Most investors have a deep-seated belief that bonds are a
safe investment while gold is risky and volatile. If we explore this belief
with an open mind, however, we will find that gold, not bonds, offers vastly
superior wealth protection.
The 2008 financial crisis saw an unprecedented move out of
equities and into bonds as investors looked for a safe haven, one that would
protect their portfolios. Relatively few investors chose to move into gold.
This is curious because gold, unlike bonds, is an asset class that has a
negative correlation to financial assets, thus providing the greatest
diversification as well as protection from inflation and currency crises.
This is illustrated in Figure 1, which shows how
gold has outperformed all major asset classes.
In addition, gold has outperformed all major currencies,
as illustrated in Figure 2.
The US government's response to the 2008 financial crisis
was to embark on and continue with policies of extreme stimulus and bailout
packages. These policies will provide only a temporary reprieve, a Band-Aid
solution to America's dire situation. Since the financial crisis was caused
by excess debt, issuing more debt can hardly be the cure. The US Treasury,
with help from the Federal Reserve, essentially flooded the economy with
excess dollars, driving the money supply to unparalleled levels and inviting
the very serious threat of future inflation.
In Figure 3, we see gold offering another distinct
advantage over bonds; historically, it performs well during periods of
inflation. Bonds, however, are severely hurt by inflation, which wipes out
the purchasing power of the principal balance as well as the purchasing power
of the bond yield.
When considering inflation, it is important to use
accurate, honest data.
Currently, the official Consumer Price Index (CPI) stands
at a very modest 2 percent. However, the methodology for calculating the CPI
was changed in the early 1980s. Instead of using a fixed basket of goods that
represented a certain standard of living, today's methodology uses
substitution, hedonic adjustments and geometric weighting to understate the
CPI. John Williams of www.shadowstats.com, calculates the CPI using the
original methodology, as shown in Figure 4. From this, we can see that
real inflation is already at 8.5 percent and is poised to get much worse.
The US government is also intervening to keep interest
rates artificially low by having the Federal Reserve issue new money with
which to purchase US Treasury debt. With interest rates at record lows there
is no room to maneuver, except with further quantitative easing, which Fed
Chairman Ben Bernanke has already stated he will continue to use. This will
only serve to increase the money supply and lead to higher inflation. This
policy of aggressive quantitative easing - or, to put it bluntly, money
printing - will most certainly devalue the US dollar further, again eroding
the real value of bonds and boosting the prices of precious metals prices and
other commodities.
Critics of gold as an investment will argue that the
yellow metal does not pay any interest. While it is true that gold held in a
vault does not pay interest, it also has no counterparty risk and cannot
decline to zero. Bonds are subject to credit rating downgrades as well as
defaults, as became clear in the 2008 crisis, and can become worthless.
With interest rates much lower than inflation we can see
that, in relative terms, it is bonds that are not providing any returns. With
real inflation at 8.5 percent, bonds are not a safe investment; rather, they
represent guaranteed annual losses of about 5 percent of purchasing power. At
this rate, bond principal will be halved after 14 years. Gold, however, has
generated annual compounded rates of return of 16.7 percent.
Gold investors who require cash flow can simply liquidate
part of their gold gains in order to generate such cash flow. To match the
after-tax cash flow from bond interest payments, investors need only
liquidate part of their capital gain; the remaining gain would be enough to
keep the purchasing power of the principal from declining.
BMG has a comparison chart on its website that compares
bond income to a systematic withdrawal of units in BMG BullionFund, taking
tax and inflation into account. The chart is customizable to investors' own
situations and/or expectations, and can be found at www.bmgbullion.com/calculator.
The example in Figure 5 compares bond income to an
investment in BMG BullionFund with systematic withdrawals, assuming an
investment of $1 million, a 4 percent bond yield, an 8 percent inflation rate
and a 13 percent annual appreciation of BMG BullionFund.
The BMG bond calculator shows the inflation-adjusted cash
flow and the inflation-adjusted principal. In the grey section under the
heading "Bond vs. BMG BullionFund/Inflation Adjusted/2008 Dollars",
we can see that the after-tax bond interest income starts at $24,000 and
reduces to $11,332 in purchasing power by the tenth year. The bond principal
balance reduces from $1 million to $472,162.
In the gold section, BMG BullionFund investor has
liquidated only part of the annual gain, but still maintained the
inflation-adjusted purchasing power of the after--tax cash flow for the
entire period. In the "Inflation-Adjusted After-Tax Income"
section, we can see that the $24,181 net cash flow was increased to $27,347
in the tenth year. BMG BullionFund nominal value increased to $2,686,169
while the inflation-adjusted value of BMG BullionFund holdings increased to
$1,268,306.
Bond returns are so minimal at present that it has given
rise to the serious question of whether the bond sector is in a bubble and
subject to losses if interest rates rise. This is perhaps a separate
conversation, although it is common knowledge that feverish, inexplicable
buying is the cornerstone of any bubble; with the negligible interest rates
on bonds being wiped out by inflation, it is hard to understand the attraction.
While the Federal Reserve can control short-term interest
rates, when bond investors around the world lose confidence in the US economy
and its currency, bond yields will rise and bond values will fall. In
addition, there will be day-to-day inflationary losses.
Finally, it is worth noting that bonds, like equities, are
a financial instrument, someone else's liability; a holding of physical gold
bullion is not. A bond holder gives up their money and risks a loss of
principal for a certain period of time in return for a yield. A holder of
physical bullion could lease out their gold and generate income, but they
seldom choose to do so as it is precisely the safety of preserving wealth in
real terms without risk to capital that savvy investors seek in uncertain
times.
Given the current economic climate and the fiscally
irresponsible policies, including competitive currency devaluation, which
governments in the US and indeed around the world are implementing, it is no
wonder that investors are desperately seeking ways to protect their wealth.
As explained above, however, moving from equities into
bonds is like jumping from the frying pan into the fire. The smart move for
wealth preservation is to a physical holding of gold bullion.
Nick Barisheff
Bullion Management Group
Nick Barisheff is
the co-founder and President of Bullion Marketing Services Inc., which was established
to create and manage The Millennium BullionFund. The fund is Canada’s
first and only RRSP eligible open-end Mutual Fund Trust that holds physical
Gold, Silver and Platinum bullion www.bmsinc.ca
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