Bullion versus Bonds

While people do invest in bullion for investment purposes, for the purpose of long term capital accumulation, a main use of bullion by individual investors is its use as a hedge for other investments, particularly investments in the stock market.

If one is married to their stock positions, then given the long term swings of stocks, it can certainly be beneficial not to have all your funds in stocks and have a portion of your money in something else.

This hedging very often involves using bonds to offset this risk, to look to water down the amount that your mark to market profit and loss is at, if you were to liquidate all of your stock positions in other words.

Bullion versus BondsWhile the current valuation of one’s stock portfolio is often not that relevant, as when one for instance is focused far down the road, we do need to be aware of the risks involved with bear markets in our actually having to sell our stocks during one of them. We need to be particularly aware of the risk of ultimately selling loss or at a significantly reduced return on investment relative to our expectations and goals.

Stocks go up more than other things do, but they also tend to go down more as well, although bullion markets do measure up very well as far as potential downside goes and can lose a lot of value during a given longer term downturn in prices.

The hope with bullion as a hedge is that when your stock positions go down, bullion will go up, and if bullion goes down, this will be more than offset by rising stock prices. While this does happen at times, it’s much more of a myth that stocks and bullion are strongly inversely related like this.

Overall, this relationship is neutral and they are actually slightly correlated, more likely to move together than in opposition.

Bonds are also thought to be inversely correlated with stocks, but the truth is that they tend to move together at least somewhat, and the real hedge here is that bonds move both up and down at a slower pace than stocks do.

This does serve to make bonds a real hedge, although perhaps not as good of a hedge as cash, where one can for instance lock in a certain rate that is not subject to seeing one’s capital decrease, such as with a certificate of deposit.

If one is looking to hold bonds to maturity, the only real risk involved is inflation, devaluing the future payment by the amount of inflation involved.

Which Investment Provides a Better Hedge?

How good of a hedge bullion provides to stock positions depends entirely on the current and expected markets for bullion. Investing in bullion blindly as a hedge, for instance dedicating a certain percentage of one’s portfolio to it, whether that be 10%, 20%, or whatever figure, really doesn’t provide much protection.

It is true that both stock markets and bullion markets tend to run in different cycles, and these cycles usually don’t correspond, so one may think that there is no need to do anything but just hold both and allow for their out of phase relationship to provide a hedge.

Among those who do understand the true relationship between these two investments, this can seem to make a lot of sense, thinking that when stocks are going down, bullion may be going up, and that can offset part of one’s losses in the stock market.

This isn’t quite a real hedge though, and this would be better described as two separate positions that each require hedging. With this being the case, we want to be a little surer than random that one will indeed hedge one another and that they just don’t both move down at the same time.

Looking at hedging with bonds is much simpler. The real goal here is just to dilute the downside, not look to compensate for it. There are some times where one may be compensated somewhat, during bear markets with stocks, but this is more of a side benefit to the strategy of hedging with bonds, and there are indeed times where both do go down together.

Bullion Does Outperform Bonds During High Inflation

Since bonds are so married to interest rates, and bonds are in fact purely based upon them, rising interest rates are the real enemy with them. In periods where interest rates are rising, bond yields on new issues rise in concert, but the value of bonds already issued, at lower rates than the present ones, decline in value.

The extent that we should be looking to invest in bonds or even hedge with them will therefore depend on what the outlook for future interest rates are, which does involve looking to predict future inflation rates.

A lot of people simply view this as a matter of deciding how much to hedge with, and primarily just look at bonds to do it, and don’t tend to do so with enough attention to where bonds may be headed.

This is not a particularly sound approach to investing or hedging or anything, as we always want to look to assess the outlook for any investment we make, whether or not our strategy for it is a hedge or not. We always have options when looking to hedge, even if that involves just keeping some of our money in a deposit account.

Given the fact that the investment industry makes money based on funds under their management, it is not surprising that they focus on people being fully invested under their care with something, whether that be stocks or bonds. Bullion takes a big back seat to stocks and bonds, as well as cash, especially cash not held in money market funds.

Bullion, on the other hand, does tend to do quite well during periods of higher interest rates and higher inflation. Stocks aren’t big fans of higher interest rates and bonds absolutely hate them, but bullion doesn’t mind this at all and actually likes these higher rates.

Tailoring our Approach to the Circumstances

Markets and economies are quite dynamic, and there is no one size fits all solution to hedging or investing for that matter. Instead, if we are looking to benefit our portfolios, both in terms of managing risk and allowing for growth, we need to look to tailor our approaches as best we can to the changing circumstances of markets.

With bullion, this is going to involve assessing where the market is for a certain precious metal, gold for instance, and first and foremost assess whether we want to be holding the asset at a given point in time, based upon where it is likely to be heading over the time frame we are looking at.

Bullion and stocks can indeed offset themselves due to their not moving in the same direction all the time, and often not moving in the same direction, but the desirability of this play will depend entirely on where the two happen to be moving.

This cannot just be a once and done decision though, as some would seem to prefer it, perhaps being bullish on gold at one point in time and then going with a certain strategy. Unless we assess this as we go, our assessment will likely become dated and therefore far from ideal or far from pertinent actually.

The big run up in gold that we saw between 2000-2011 provides a good example of this. Bullion sellers are still trumping this as an advantage to hedging with bonds, even after gold gave back much of these gains. If one is considering adding an asset to their portfolio, doing so during a bull market can be very wise, but doing so during a bear market is not so wise.

Obviously, if we look at the first decade of the 21st Century, bullion was a much better hedge and much better investment than bonds were, and the sole reason was that bullion prices were on the rise during this time, in a real bull market.

Bullion investing has historically involved a long-term commitment due to the wide spread that is involved with physical bullion, where the value of the investment needs to go up quite a bit to even break even.

With the advent of ETFs though, one can enter and exit bullion positions with such ease and such low cost compared to buying the bullion themselves that one can now select whatever time period they want for this to be used as a hedge.

All investing involves some trading, some decision making as to entries and exits, at least if we’re looking to take a sensible approach to all of this. Even with the longest term outlooks on an investment, we still need to be paying attention to the behavior of our investments to even be aware of whether or not our goals are being realized, and to what extent they are.

Deciding between bonds and bullion as a hedge, as far as which one we want to go with, or perhaps use both in a certain proportion, or for that matter, how much hedging overall we need or want, is all going to depend on the circumstances.

There are times where bonds are a much better bet, especially when bullion prices are dropping, and there will also be times where bullion serves as both a better investment and hedge, when bullion prices are on the rise.

Looking to simply our investment principles and strategies is a fine goal, and for the most part, simpler is better, all things being equal. The problem though is that they are very often not equal or even close to that. The virtue of simplicity is to reduce mistakes, but the strategy itself cannot be a mistake, where if we seek to oversimplify things we may end up seeing much reduced expected outcomes.

The fact is, bullion should be in the discussion a lot more than it is when we consider hedging, but only when it makes sense to have bullion in the discussion. The degree of hedging required also needs to be examined more closely, and this should not be a once and done effort, or one based upon a fixed percentage irrespective of market conditions and expectations.


Editor, MarketReview.com

Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.

Contact Monica: monica@marketreview.com

Topics of interest: News & updates from the Office of the Comptroller of the Currency, Forex, Bullion, Taxation & more.