I Bought What?!

There are several nations that charge investors for the privilege of loaning money to them. Denmark yields are negative past a year, German yields are negative out to the 5 year bond, Switzerland bond yields are negative past 7 years, and even Austria sports negative yields on short term debt.

Now why would any investment entity allow a borrower to take their money, tie it up for several years eliminating the ability to use it, finally ending up with less than they started? Any rational investor would keep the cash and maintain the flexibility to use it if an opportunity or emergency arises. The reason yields have drifted negative is due to out of control monetary policy such as negative overnight rates in Switzerland, Sweden and Denmark, as well as the ECB’s introduction of QE. This coupled with regulations forcing pension funds and insurance companies to buy only “safe” sovereign bonds as their investment have caused this financial abomination. I wish I could force someone, anyone, to buy debt I have taken on where they would pay me interest for their trouble but I guess that privilege is reserved for governments.

So government coercion forces pension funds and insurers into this negative rate world but no one with a choice would fall for ultra-low or even negative interest rates from insolvent entities, would they? Unfortunately the answer is yes, it might even be you, and it can be done at the worst possible time unless you understand the financial dynamics at play.

When there is a shock in the economy there is a knee jerk reaction to sell equities (stocks) and buy government bonds. In the United States this is done blindly without much thought by institutions or individuals.

At times this shift is done with the understanding that the investor is buying bonds, but often, particularly for individuals, it is not. Many individuals who own accounts such as 401k’s, IRA’s or brokerage accounts, thinking they are getting ahead of the crowd, have become accustom to selling what they perceive as risky investments such as equities when volatility strikes. As when we sell pretty much any other item, be it a car, house, or pogo stick we normally receive dollars and investors believe the same is true when they sell investments in their various investment accounts. This is simply not the case. The money is shifted into a money market account, and while the units may show the dollar value, the investor has actually bought short term bonds.

If investors would read the prospectus of these money market funds they would find verbage similar to what is found in the Vanguard Prime Money Market Fund profile as follows:

“As such it is considered one of the most conservative investment options offered by Vanguard. Although the fund invests in short-term, high-quality securities, the amount of income that a shareholder may receive will be largely dependent on the current interest-rate environment”

When things get rocky, no matter what the cause, investors sell equities and other investments in their portfolios and this held true during the debt ceiling debates in the United States. As most of you know in the fall of 2013 the US federal government was in a legislative battle whether to raise the debt limit or not. Not doing so would cause the some of the payment obligations of the government not to be met. When the Treasury Secretary, Jack Lew, was asked if he could ensure that debt service payment would be made to ensure the credit standing of the United States he responded in this way: “There is no plan other than raising the debt limit,” he said. “The legal issues, even regarding interest and principal on the debt, are complicated.” “Our systems were not designed to not pay our bills” and “I don’t believe there is a way to pick and choose”. During the time of the debt ceiling legislative impasse due to the knee-jerk reaction to buy bonds knowingly and unknowingly during times of economic stress, bond yields fell. Said another way, during a time when the Treasury Secretary announced that if a deal was not reached the United States would default on its bonds, investors thought that would be a good time to buy the asset that was threatening to default. Though this reaction could be expected it was still jawdroppingly shocking to watch in action.

The last major economic crisis in 2008-’09 was a debt crisis in the private sector, particularly home mortgages, but the systemic fallout nearly brought down the whole system. Much of these bad debts were shifted to sovereign balance sheets making it very likely that the next crisis in major economies will be a sovereign debt crisis. Obviously there have been some major debt issues in smaller economies but for some reason the powers that be assume, or want you to assume, it is not possible for developed economies (Japan, US, UK etc.).

If there were to be a debt crisis, in the US or Japan for instance, there would be the knee jerk reaction into bonds. Granted if it were a debt crisis it would be at higher yields but they would still be pushed lower by a temporary ignorant demand for bonds. The issue with a real debt crisis, not one caused by an arbitrary debt ceiling, is the default will not be remedied as soon as Congress or the Japanese Diet comes to an agreement. The losses will be real. As if the initial turmoil of a debt crisis wouldn't be enough the shock of a collective realization that investors were buying the one thing that is in danger, without knowing would exacerbate the volatility.

If the big debt bomb does hit, normalcy bias could have devastating results. Be prepared and know what you are invested in at all times. It might be getting skimmed as you read this post.

Investor - Why is my money market account balance dropping?!

Financial Adviser - Some of the money market investments were in short term US treasuries which are in a form of default. You may be able to get some of that money back but currently, since those bills are not being traded and cash is not recoverable, they have been marked down to zero. This has been reflected in your account balance.

Investor - Wait…What?!

Financial Adviser- Did you read the prospectus?

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