I noticed a few of the wilier cats among the Monevator crowd were holding US government bonds going into the coronavirus crisis. They seemed pretty pleased with themselves, so I decided to see what’s up.

After all, there’s no better time to change your strategy than after the horse has bolted…

Most of the passive investing gurus advise holding high-quality domestic bonds (i.e. gilts, if you’re a UK-based investor). But then, most of the passive gurus are from the US. What if there’s some kind of American Exceptionalism playing out here and I’ve been a Lee Harvey Oswald-style patsy all this time?

To assuage my fears I logged into the ETF-screening and portfolio-building service, JustETF.

I compared unhedged ((i.e. Not currency hedged.)), intermediate government bond ETFs of the US, Euro, Global, and UK persuasion. ((Long bond ETFs would be more dramatic but we’ve never recommended them here due to the potential losses from interest rate rises.)) I pitted them against each other and an MSCI World ETF during as many stock market bloodlettings as possible. My fears were un-assuaged.

Coronavirus Crisis – government bond comparison

The yellow line is why those Monevator cats are purring about their US Treasury bond holdings.

World equities hit bottom on 23 March. Our team of high-quality government bond ETFs were all straining in the opposite direction that day – stopping our portfolios and us jumping off the ledge.

Some did more work than others, however. As world equities clocked a loss of -26.4% (relative to 20 February), the bond ETFs countered with gains of:

• 4% – Intermediate UK Gilts (Blue line; ticker: IGLT)
• 7.6% – Intermediate Euro Government bonds (Red line; ticker: IBGM)
• 11.9% – Intermediate Global Government bonds (Orange line; ticker: SGLO)
• 17.7% – Intermediate US Treasury bonds (Yellow line; ticker: IBTM)

Gilt returns peaked on 9 March and then the pound slid 12% through to 23 March. Gilts turned negative on 18 to 19 March while overseas bonds were buoyed by the falling pound. The Euro has fallen away since, but US Treasuries are still up 11.9% to gilts’ 5.3% on 24 April.

Consider my interest piqued.

Global Financial Crisis (GFC)

The same ETFs are back in play bar the global government bond effort (it was only launched in the midst of this crisis).

The world turned dark on 6 March 2009 with losses reaching -38%. ((Relative to 12 October 2007.)) Thankfully our bonds would have offered a ray of hope:

• 18.6% – Intermediate UK Gilts (Blue line)
• 47.7% – Intermediate Euro Government bonds (Red line)
• 73% – Intermediate US Treasury bonds (Grey line)

The pound took a beating against the US dollar in 2008 and, though it recovered some ground in 2009, by the end of the crisis the US Treasury bond ETF was up 62% versus 57% for the Euro gov bonds and 16% for the gilts.

Clearly we’d have all slept more soundly with US Treasuries in our portfolios.

Incidentally, notice that shark’s jawbone image you get when you compare the grey line’s upward flex versus the orange line’s downward gape from October 2008 to August 2009. That’s what textbook negative correlation looks like and that’s why we hold high-quality bonds in our portfolio.

European Sovereign Debt Crisis

The world was down -14.9% on 2 Jul 2010. ((Relative to 15 April 2010.)) By that day our bond ETFs had responded with:

• -2.1% – Intermediate Euro Government bonds (Red line)
• 4.6% – Intermediate Global Government bonds (Orange line)
• 5.2% – Intermediate UK Gilts (Blue line)
• 9.1% – Intermediate US Treasury bonds (Yellow line)

Okay, Euro Government Bonds were not the place to be during the European Sovereign Debt Crisis. Fair enough. Once again US Treasury bonds proved to be the safest of safe havens, though there was less than a percentage point in it by 13 December 2010.

It’s starting to feel a bit voyeuristic – like I’m some kind of rubber-necking vulture looking for another carve-up.

Still, why stop now when we’re having fun?

2018 Global Stock Market Downturn

World equities delivered an unwelcome Christmas present of -15.9% in just a few months to 24 Dec 2018. ((Relative to 29 August 2018.)) Bonds took until 3 January to respond properly, after the sales were in full swing:

• 1.5% – Intermediate Euro Government bonds (Red line)
• 1.7% – Intermediate UK Gilts (Blue line)
• 4.5% – Intermediate Global Government bonds (Orange line)
• 6.4% – Intermediate US Treasury bonds (Yellow line)

Again US Treasuries were the place to be in comparison to gilts.

JustETF doesn’t have the data to take me back further in time. But if the last 12 years’ worth of downturns are anything to go by then I have just one question…

Is this a thing?

US Treasuries look better than gilts for UK investors when it comes to stock market crash protection over the last decade and more.

But it’s also nice if your assets provide long-term returns, so let’s see how our options stack up on that score:

US Treasuries win again. ((The 6 March 2009 start date is defined by the launch date of the youngest product in our line-up: iShares Global Government Bond ETF.)) Not by a devastating margin, but you wouldn’t say no.

And there’s certainly a rational story to justify holding US government bonds. America is the global superpower and the dollar is the world’s reserve currency.

Why wouldn’t everybody run into the arms of US Treasuries during a meltdown?

Moreover, the pound is described as a pro-cyclical currency: it tends to fall when the global stock market falls. In which case, you might well expect to see an exaggerated spike in US Treasury returns (as measured in pounds) at the very moment equities nose-dive, especially as currency volatility is meant to dominate government bond returns.

Wait! Let’s get a longer-term perspective

A portfolio is for life, not just for bear markets.

This table comes from the Sarasin Compendium Of Investment, albeit from 2012. It shows that US Treasury bonds are far from a no-brainer for UK investors when viewed over a different timeframe. 

This comparison of 10-year government bonds shows that UK investors averaged a return of 8.9% per year versus 7% for US Treasuries of this period when returns are measured in pounds (see the Sterling Return column).

Notice that in 1987 – the year of the Black Monday Stock Market Crash – US 10-year government bonds returned -19.7% in pounds, whereas gilts brought home 15.5%. The falling dollar wiped out 21% off the return of Treasuries.

Global equities suffered another set back in 1990 as Saddam Hussein invaded Kuwait and Japan entered its multi-decade slump. Gilts spiked 9% while US Treasuries dropped -9.5%. Unhedged currency exposure backfired again, this time to the tune of -16.7%.

So. Maybe this special relationship isn’t all one-way.

The monumental returns of the 80s and 90s (I weep that I was in short trousers not the market then) ended with a pop as the dot-com bubble burst. US Treasuries trounced gilts in 2000 and 2001, but suffered a reversal in 2002.

If you scan your eye down the Currency Effect column, you can see from the size of the effect versus return that most of the differential between gilts and US Treasuries (sterling return) is explained by exchange rate volatility. 2008 was the annus mirabilis as the currency effect added 57.7% to the year-end return of US Treasuries.

Still, it’s surprising to see that gilts came out on top over the whole 15-year period.

It’s a struggle to go back much further than this with the data we have access to. We do know that the 1970s oil crisis smashed up global equities in 1973-74 and that UK equities suffered their worst loss on record during this period: -71%. Gilts were a car crash, too, going down 50% between 1972 and 1974.

Meanwhile, the pound lost just -1.28% to the dollar in 1973 and then gained 1.29% in 1974. I highly doubt you’d have noticed that shimmy, what with the oil crisis, recession, double-digit inflation, miners’ strike, the Three-Day Week, and general elections every five minutes.

Did any Monevator readers have market exposure during this one? I was there but my only assets were a £5 Premium Bond, a romper suit, and dimples.

Where does that leave us?

Good question. Opting for US Treasury bonds is a currency play for UK investors pure and simple. You’d be betting on the pound falling against the dollar as investors head for the safe haven hills.

Despite recent history and the supremacy of the States, events don’t always unfold as expected. I read a couple of research papers that said the Euro was a reliable safe haven until it wasn’t. And of course, we’ll only find out that reality is no longer following the script at the worst possible moment – when we need diversification the most.

Multiple papers concluded that UK investors should hedge any global bond exposure they have, including this report from Vanguard:

In Figure 10, we examine the performance of unhedged global bonds, hedged global bonds, and local market bonds in the bottom decile (the worst-performing 10%) of monthly returns for the global equity market. We find that hedged global bonds provided more consistent returns and in many cases better levels of counterbalancing than local bond markets. Unhedged global bonds, on the other hand, had a much wider range of returns and in the majority of cases did not provide similar levels of diversification.

Thus, hedging away the currency risk is necessary if global bonds are to provide the maximum level of diversification and fill the traditional role of high-quality bonds in a balanced portfolio.

Ultimately, I’m a passive investor because I want to keep my investing life simple. I’m unlikely to be agile or informed enough to know if there’s no longer good reason to believe in the dollar as a ‘risk-off’ currency.

Yes, I get my head turned when I come across a fund that would have been amazing to hold these last few years. But by the time I’ve found out about it, it’s already too late.

My portfolio is built for the next 40 years (I hope) and I believe it’ll get through the next 40 months just fine.

Take it steady,

The Accumulator

Bonus chart: August 2011 stock market downturn

After I finished the post, I had a nagging doubt I’d missed something and here it is. The oh-so memorable August 2011 slump. At last there’s a recent-ish downturn when US Treasuries didn’t completely dominate gilts. World equities had their darkest hour on 19 August 2011 bottoming out at -18.7%. ((Relative to 8 July 2011.)) Gilts topped the charts that day:

• 1.8% – Intermediate Global Government bonds (Orange line)
• 2.4% – Intermediate Euro Government bonds (Red line)
• 3.7% – Intermediate US Treasury bonds (Yellow line)
• 5.1% – Intermediate UK Gilts (Blue line)

US government bonds had nudged slightly ahead by the time equities nosed into positive territory on 13 March 2012. In reality it was neck-and-neck with US Treasuries on 11.2% and gilts on 10.9%.

What caught my eye this week.

When we look back on lockdown in a few years’ time, we’ll each have different memories.

For some of us the period will be marked by the loss of a loved one to Covid-19, or by commuting to essential work on near-empty roads and trains.

But for a majority, these strange weeks will be reduced to a mental mood board made up of just a few memories.

Chatting with friends and family on Zoom. The novelty of virtual drinks over video. Trying to teach the kids something other than how to turn off their screens. Joe Wicks’ workouts. Unlimited Internet porn. Quiet walks around the neighborhood. The birdsong and the incredibly clean air.

I suppose I’ll remember listening to the Ninefox Gambit on Audible while taking my daily wander, marveling at the British weather’s knack to deliver sunny stretches at the most inconvenient of times. I’ll definitely remember Skyping my mother to finally show her the progress of my garden (she’s into week six or seven now of a self-isolation spent mostly in hers). There was that friend’s 50th birthday on Zoom when this was all new, and several dozen of us crammed into the screen like a University Challenge episode on steroids.

Cooking too much as if my friends were coming over for dinner, and then missing them when of course they don’t…

Once in a Lifetime

That’s the sort of stuff memories are made of.

But in reality – as suggested by the number of relevant links below – I’ve spent 4-6 hours each day digging into Covid-19, consuming everything from Tweets and news stories to research papers (or at least their abstracts!)

If you’ve been following the comment threads that have followed Weekend Reading these past few weeks then you might be the same. We’ve had hundreds of contributions, suggestions, and counter-suggestions. Great stuff.

However some readers – and my friends and family as usual – think I’m crazy.

They are happy (or commendably humble) enough to leave Covid-19 to the government experts. They don’t want to second-guess the consensus.

They’re passive pandemic-ists.

Whereas I like to believe that I’ve been trying to figure out the virus in part to inform my naughty active investing.

Or that’s what I tell myself.

Really, I’m sure it’s also my way of coping with Covid-19, just the same as other people are drinking too much or working out twice a day or pressure cleaning the patio.

As Arthur Brooks wrote in The Atlantic this week (my bold):

At present, Covid-19 is more of an uncertainty than a risk.

Will you get the virus? What happens if you do? When will the crisis end? Are we creating an economic depression?

People can opine and make informed guesses, but no one really knows the answers to these questions.

It’s natural to try to convert uncertainty into risk by gorging ourselves on available information.

And I’ve definitely been doing that.

Brooks thinks it’s futile and only liable to make things worse. It makes me think of my late father, who if he were still here would be both vulnerable and sanguine.

I’m sure he’d have quoted the serenity prayer at least once. You know the one:

“Grant me the serenity to accept the things I cannot change, courage to change the things I can, and wisdom to know the difference.”

But I can no more do that then I can sit in a tracker fund, however sensible. It’s not me.

Stop Making Sense

One comment asked last week why I’ve not written an article about the virus, and fully outlined and sourced my hypothesis?

(Which for what it’s worth has basically been that it’s more widespread and not as deadly as commonly believed – all less controversial now than a few weeks ago, I’d suggest – and that an ongoing extreme lockdown could do worse to us via economic damage, including health-wise, so we should phase out of the justifiable emergency measures ASAP, and more directly focus on protecting the most vulnerable.)

The first reason is the one I gave him, which is I have no expertise at all in this area. My hypothesis was simply where my reading and hunches were leading me, and I was happy enough kicking that about with readers.

But the other reason is that word ‘hunches’. It’s perhaps also another reason why I don’t write about active investing here anymore. (The main one being that most people will definitely do better investing passively!)

People want certainties. They want to know sunlight does or doesn’t slow the spread of the virus. They want to know that low P/E stocks will do better than high P/E stocks. They don’t want to wonder too much why one city has had thousands of deaths from Covid-19 but a similar city has not. They want to be told that investing for the long-term is better than being tactical and trading, or vice-versa, and they want evidence to show it.

Me, I’m very comfortable with fuzzy, nuance, intuition, and changing my mind – for good and for ill.

Life During Wartime

One day we’ll know all about this virus and everything will be proven, but by then it’ll be too late to do anything.

And one day we’ll know if the FTSE 100 at 1990s-levels was the buying opportunity of a lifetime, or the opening bell on a multi-year bear market that sloped in ahead of a looming depression.

Again, by then it’ll be too late to do anything about it.

I’m not saying I know what will happen, obviously. I’m saying I’ve got to try to guess. Doing so will be my memory of 2020, in the end. Each to their own. (And incidentally I’m very glad I don’t have to decide for the nation. All governments have made mistakes, but these are crazily difficult times.)

How are you coping with the coronavirus uncertainty and life under lockdown? Let us know in the comments below.

[continue reading…]

Read any article praising income-orientated investment trusts and you’ll hear about their revenue reserves.

These reserves, you’ll be told, are a hidden benefit of investment trusts – one reason the so-called dividend heroes have been able to grow their dividend payouts for 20 years or more.

The reserves will be compared to a rainy day fund. Some journalists will be more explicit, talking about trusts keeping back “some of the cash for the bad times”.

This is a typical from the Financial Times:

During bad years when dividends may be scarce, the investment trust can dip into the revenue reserve to either maintain or grow the trust’s own dividend payments.

And here’s Hargreaves Lansdown:

Investment trusts can put some dividends aside for a rainy day.

They can hold back up to 15% of their income in good years so they can top up dividends paid to investors in the bad years.

It’s known as a trust’s ‘revenue reserve’.

These statements are right – but they may give you the wrong impression.

It’s true that most investment trusts have a revenue reserve.

But this reserve is simply a bookkeeping entry. It’s not a pot of cash tucked away in the fund manager’s attic.

Tapping the revenue reserve will enable a trust to maintain – and even grow – its dividend. But there’s no adding a few notes from a fat wodge of crisp £50s going on here!

Instead, the manager will do what else anyone would if they were short of a few bob and needed income.

They will sell some of the trust’s investments (its net assets, or NAV) and pay out the proceeds as part of the dividend.

I don’t think that’s what most people think of when they hear ‘cashing in the rainy day fund’…

Smoother operators

You may be wondering then why everyone bangs on about revenue reserves? Are they useless – like some vestigial organ we’ve outgrown?

Well, not exactly (although trusts have indeed evolved in recent years, as I’ll get to before we’re done).

The first thing to stress is investment trusts really can provide a steadier level of income than open-ended funds, thanks in part to those revenue reserves.

That’s because a standard open-ended fund – whether an index fund or an active fund – must distribute all of the income it receives to its investors at regular intervals.

This means the income you get from such a fund will fluctuate with the payouts it recieves from its holdings.

In contrast, investment trust rules state they only have to pay out 85% of their income each year. The remaining 15% can be allocated to revenue reserves.

If the income the trust receives from its underlying portfolio dips, the trust can then top-up its own dividend by getting extra money via these revenue reserves.

So from an investors’ perspective, the trust’s dividend really has been ‘smoothed’. That may be preferable for planning purposes, for example, and the revenue reserving malarkey has done the job.

But there’s nothing magical going on.

At some point in the mists of time, this trust received some cash, paid out less than 100% of it, kept the change, and added to its revenue reserves bookkeeping entry. Now it’s paying that out later.

In contrast an investor in an equivalent open-ended fund would have received a higher payout (i.e. 100%) earlier.

So it mostly comes down to personal preference. Do you want to get your income as it comes from an open-ended fund, or would you rather have a manager smooth the payouts for you?

If I was using funds for retirement income, I’d rather the steady option, particular if I was getting on. Not having to think very hard is a big benefit of an income investing approach in my view. But your tastes may vary.

Of course many investors don’t care either way. They prefer a total return approach to investing. Their strategy is to sell a percentage of their portfolio to generate whatever spending money they need (as detailed in The Accumulator’s many articles on the sustainable withdrawal rate).

Again, personal preference. According to financial theory it should all work out the same in the end (assuming you’re comparing like-with-like).

Dividends paid out from capital profits

Why is this article still going? Aren’t we done?

No. There’s some mopping up to-do, because nothing is ever simple with investing.

Firstly, in 2012 the rules were changed so that investment trusts could pay dividends from money raised by selling their profitable investments – even though these capital profits weren’t ever allocated to a revenue reserve!

I forget why the rule was changed – probably something to do with offshore funds – but as far as I can see it’s made the whole concept of revenue reserves a bit moot. Perhaps these days they’re mostly a marketing gimmick?

There are now investment trusts that explicitly state they will pay, say, a 4% income, by selling 4% of their net assets over the course of a year.

If one trust can do that, I don’t see why another can’t sell any investment it has made a profit on – or cash it previously earned from selling profitable investments – to top-up an underweight dividend.

One niggle may be that trusts are companies with their own articles of association, so it may require shareholder approval to change the rules.

But they’ve had since 2012 to change the fine print – and were advised to by their trade body – so you’d hope most would have.

Years of dividend cover in reserves

Second bit of mop-up – the juicy-sounding concept of ‘years of reserves’ of dividend cover, which also invariably comes up in those revenue reserve articles.

As IT Investor wrote last week:

55% of trusts that pay a dividend have a revenue reserve covering at least 0.5 times their most recent annual payout.

An impressive 45% have reserves of at least 1 times their latest annual dividend.

13% have at least 2 times.

If we assume dividends fall by a third this year and take two more years to get back to 2019 levels, then a trust needs about 0.5 years in revenue reserves to see it over.

You can find out how many years of (notional) revenue reserves a trust has by reading its annual reports. Or you can dig around on the AIC website.

However following on from what I’ve written above, I don’t believe it matters much anymore.

Trusts can now pay dividends out of capital profits, so a trust with zero revenue reserves could increase its dividend if it wanted to, presuming it’s made some profitable investments

I suppose in a bear market that’s not guaranteed, especially for newer trusts.

Then again if a trust is seeing income fall and no gains on its investments, is this really a good time to be returning cash to shareholders? Is it even a trust you want to own?

Short of cash

Finally, I should say that as far as I know a trust could actually keep its revenue reserve in cash. And most trusts do hold a little bit of cash, after all.

However if you study their portfolios or read their annual reports, there is usually little indication this is the case – or in fact any sign of how a revenue reserve is actually invested.

To give an extreme example, the Caledonia trust said in its 2019 annual report that it had £1,794m in reserves:

“…broadly equivalent to 55 years’ payment of the current annual dividend, which could be used to smooth any investment income shortfall.”

Those revenue reserves are more than the current market cap of the trust! And as of that report, the trust held only £112m in cash.

Almost all Caledonia’s assets were (sensibly) in more productive investments, such as property, equities, and bonds.

This makes Caledonia perhaps the most glaring example of the fallacy of the ‘piggybank of cash’ mental model of revenue reserves.

Bottom line on revenue reserves

The ability of investment trusts to smooth their income payments is a nice enough feature. But don’t get bedazzled by talk of revenue reserves or hints of some semi-magical ability to plump up dividends.

To make up for a shortfall income, investment trusts will mostly have to sell capital, just like anyone else.

I like investment trusts, but they are much more complicated than normal funds. You have to get your head around premiums and discounts, and they can use debt, too, so will usually be more risky than an open-ended equivalent.

So – ahem – reserve your enthusiasm.