Your bond portfolio is your back-bone. It supports both the fixed-income and growth aspects of your portfolio by virtue of its stability, predictability, and cash-producing nature. No matter what, you know what kind of returns you’ll be getting from this portfolio, provided that there is no economic apocalypse that renders your entire portfolio worthless.
That being said, the presence of a raging gold boom looming over the markets throws a wrench in even our most cautious of plans. While, on the one hand, the liquidation of the gold markets might present an opportunity to pick up some serious short-term gains from our bond portfolio, the longer term implications mean that we’ll need to seriously buckle down to save the proceeds.
As I’ve mentioned ad-naseum throughout this series on the implications of a Gold-Bust, the value of Gold Bullion stems from its physical nature, and its ability to store value. In the event of a liquidation in gold, the market is effectively losing faith in the ability of gold to store the value of their wealth in comparison to other investment opportunities. Essentially, people believe that the price of gold will decrease. In this event, the market will begin searching for other stable investment opportunities, which will lead them to pouring money into the bond market.
Assuming the gold bulls are pursuing value maintenance, they will very likely turn their funds towards extremely safe government and corporate bonds after having sold their holdings. However, safe bonds are already extremely expensive, to the point at which they yield less than half a percentage point at some times. This means that the value of these bonds will increase even more, causing something extreme strange to happen.
All of a sudden, we will see that our bond portfolio, the stable back-bone that we never invested with the intention of earning capital gains on, will be trading at an extremely valuable premium. While I’m in no position to advise on what sort of actions should be taken in this sort of scenario, I’m comfortable saying that I would personally be selling off positions in the back-bone to take advantage of what is very likely to be a short-term ‘pop’ in prices.
While realizing capital gains from a bond sale is extremely rare for a personal investor, it is important to recognize what this sort of situation signifies to the market. Suddenly, the market has decided that bonds are worth more than before, and borrowers are therefore able to begin issuing new debt at lower rates. This will then increase the value of our riskier fixed-income investments, and continue to compel us to sell-out for short-term gains.
However, as the new debt issuances come with lower yields, we will not be able to re-invest our money at the same rate of returns as before. This is known as ‘re-investment’ risk, and it presents a sizable issue for us in this situation. Specifically, we need to be aware of the fact that we will need to re-invest the proceeds of our capital gains into a lower-yielding security in order to maintain our regular cash flows. So the question on the table is one of whether or not we have actually incurred a long-term profit? In the next article, I’m going to describe how it is we should evaluate re-investment risk, and make the decision as to whether or not we should sell or hold in a situation like the one described above.