Missing the Bigger Picture Can Be Costly – When 3 Years Matters More Than 100.

You may remember not that long ago interest rates were flirting with 0%. Unlike the U.S., Austria decided to capitalize on a great opportunity to lock in historically low interest rates for a very long time. In 2017 Austria issued a 100-year bond that was sold at a rate of 2.1%. Cheap money became cheaper as interest rates continued to trend lower over the next three years, prompting Austria to again come to the market with a new 100-year bond in 2020. This time they were able to lock in an interest rate of 0.85%. Keep in mind, that meant for the next 100 years Austria only must pay $8.50 of interest per year for each $1,000 bond— and this 2020 issue is about $2.2 billion of debt. The Austrian government probably regrets that they didn’t give investors all the bonds they wanted, because the issue was oversubscribed by $20 billion (investors wanted 10x more than was sold). Fast forward to 2023 and the Austrian government now looks brilliant while investors are wondering: “What were we thinking?” Investors suffered big losses and it is not hard to figure out why; they only focused on the short-term. There are some valuable lessons here.

 

 

The first bond that was sold in 2017 had increased in price 85% by 2020 due to declining interest rates. Investors were seduced into thinking there was more quick money. Interest rates were low and showing no signs of moving higher soon, so even with a small decline of 0.25%, investors would realize a gain of 10%. That seemed doable for the 2020 issue, if rates declined just another 0.85% to 0%, gains would approach 40%. Everything seemed to be favorable for investors in 2020, because there were several European countries with 10-year debt already at a negative interest rate, so 0% rates in Austria seemed possible. As is always the case, the last people to leave the party usually don’t feel too good the next day. The bonds that were issued in 2020 are now only worth about 40% of their initial offer price, or $400 of the initial $1,000 value. It is hard to imagine that investors did not think that at some point in the next few decades, or at least well before 100 years, interest rates would eventually be higher than 0.85%. As is often the case, nobody seemed to care about the long-term consequences of being wrong, they wanted fast money. The Austrian government is rated AA, so this story is not about Austria suddenly turning into Greece. It is a story of simple math and seeing the whole picture. This is what happens to a bond when interest rates change. The bonds have now declined by 60%, it will take approximately 70 years of interest at $8.50 per year ($600 divided by $8.50) to get back to even (it is slightly more complicated, but you get the point). The lessons we can learn are simple; don’t ignore the bigger picture and be extremely careful when the risk is higher than the reward. The interest rates on these bonds had little room left to decline, but a lot of room to go up, which is bad for bondholders. They are currently yielding 2.7% at a price of $400, so it will only get worse if Austrian rates climb to 4%. How much worse, you ask? Another 40% decline from present prices. That is called a financial disaster for investors and this same scenario applies to the stock market.

 

 

Davis Advisors illustrates a study done by Charlie Bilello that shows if you had invested in 1928 through 2022 (not 2120), what your return would have been if you had the foresight to sell one year before the start of a recession and then buy back into the market one year after the recession ends. If you were offered that option, would you take it? You likely would have avoided many of the 25 times the market declined by at least 20% and your annualized return would have been 9%. Giving up some volatility while still earning an attractive return is tempting. The alternative was to not trade in and out over those 94 years, which also meant you would not miss any of the big recoveries. By not trading, you compounded your money by 9.7% per year. What is the real cost of giving up some volatility? From an initial investment of $10,000, that 0.7% extra return compounded over 94 years almost doubles your money and earns you an additional $27 million. It’s a big number but nobody expects to be invested for 94 years and not touch it, and few investors buy bonds that mature in 100 years, so what is the point?

 

 

It seems that almost everyone thinks that a recession is coming, and it is normal to not want to watch your money decline. It seems obvious now that when interest rates were 0.85% it was virtually a certainty that at some point they would be higher, you just could not time it. We know a recession is coming, we just can’t predict when, but it is virtually guaranteed that the economy will eventually be higher after the recession ends. This is the antithesis of the low interest rate scenario we just described. You know at some point stocks will be higher and all the research points to recessions can’t be timed. This still doesn’t make it any easier to resist selling. A growing dividend strategy helps to keep you invested and it tends to be a higher-quality portfolio that eventually recovers with the economy. It is not a silver bullet nor is it always the best strategy, but it does help keep you invested. The best results almost always come from a long-term approach and seeing the bigger picture.

 

Observations On The Market No.387