Let’s start with a couple of mistakes that the average investor might make when looking for yield in the markets today. Let’s ignore securities like GICs and savings accounts for now, because we all know that it takes more than a tenth of a percent to pay the utility bills. Let’s start with the most obvious choice to an investor: the government bond. I’ll save you the two minute trip to Bloomberg, and tell you right now that the local government bond yields of today are all generally paying you less than a half of a percent in returns.
This is before we take into account the fact that most of us small-time investors have interest payments of our own to make, and that we would be better off paying down our 8% debt levels than accepting a 0.5% return from a bond.
Granted, foreign bonds are paying better rates than what we’re seeing today in the USA, but then we need to worry about currency exchange rates, and effectively keep track of another entire economy as well as our own! As if watching the volatility at home wasn’t enough, now you need to study it all over again on the other side of the world. Government bonds, on their own at least, are out of the question. However, if you ask, your investment advisor should have a couple of tricks up their sleeve to help you broaden your bond investing horizons, without taking on excess risk.
Let’s start by going back to those government bonds we looked at earlier. Specifically, we’re going to look at the Australian 2-year bond. Why? Because the payout is about 2-3x that of the local US bond, it has a solid rating from the agencies (generally AAA), and it has not demonstrated any indication that it will be defaulting on any debts in the short-mid terms.
While the investor is still taking on the risk of default for purchasing this bond, they are being greatly compensated (6.8%/year) for taking what the professional ratings agencies generally consider to be an extremely high-quality instrument. In addition to that risk though, the investor is taking on currency exchange risk, which has the power to completely destroy an investors returns if not put in check. Here’s how you investment advisor can assist you.
By purchasing a ‘swap’ contract on the value of the Australian dollar, you can completely nullify the risk associated with any fluctuations between it and the US Dollar. Granted, you need to pay the bank a fee to do this sort of transaction, the contract (known as a ‘hedge) is a onetime payment, and can be easily covered by the coupon payments made by the bonds.
The end result? You get the better rate of return associated with the foreign bond, without the currency volatility. Your investment advisor is qualified to keep you in the loop about whether or not the Australian economy is about to disappear from the face of the earth, and you can rest easy knowing that you have managed to out-smart an over-crowed USA bond market.
Think that was cool? Check out the next post when it’s ready. I’ll show you a similar trick that transforms an overbought market for dividends into a income-hungry saver’s dream.