usefulness as a crisis hedge in times of quantitative easing and negative interest rates is, at best, incomplete. It is entirely possible that interest rates near zero will impair the ability of bonds to act as a performance-offset to falling stock prices. While hard to predict, we do think that the current experiments in monetary and fiscal policy cast more of a doubt on fixed income’s credentials as a hedge versus those of gold.

Inflation and default risk favor gold

Investors allocating large sums to fixed income instead of gold need to dig deeper to explain themselves if yield and the hedging argument no longer suffice. But the harder we look, the more the narrative turns in favor of gold. Investing in bonds means taking on substantial inflation and default risk, whereas gold is an inflation hedge to a large degree and is an actual asset with no counter party risk.

Investors might be ignoring inflation risk as it has remained muted in recent years, but substantial money printing and the specter of modern monetary theory should worry bond investors. The reality is that inflation even modestly above expectations (and the potential consequence of rising interest rates) will be highly detrimental to bond investors, inflation-linked bonds aside. On the other hand, gold provides some benefits when higher-than-expected inflation occurs. Gold has protected investors effectively during inflation shocks, but its designation as an inflation hedge might not be perfect unless looking over longer time periods. We’d certainly prefer to hold gold versus fixed income considering pricing and low inflation expectations, and within the context of current monetary experimentation.

We also should not forget the risk of default. Fixed income investors seem to be ignoring credit risk exactly when financial system pressure is moving ever higher. The indebtedness of governments across the globe, as well as corporations and households, has ramped up to astronomical levels.

Global debt has risen as financial conditions have eased.

Source: Institute of International Finance, August 2019

Investors may even want to assess the creditworthiness of the US government (bar inflationary money printing) in the current market, yet investors are accepting record low yields and minimal credit event protection. It seems misguided to accept little to no compensation for credit risk at a time when it is elevated. For the same yield, investors can buy an actual asset with no default risk in the form of gold.

Cash is king – Gold is the best cash

Not everybody thinks of gold as currency, but it is arguably the best one out there. Take just about any major world currency from the US dollar to the Swiss franc since 1971 and compare it to gold--and you will see that they lost essentially all their value. It doesn’t look any better when viewed even longer-term. Gold holds its purchasing power over time, fiat currencies do not. Gold’s claim to the crown is supported by 5,000 years as sound money.

Fiat currencies do not hold their purchasing power, gold does.

Source: Bloomberg, Reuters, Gold Silver

Fiat currencies face many issues currently, ranging from a fragile Euro currency block to Brexit and seemingly endless efforts to devalue. Not to mention the rising narrative that the US dollar may lose its status as the world’s reserve currency. There are certainly arguments for holding one’s home currency, but historical purchasing power trends and the substantial risks many of the major fiat currency face at the present time, point to gold as an attractive alternative.

It’s also important to note that gold can function as a replacement for cash or securities such as treasury bonds without sacrificing liquidity. Gold is a highly liquid asset, which we’d guess is more likely to stay liquid even in the worst of downturns. Treasuries and even cash in a fractional reserve banking world are not assets, but rather claims or promises to pay and ultimately somebody else’s debt. In a crisis, we’d rather hold an asset than a promise to pay.

Adding gold to a portfolio

Investors can get exposure to gold through ETFs such as the SPDR Gold Trust (NYSEARCA:GLD), which is the world's largest gold ETF. But some investors may be skeptical of "paper gold" investments such as ETFs as they may not protect against an unstable monetary system. Swiss or other European investors might find some comfort in opting for the Aberdeen Standard Physical Gold Shares ETF (NYSEARCA:SGOL), which stores its physical gold in Switzerland, but the ultimate solution for most will be physical gold. We complement our physical gold holdings with some related and high quality mining or streaming companies such as Franco-Nevada (FNV), which we have published on in the past.

Conclusion – Gold is the new fixed income

For many investors, fixed income no longer provides a superior yield versus gold. As the opportunity cost of owning gold has vanished, investors may want to consider gold as a viable alternative to bonds in a balanced portfolio. The argument for gold is strengthened by its competitiveness with fixed income as an equity hedge in times of significant stock price drops, as well as its protection against inflation and default.

Attractive bond yields and the hedging relationship of bond and equity returns in times of trouble have long been the bedrock of asset allocation strategies, with many financial advisors never having experienced anything else. Breaking with accepted norms, even when supported by clear logic, is tough, and the consequence is a reluctance to remove substantial fixed income weightings from portfolios in favor of gold. We fear that many investors may be shocked if current monetary experiments cause equities and fixed income to drop significantly in tandem.

A quote from Fasanara Capital effectively summarizes the situation:

Bonds as an asset class are in an existential crisis. But, if bonds are not bonds, it also means that a lot of ‘balanced portfolios’ out there – incidentally representing the bulk of asset allocation globally – are no longer ‘balanced portfolios’, but rather ‘long-only equity portfolios’, with some ‘cash’ to the side. Except the ‘cash’ is fake-cash, insofar as it can lose money too, and is likely to do so at some point down the road upon resurgence of inflation, default risk or confidence crisis. This is one big unintended consequence of negative rates for global asset allocation and the institutionalized Asset Management industry as we know it. Reluctantly when not unawarely, a lot of institutional investors the world over, mandated with low volatility safe allocation targets and typically expressing it through mostly-fixed-income portfolios, find themselves instead to be ‘long only equity’ managers, de facto.

The logical solution for many investors may be to replace the majority of fixed income with gold, even if that means allocations of 30% or more. Skeptics of such sizable gold positions might find comfort in the words of respected long-term investors such as Anthony Deden and Grant Williams, both of whom have dedicated over a third of their capital to the asset.

This article was written by

Oyat profile picture
1.92K Followers
We are a Swiss-based family office focused on managing our own capital, as well as helping other families and individuals meet their financial goals.Our principal goal is the long-term preservation and appreciation of capital in real terms. We are active across asset classes, including private and public equities, fixed income securities, real estate, precious metals, as well as alternative investments. Our background and specialization is in global equities. Our investment process focuses on owning competitively-advantaged companies at reasonable prices.We also like to engage with the Seeking Alpha community to share our opinions and hear other viewpoints.

Disclosure: I am/we are long FNV, PHYSICAL GOLD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The information enclosed in this article is deemed to be accurate and reliable, but is not guaranteed to or by the author. This article does not constitute investment advice.

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