Why investing in US bonds may not be a good idea | Mint

Why investing in US bonds may not be a good idea

The only thing that stands in between the US and a debt crisis is the lack of a viable alternative to the dollar as a reserve currency (Photo: iStock)
The only thing that stands in between the US and a debt crisis is the lack of a viable alternative to the dollar as a reserve currency (Photo: iStock)

Summary

  • Even if we assume that higher interest rates are coming, that will likely be bad for treasury bonds (longer duration). This doesn’t seem to have been factored into the idea of global diversification into US treasuries

I recently read a piece in Mint on investing in US bonds titled ‘Know how to diversify your portfolio with US bonds’. My point of view is different, which is why I felt the need to write this edition of Contramoney on the subject. 

My goal is to lay out the facts as I understand them to be, and then leave it to you, dear reader, to decide what you want to do with your money. 

Let’s start with what I don’t agree with in the piece I refer to. 

First, the piece makes an interesting assumption – that US interest rates are expected to keep rising for some more time. This statement makes it seem that higher interest rates are a given, but the fact is that no one knows for sure. In fact the view on US interest rates, both at the short end and the long end, is divided today, with many stalwarts taking opposing views. Many a fortune has been destroyed just in the past couple of years as people bet incorrectly on the direction of interest rates. 

Having said that, even if we assume that higher interest rates are coming, that will likely be bad for treasury bonds (longer duration), and that doesn’t seem to have been factored into this idea of global diversification into US treasuries.

Second, to make a case for US bonds, the earnings yield (nothing but the inverse of the P/E) is compared with the US bond yield. The article cites the Nifty yield at 4.5%, while the one-year US treasury yield is at 5.43%. 

To be fair, comparing the earnings yield to bond yields make sense, as people may do a risk-return trade-off in their heads (or spreadsheets) when investing. 

But how and what you compare is equally important.

Here are a few points to ponder:

  1. The US bond yield is forward-looking and locked in. The Nifty yield, on the other hand, is based on past data and will change year on year.
  2. Should you, therefore, compare the Nifty yield to a one-year US treasury bill? Or should it be a longer-duration treasury? To my mind, longer. 
  3. Then there is, of course, a currency issue - Indian rupee vs US dollar - that needs to be factored in (and the related issue of costs and taxes).
  4. The comparison of the Nifty earnings yield to the Indian bond is a better idea, and the article covers that. However, even when doing this comparison, one needs to understand the risk premium on offer for investing in stocks (it needs to be high enough to reward you fairly for the risk of investing in stocks). This is a deep topic and perhaps we will return to it later in Contramoney. For now, the point is that a simple earnings yield comparison may not make a lot of sense without factoring in other things. 

Third, the Mint article assumes that over time the Indian rupee will depreciate. 

However, the point is stretched to the implication of a 4% to 5% depreciation per annum. While this may be true historically, and perhaps come true in the future, what’s the probability this will be gradual over time? Perhaps it could be lumpy, thus leading to sharp volatility in year-on-year returns. That’s a big risk if you are investing for a one-year period and expecting about 50% of your gains to come from currency related reasons. 

Fourth, the article compares the sovereign rating of US debt vs Indian debt. However, the US is hurtling towards a debt crisis. The only thing that stands in between the US and a debt crisis is the lack of a viable alternative to the dollar as a reserve currency. It’s more a TINA (there is no alternative) situation than fundamentals. India’s track record, on the other hand, although not exemplary, is far better. 

The other fact is that in recent years, credit rating agencies have downgraded US debt (most recently by Fitch two months ago). India, on the other hand, is likely to move in the other direction (that is, higher ratings). 

If not anything else, the above should give you pause to think about whether investing in US bonds is really a no-brainer. 

From my perspective, such investment opportunities, as things stand today, are generally not suited for most investors. On the other hand, if you have some big expenditure coming up in the future, in the US, then perhaps this makes more sense (now that there is no currency movement issue). But even then, it’s inefficient as the costs of currency conversion and taxes will be significant. 

Now, like I said before, there could be circumstances when investing in US bonds could make sense to some Indian investors. 

Having said that, I want to end this piece with some thoughts on how to go about thinking on investing in global assets. 

First, global diversification is a huge opportunity both in terms of managing risk and finding opportunities that are otherwise not available in the local markets. 

Second, the principle of investing in what you know and understand remains unchallenged when investing abroad. Just because US bond yields are higher today than a year ago, is no reason to invest. You really need to be sure you understand all the parameters (some mentioned above). And even then, be sure it fits into your asset allocation. 

Third, understand the costs and taxation of investing abroad. The global investing world has changed a bit for Indians after the new tax collected at source (TCS) guidelines went into effect. If you are not aware of this, then perhaps you are not ready for global investing anyway.

Fourth, there are many investment opportunities available to you at any point in time. If you go about chasing each one of them, it may not help. Start with your asset allocation, see what you need, and then go about finding the best fit. 

Finally, do not take the written word by anyone, including me, and accept it as gospel truth. 

Read it, ask questions, challenge the writer. Think for yourself. After all, it’s your money, and you need to take responsibility for it. 

Rahul Goel is the former CEO of Equitymaster. You can tweet him @rahulgoel477. 

You should always consult your personal investment advisor/wealth manager before making any decisions.

Catch all the Business News, Market News, Breaking News Events and Latest News Updates on Live Mint. Download The Mint News App to get Daily Market Updates.
more

MINT SPECIALS

Switch to the Mint app for fast and personalized news - Get App