I believe any private investor can create a sound and well-diversified investment portfolio by using just two assets as building blocks – a world equity index fund, and an appropriate government bond fund.
Other assets can be added to suit. But those two assets alone can be a firm foundation for your long-term investment plans.
There have already been several articles here on Monevator about world index funds. However I’ve not spoken much about the second piece of the puzzle – the minimal or ‘risk-free’ government bond fund.
This article is one of a short series to put that right!
Today we’ll look at how you can decide upon the lowest-risk investment that will be the basis on which your riskier portfolio can be built.
Next time I will describe how and why you should match the time horizon of your minimal risk asset to your investment time horizon, how you invest in your chosen minimal risk asset, and what returns you can expect to make.
What is the minimal risk asset?
For a sterling-denominated investor, short-term UK government bonds are a good choice for your minimal risk-asset.
There is probably no genuinely riskless security in the world today. However the probability that the UK government will default on its debts is as low a risk as we can find when investing in sterling. Thus it is ‘minimal risk’.
Incidentally, cash in the bank is not entirely without risk, as I have discussed before on Monevator. But it is worth looking briefly at cash as a minimal risk asset, as there can be some particular benefits for private investors. Look out for that below.
One of these days I’ll also outline why other asset classes traditionally designated low risk – gold, property, physical assets – are not that low risk at all.
Buy government bonds in your base currency
Your choice of your minimal risk asset also depends on your base currency.
A US-based investor buying short-term UK government bonds has the same security of getting his principal back as any British investor. But they also incur additional currency risk due to exchange rate fluctuations.
If, for example, the UK government bond promised to pay the investor £101 a year hence for a £100 investment today, both investors are equally certain of receiving £101. But while the £101 would always be £101, the US dollar value of that amount will fluctuate quite a bit and is thus riskier.
The US investor would therefore be better served by choosing as their minimal risk asset short-term US government bonds. These bonds would be of a similar credit quality to the UK government bonds, but the returns would be independent of currency risk.
Similarly, a French or German investor could opt for German government bonds.
Wait, what is my base currency?
While most reader’s base currency is obvious (sterling for UK investors, dollars for US ones, and so on) and currency risk is a risk you would rather avoid, your base currency can also be a mix of currencies.
Your base is the currency that you think you will one day need to spend the money in.
For example I live in the UK and will probably have the majority of my future expenses here. But I also spend a lot of my time (and my money) in Denmark, the Eurozone, and the US. I may have future expenses for my children’s education outside the UK, and my wife and I might live or retire abroad one day.
By having my base currency as a mix of several currencies, albeit dominated by sterling, I can better match my future cash needs and reduce the risk of my being caught out by a falling currency against my future foreign-denominated expenses.
Rate my bonds
If your base investment currency is one where the government credit is of the highest quality, those government bonds will generally be a great choice for your minimal risk investment.
But how do you know if your government bonds are the good stuff?
Most people will need to turn to the professional ratings agencies. Today there are three major credit agencies that rank the creditworthiness of bonds – Moody’s, Standard & Poor’s and Fitch.
Here are the classifications these agencies use to rate long-term bonds:
|Long-term bond ratings||Moody’s||S&P||Fitch|
|Investment grade||Aa1 to Baa3||AA+ to BBB-||AA+ to BBB-|
|Non-investment grade||Ba1 to Ca||BB+ to C||BB+ to CCC|
|Default||C and lower||D||DDD to D|
The credit agencies were widely discredited after 2008 when they wrongly gave high ratings to all sorts of sub-prime garbage. In general though they give you a good indication of the credit quality of a country’s bonds.
Credit ratings change frequently. When you consider adding to your minimal risk asset, you can look up the latest credit ratings on Wikipedia by searching for ‘List of countries by credit rating’. If the government credit of your base currency is listed there as AAA then you have an easy choice for your minimal risk asset.
With the adverse environment of government debt and deficits in recent years, the list of AAA-rated countries from all agencies has shortened. That said, if your home base currency offers AA or higher-rated bonds then it would be sufficient to accept those as your minimal risk asset. If we only accepted bonds with the very highest rating, at the time of writing this would exclude bonds from major economies like the US, UK, Japan and France, which is neither practical nor desirable for many investors.
While there is obviously a reason for these countries losing the highest rating, it is worth noting that the financial markets trade these countries’ bonds at real yields that are among the most creditworthy in the world in any currency.
Beyond government bonds
I have referred repeatedly to government bonds, but what we are really after is the lowest risk investment for you, given your currency and maturity.
In many countries, there are other kinds of domestic bonds related to the sovereign issuer, such as government-guaranteed regional, city, or municipal bonds. Those and similar bonds could be reasonable alternatives as minimal risk assets, particularly if there are tax or other advantages to investing in them. However, you need to make sure that the government guarantee is bulletproof, even in distress.
If you get a superior yield from these alternative bonds compared to the standard government bonds, you are probably taking additional credit risk.
Also, be careful in thinking that adding these kinds of bonds provides you with additional safety. They are typically poor diversifiers of risk, because they tie back to the same creditworthiness as the domestic government bonds.
In the end, government bonds will often be the best choice for the minimal risk asset.
What about cash?
Everything I’ve written so far would apply today to funds and to most very wealthy individuals.
However what if you’re a more typical private investor, with maybe a few tens of thousands of pounds invested in your ISA or SIPP – or even a larger portfolio but with your non-equity allocation still amounting to a low-ish six-figure sum?
Well, these days you may decide it is better to keep your minimal risk asset as cash instead of government bonds.
There are a couple of reasons for this. For one thing, after years of easing by central banks, government bonds yields are currently very low. Depending on which country you’re based in, you may well be able to find cash savings accounts that pay a higher interest rate than you’ll get on similar government bonds.
- For instance, in the UK you can currently get almost 2% for cash that you lock away for three years, provided you choose from the Best Buy accounts.
- In comparison, short-term UK government bonds (gilts) are yielding less than 0.5%.
To trust that your money in the bank is safe, there has to be a reputable credit insurance scheme in place. In the UK that’s the Financial Services Compensation Scheme (FSCS), which guarantees deposits in authorised banks to the tune of £85,000.
Now, while the FSCS was set-up by the UK government, it operates independently of UK lawmakers. The compensation scheme is funded by compulsory levies on financial firms authorised by two UK regulators – the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA).
The scheme has paid out billions in compensation since being set up by Act of Parliament in 2000, and means cash in a bank that’s covered qualifies as ‘minimal risk’ under any sensible definition of the term. However you might wonder what would happen if the FSCS ran out of firepower due to a financial crisis?
In practice, while the FSCS operates independently of the UK government, the latter provides an implicit backstop. For example, in 2008 the authorities and the FSCS worked together to guarantee the deposits of 2.5 million customers of the Bradford and Bingley Building Society, which saw the FSCS receive an initial top-up loan from the Bank of England and later from HM Treasury.1
Effectively then, provided you choose an FSCS-covered bank for your savings, you have the same credit risk as with gilts – because both are backed by the UK government – but you’re getting a higher interest rate.
That’s attractive, and not an option for institutions.
Remember that if you decide to use cash as your minimal risk asset and you have more than £85,000 to find a home for, you’ll need to open more than one account with different FSCS-protected firms – operating under separate banking licences – to ensure all your money is covered.
You will also have to keep moving your cash as your higher-rate terms come to an end.
At some point as your wealth grows you might decide it’s easier to keep your money in bonds, not least for the diversification benefits – government bonds tend to go up when shares fall – and also because the yield on government debt may improve in the next few years, and so reduce this ‘free rider’ gap between cash and short-term government debt.
Remember that any credit insurance backing a bank is only as good as the government providing it. Besides the details of the credit insurance scheme itself, you’ll want to evaluate how the credit markets perceive your government’s standing when deciding whether you can trust such schemes.
Also remember that in a really dire scenario, it’s possible a country’s government may decide to reduce the compensation limits, which might mean it was ‘fake insurance’ – and not there when you need it.
However for the UK and US I believe this is very unlikely indeed (the UK actually extended its coverage to Icelandic banks in the last crisis).
Help! I don’t trust my government!
For all their undoubted economic successes over the past decades, countries like Brazil, Mexico and India do not have highly rated government bonds – they are all BBB rated or lower at the time of writing.
If your base currency is one without a highly rated bond available, you face a tougher choice.
For example as an Indian you could buy Indian short-term government bonds, which would not be minimal risk, or else you could buy highly-rated government bonds in one or a couple of foreign currencies, which introduces currency risk.
Depending on the credit rating of your base currency government, you may choose to take the credit risk of the domestic government bonds instead of taking the currency risk of highly rated foreign bonds, or perhaps even keep money in cash deposits in the local bank if that is considered a superior credit option to domestic government bonds.
Incidentally, the absence of a great local currency minimal risk asset is one reason why an asset like gold is the de facto ‘money under the mattress’ asset in places like India.
Older people in certain parts of the world, such as India, undoubtedly remember previous eras of domestic economic turmoil. The thought of buying local government bonds as their minimal risk asset will seem like heresy to them.
And they are right. These investors do not have essentially risk-free bonds in their local currency – however far the government has come. Perhaps one day the credits of these governments and many like them will grow in esteem to the point that they become the lowest-risk bonds in the world, but not today.
As a result, investors with a less-creditworthy domestic government often make their base investment currency the US dollar, because of its status as the global reserve currency. They then choose US government bonds as their minimal risk asset.
While the lower credit ratings of some countries’ government bonds mean that their bonds yield more, this is not a good reason to have them as your minimal risk or safe asset. If you want to add returns to your portfolio, you can do so by adding broad exposures of equities instead. These have the added benefit of both being geographically diversified and adding expected returns.
Consider diversifying even the very low risk that your domestic government might fail
Investing in sub-AA credit ratings is a question of degrees. Some investors would be happy to invest in their BBB-rated local currency government bonds whereas others would rather invest abroad with currency risk than have an AA domestic-rated government bond.
The choice partly depends on your situation and your sensitivity to currency risk versus domestic credit risk.
For those inclined to accept sub-AA domestic government bonds as your minimal risk asset, I would encourage you to think about what else would happen in your portfolio if your domestic government defaulted. In many cases, a domestic government default could have a catastrophic effect on your portfolio and on your general life. If you had diversified some of the domestic risk away by having your minimal risk asset as highly rated foreign bonds, such as German, UK, or US government bonds, then you would at least have some respite when the domestic calamity hit.
Some investors believe that having all your minimal risk assets invested in the bonds of just one government, however creditworthy, is a bad idea. Those investors argue that while the government bonds of Britain or Germany are highly rated today, there is always some risk that they could fail – perhaps even spectacularly and quickly2. Because of this possibility, they argue investors should diversify their minimal risk asset into a couple of different, highly rated government bonds, even if this means taking a currency risk for those bonds that are not in your base currency.
My own view is that if you are invested in government bonds that are among the most highly rated in the world, the probability of a sudden default is so low that for practical purposes it is a risk you can feel safe taking.
Minimal risk assets and you
Here are my own recommendations for minimal risk assets for various base currencies:
|Base currency:||Suggested minimal risk asset:||Alternative minimal risk asset:|
|US dollar||US government bonds||Mix of world-leading government bonds
(take a currency risk)
|Euro||German or AAA/AA Eurozone government bonds||Mix of world-leading government bonds
(take a currency risk)
|UK Sterling||UK government bonds||Mix of world-leading government bonds
(take a currency risk)
|Other currency with AAA/AA government credit||Domestic government bonds||Mix of world-leading government bonds
(take a currency risk)
|Other currency with sub-AA domestic government credit||One or a mix of world-leading government bonds (take a currency risk)||Domestic government bonds
(take a credit risk) or bank deposits if a strong credit bank (or other)
As you can see, I believe your minimal or ‘safe’ asset is not necessarily your domestic government bond.
Consider a Spanish investor who is after the lowest risk asset, and does not want to take a currency risk. This investor should not be buying Spanish government bonds that are relatively lowly rated, but rather should buy German government bonds that are also euro denominated.
If this investor did not want the minimal risk to be the bonds of just one government, he could diversify by either adding other euro-denominated government bonds, or he could accept the currency risk of investing in highly rated non-euro government bonds from the US or UK.
Watch out for more on risk
Below you’ll find a video that recaps some the things I’ve discussed in this article. (You will also find other interesting videos on my YouTube channel).
In my next article I’ll explain why and how you should match the time horizon of your investment to the minimal risk asset, what returns you can expect from these minimal risk investments, and how you can go about buying them.
- In the end, B&B customers were transferred to rival Abbey and compensation was not required. [↩]
- For those who don’t think government bonds can default I would encourage you to read This Time is Different: Eight Centuries of Financial Folly by Carmen Reinhart and Kenneth Rogoff (Princeton University Press, 2011). The authors make a mockery of the belief that governments rarely default and that we are somehow now protected from the catastrophic financial events of the past. [↩]