Wednesday, February 5, 2014

Fixing Income in Shekel

By now, you have finished drinking up The Coffee Hypothesis. If you’re like me, you only have another few minutes before the caffeine wears off and the world begins to look bleak once again. 

Sure, you have some good opportunities in the Israeli stock market, but you are not planning to put all of you money into the stock market. What about the Israeli bond market? How does it compare to the options you have in America?

I would say that it is very much like the difference between the way children in America and Israel eat pizza.

Mostly, there is no difference at all. In both cases, it’s a pretty messy deal. The cheese (or whatever it is that Israelis use) can get very goopy and the sauce has a way of making its way all over their faces. The main difference is that only Israelis think that it is perfectly normal to put a full color, high resolution picture of this on the menu.

Bonds are similar in this regard, just without the messy children. Mostly, they are the same, but in some ways they are different.

The Same

In both countries, you can buy bonds. Basically, this means that you lend some money (“principle”) at a certain rate of interest (“interest”). The borrower pays you the interest until the bond matures and then returns the principle to you. Like any loan, there is a risk that the borrower will spend all of his money on pizza and not be able to pay you back (“credit rating”). Bonds issued by the government are generally considered to have the lowest risk, because governments can always take away your money if they spend all of theirs (“taxes”).

In both the U.S. and in Israel, you can invest in government bonds. Here is a snapshot of rates from earlier this week:


U.S.
Israel
5 Year Bond
1.65%
2.22%
10 Year Bond
2.64%
3.66%

The rates in Israel are slightly higher which makes sense considering the difference in credit ratings between the two governments. I have heard people argue that they prefer the U.S. government bonds because they are considered “no risk” in terms of default; whereas, the Israeli government bonds have some risk, even if it is small. I find this odd because after deciding to live here, you have already placed a large amount of faith in the Israeli government. Basically, this is saying that you are willing to take the risk with your life, livelihood, and the future of your family; but, when it comes to your bond investments, what’s where you draw the line.

I think that money you have designated for government bonds will be more-or-less just as well off in Israel. The only difference is that when it is in Israel, it will not lose any of its value in shekel; whereas, if you keep in dollars it could gain or lose as the exchange rate fluctuates.

The Different

The real difference between the bond markets is found in corporate bonds. This is because Americans and Israelis have a different understanding of what money is. Example:
                                                                      
George has $100 today. He keeps this money in an entirely realistic U.S. bank account that pays him 2% interest every year. In five years, George has $110.14. George believes that he now has more money.

Zohar has 100 shekel today. He keeps this money in a strictly hypothetical Israeli bank account that pays him 2% interest every year. In five years, Zohar has 110.14 shekel. Zohar believes that he has less money than he started with.

Has Zohar had a bit too much of that leftover hummus for breakfast? Probably, but that’s not what is causing him to think this way about money. The difference between them is that Zohar thinks about money in terms of what it buys; whereas, George thinks about the absolute amount of money that he has. Zohar understands that with average annual inflation of around 2.5%, his 100 shekel is worth much less five years later. The interest of 2% that he received is not sufficient to make up for the effects of inflation.

In Israel, looking at money through inflation-protected lenses is prevalent everywhere: in the way the banks like to sell mortgages, in how payment plans are structured, and even in the way taxes are assessed. Israelis believe that inflation adjustments are just natural adjustments to the very same money; whereas, Americans believe that if you have more money than you started with, you have received interest regardless of how it was calculated.

When Zohar invests in bonds, he expects that his investment is protected against inflation unless he explicitly seeks out the alternative. This is why in Israel you can invest in inflation protected bonds not just from the government like you can in the U.S., but also from corporations.

But just like we say to Israeli pizza photographers: “just because you can do something, doesn’t mean that you should.” It is nice to have the option, but you will need to consider the credit worthiness of corporations before you invest in their bonds.

Inflationary Interests

Comparing interest rates between inflation indexed bonds in the U.S. and Israel is difficult, but I’ll give it a shot because I already started writing this blog.

For government bonds, the comparison is straightforward. We find a difference in interest rates similar to what we saw earlier with regular bonds:


U.S.
Israel
5 Year Bond
-0.50% + inflation
0.26% + inflation
10 Year Bond
0.52% + inflation
1.42% + inflation
  
Corporate bonds are much like comparing blueberries to pomegranates. The credit ratings are measured differently, so you will need to take any comparison with a grain of powdered sugar. Nevertheless, here is an approximate comparison based on the highest rated corporate bonds from each country:


U.S. Corporate
Israel Corporate
5 Year Bond
1.95%
1.27% + inflation
10 Year Bond
3.35%
3.00% + inflation

For those already inclined to invest in corporate bonds, the Israeli corporate bonds present an interesting opportunity to consider.

For investment in both the U.S. and in Israel, you need to evaluate whether the interest rates are fair considering the risk that the corporations will not be able to pay you back. Also, for both you need to evaluate whether the rates are reasonable for the length of time that you are lending them money.
                                                                                           
However, with the U.S. corporate bonds, you will also need to consider the risk that the 1.95% or 3.35% return will not sufficiently outpace inflation over 5 or 10 years. For the bond investment in Israel, the corporation that borrows the money assumes this risk and pays out the interest and the principle on the bond with adjustments according to inflation.

Same Same But Different

I’ve been making the case that your money should make aliyah to protect you against a weakening dollar. In an attempt to fortify you against the tough times ahead, I’ve given you a caffeine high with The Coffee Hypothesis by showing you that money you want to invest in stocks has a lot of opportunity in Israel. For bonds, it’s no worse off and may have a few advantages. Basically, you could say that it is 8 pieces of one and 8 triangles of the other, with some advantages to consider around the corners.

So… who’s ready to talk about taxes? 

7 comments:

  1. What will happen if boycotts occur with Israel's export market?

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  2. Oy vey... haven't the Jews suffered enough?

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  3. You forgot to mention the advantages of the weakening dollar: The price of Honey Nut Cheerios has been hovering around 15 shekels a box for a few months. Based on my kids' consumption of said sugary (but obviously healthy) cereal, we are coming out ahead overall. Not.

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    1. That could be a whole new approach to commodity trading. Stock up on the cereals now and then sell them back to the supermarket when prices rise. (Unless of course you eat them all first... then the plan would not work at all.)

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  4. The question is: how do you manage the risk that boycotts may occur? Is it an investment risk that should be hedged or not?

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    Replies
    1. Prediction is very difficult, especially when it is about the future. I just started Investing by Accident, and I'm not sure I'm ready yet for Politics by Accident. But, I'm adding the topic to the backlog, because a great question for investing is how to react to what could happen.

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    2. Hedging by accident! I like this theme.

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