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Low yields prove an investor's challenge in deflationary times

By Neville Bennett

Friday 13th June 2003

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Not everyone likes to study charts. Yet even sceptics might like to look at the yields on the New Zealand government 10-year bond. The trend is unusually pronounced. Yields have steadily trended downward from 19% in 1985 to 5.4% at present.

It doesn't need a rocket scientist to deduce the trend will continue. The yield on the 2013 bond fell from 5.36% to 5.29% in the last week. It was aided, of course, by the Reserve Bank's cuts and indication further ones will be made when necessary.

The trend is one of the decisive events of our times. It radically illustrates the transition from an era of galloping inflation to a relatively controlled era. It is a sobering demonstration that investors could in the 1980s secure a near 20% gross yield from an absolutely secure investment.

In contrast, yields on bonds have fluctuated between 8% and 6% since 1997. The latest break below the 6% line suggests the downward trend will continue, especially if the global deflationary trend gains momentum.

The deflationary trend globally is strong. It dominates Japan, Hong Kong and Germany. US Federal Reserve chairman Alan Greenspan has indicated it is that country's greatest danger. The IMF has also registered some alarm.

The point will not be argued further here but it is clear the market is saying deflation is looming on the horizon. The yield curve is unequivocal, and a chart is worth a million words.

My first reaction was that retirement was going to be delayed, as my savings are insufficient to generate enough income for my family in an era of low yields. The implications are much wider as I save more than the average New Zealander.

Most households had negative savings in the late 1990s. Perhaps they had faith in the state's generosity. Perhaps they thought their funds would grow exponentially. Spending increased, saving slipped.

It is possible the bear market in equities has changed attitudes, although it is also possible many are in a feel-good mood from rising house prices. Others are severely bemused that most funds have lost about 20% a year over the last couple of years. When the housing bubble deflates there is going to be a lot of discontent in the middle class and this may dent confidence in the Labour government.

The real message of falling yields is that people will have to save more vigorously if they are to generate additional income in their retirement. Let us illustrate the point.

The first assumption is that the investor will shun risk and will purchase bonds with a good credit rating, as it is stupid to risk losing one's capital in shaky investments (NBR, June 6). So it is assumed the nest egg generates a gross yield of 6%. Taxation will remove about a third. So the net yield will be 4%.

That is lousy. The average baby boomer will be deeply shocked. Their generation has known wonderful net yields for decades. They also know compound interest will make their investments grow rapidly. Now the reality is different. It is bad for the 60-year-olds.

It is worse for the 40-year-olds. Let us imagine a rather fortunate household: they are buying a house, drive nice cars, have good holidays and are educating their children. This consumes all of their income, and will do so for many years.

However, they do have a cash nest egg of $100,000 as a result of a legacy. They assume the cash will grow into a tidy sum by the time they are 60. My calculation is that at 4% net their nest egg will grow at compound interest to $219,000 in 20 years. It takes 18 years for cash to double at compound rates of 4%. And at the end of 20 years they will have only $7700 in annual income from their capital.

It might get worse. The yield on good bonds might fall further. And who can be sure taxes on capital will not increase?

My guess is that a 4% net yield will look quite good in five years' time.

The downward trend in interest rates is strong and it is possible the government will increase its tax-take to finance its voter-friendly and ever-increasing expenditure on welfare, health and education.

Let's imagine things get bad: $100K @ 3% for 20 years is $180K and at 2% it grows to $148K. Yields did reach 2% in the depression (and are less than 1% at present in Japan). My guess is that taxes are more likely to rise than fall in the next 20 years. It is not safe to discount the possibility of falling net yields.

How much must you save to become a millionaire (excluding your house and contents)? Charles Schwab gives some data for Americans (who have it easy, as they get tax breaks). Apparently, a 45-year-old, who starts from scratch to save a million by the time he is 65, must put aside $15,500 a year. If the person starts at 50, the rate is $29,000 and at 55 $60,000. After that, forget it.

What to do? One response, and there are others, is to delay consuming the portfolio's income. In effect, this allows compound interest to work its way for longer. Yet even delaying retirement does not help much.

Let us examine the case of 60-year old Jim who has a house and $500,000 in fixed interest. He intends to retire this year. Next year his portfolio yields a 3.5% net return, after tax. The income is about $17,500. He decides to work for another five years. He takes no income from his investment but puts in another $10,000 a year. At 65, his investment has grown to $643,000, and at 3.5% it yields about $22,000.

This is pretty tough on Jim. He feels hard done by as he has scrimped and saved to get his investment together. The yield is about the same as the state now hands out to a married couple (at present $18,000, but it will increase in five years).

The low yield is therefore a grim scenario.

Nevertheless, this column will help readers to some more profitable ideas. A few weeks ago, it suggested diversifying into Australian assets. The timing was sweet. We picked the top of 93c. It is 87c now: so the play has gained 6% gross quite quickly.

Two weeks ago, we picked the top of the New Zealand dollar's value against sterling: that is paying off, too.

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