Bitcoin are the new bonds
The Intelligent Investor
In 1949 Benjamin Graham, a British-born American economist, professor and investor, published „The Intelligent Investor“, which is considered one of the founding texts of value investing and a classic of financial literature. In the book, Graham teaches investors how to protect an investment portfolio from significant damage and develop long-term strategies. One of his tenets is that a “balanced investment portfolio” should consist of 60% stocks and 40% bonds, as he believed bonds protect investors from significant risk in the stock markets. This rule has become something of an unwritten law in the investment world. A bond is a financial instrument where an issuer, usually a government or corporation, borrows money and is obligated to repay the bondholder the borrowed amount of the bond on the maturity date as well as interest (called the coupon) over a specified amount of time. The size of the bond market is estimated to be at roughly $120 trillion worldwide, according to the Securities Industry and Financial Markets Association (SIFMA, 2022).
The most commonly purchased bonds are government bonds such as US Treasuries (Amadeo, 2022). These are considered to be one of the best risk-adjusted debt instruments due to a low probability of default by the US government as the obligor. The corporate bond market is the second largest part of the bond universe and allows companies to borrow money from the public. Bonds have become an integral part of our financial system because, among other reasons, they give nation states the ability to borrow and have historically allowed investors to allocate money to low-risk financial assets because nation states had a low probability of default.
Things change
While much of what Graham described still makes sense today, I argue that bonds, particularly government bonds, have lost their place as a hedge in a portfolio. Mainly because bond yields cannot keep up with monetary inflation. In addition, our financial system, of which bonds are an integral part, is systematically at risk. The financial health of many of the governments that form the heart of our financial system is at risk. When government balance sheets were in decent shape, the implied risk of default by a government was almost zero. That is for two reasons. Firstly, their ability to tax. Secondly, and more importantly, their ability to create money to pay down its debts. In the past that argument made sense, but eventually creating money (for various reasons) has become a serious problem, as explained by Greg Foss (2021) in his paper “Why every fixed income investor needs to consider bitcoin as portfolio insurance”.
Money printer go brrr
Central banks are circulating more money than ever before. Data from the Federal Reserve, the central banking system of the US, shows that a broad measure of the stock of dollars, known as M2, rose from $15.4 trillion at the start of 2020 to $21.18 trillion by the end of December 2021 (St. Louis FED, 2021). The increase of $5.78 trillion equates to 37.53% of the total supply of dollars. During the past three years, M2 has grown 15% on an annualised basis. US Treasury Bonds are yielding less (Bloomberg, 2022).
Systematic risk
For the last few decades, central banks around the world have maintained very loose debt policies and national governments have borrowed heavily. As pointed out by investor Stanley Druckenmiller (2021), there is an irresponsible amount of credit in the market. Argentina and Venezuela have already defaulted. There is a possibility that more countries will default on their debts. That doesn’t mean they can’t pay off their debts by creating more money. However, this would devalue a country’s currency and cause inflation, which would make most bonds with their comparatively lower yields even more unattractive (Foss, 2022).
Minsky moment
Bonds worked, because we were riding one of the longest asset bubbles in history. For years, central banks have manipulated the bond market through bond purchases (financed by increasing the money supply). The latest examples include the Bank of Japan and the Bank of England. It is estimated that the Bank of Japan now owns almost half of the bonds issued by the government (Tokushima, 2022). The Bank of England recently announced it had bought 1.195 billion worth of UK bonds in a single day to “calm markets” after the pound weakened (Reuters, 2022). However, our “Minsky Moment” could be on the horizon. American economist Hyman Minsky theorised that a tipping point occurs when a debt-fuelled asset bubble collapses, and assets become difficult to sell at any price. A market collapse ensues. This is a real risk that is beginning to be reflected in the bond market sentiment (Foss, 2021, p. 19). The 10-year US Treasury is on pace for its worst year in history, down 20% YTD! (Budelman, 2022).
Bitcoin
Bonds have become a contractual obligation to lose money when Inflation is priced in. Bond holders are getting paid the nominal amount, but are losing purchasing power (Foss, 2021, p. 6). The only option central banks have to stabilise the bond market is by creating money to buy back bonds. However, if the return of a bond is lower than the rate of monetary inflation, what’s the point of holding one? In addition, there is the risk of a systematic failure. The global financial system is irreversibly broken and bonds as a foundation of it, are at high risk (LeClair, 2021). In this environment, it makes no economic sense to hold a bond. The rational economic incentive for any rational agent wanting to protect their wealth is to look for assets that cannot be devalued or printed. Bitcoin, with its perfectly inelastic hard caped issuance schedule, is a perfect fit.
Graham’s philosophy was first and foremost, to preserve capital, and then to try to make it grow (Myers, 2022). With bitcoin it is possible to store value in a self sovereign way with absolutely zero counterparty or credit risk.
Bitcoin vs Fiat
In the end, fiat currencies are programmed to debase and bond investors are really just a “derivative” to this reality. Bonds are an inferior asset compared to bitcoin and have lost their place in a realistic forward-looking investment portfolio. I believe the only reason financial institutions buy bonds is either because they have a quota of government bonds they must own, or because they want to protect their portfolio performance from volatility in the stock market by accepting a low-quality financial asset with a fixed 2% yield. This might look good on paper in the short term, but it doesn’t make any economic sense at all in the long term. Many old hands in traditional finance are now coming to this conclusion. Last year, in an interview with Bloomberg, Ray Dalio (2021), founder of asset management firm Bridgewater Associates, stated that he would rather own bitcoin, than a bond. Over the past few decades, Dalio has become known as one of the finest investors and practical economists of our time. His statement makes perfect sense given the risk-reward profile of both assets.
Conclusion
Bitcoin is the best store of value for the digital age. An absolutely scarce digital native bearer asset with no counter-party risk that cannot be inflated and is easily transportable and transferrable on the world’s most powerful computer network. Bitcoin is designed to play the role that bonds have historically played for the lender. A low-risk, long-term savings opportunity. The biggest risk with bitcoin is losing your access, your private key or becoming dependent on a third party and risk losing your coins in a potential fraud, hack or bankruptcy. The network itself is the most secure digital system ever built. We’ve all heard the phrase that past performance is no indicator of future performance, that may be true. But that is not the case with bitcoin. The higher a stock goes the riskier it becomes, because of the P/E ratio. Not bitcoin. When bitcoin increases in price, it becomes less risky to allocate to, because of liquidity, size and global dominance (LeClair, 2021). The bitcoin network has now reached a size where it is likely to continue to exist via the Lindy Effect, a theory that the longer an imperishable thing survives, the more likely it is to survive in the future.
It is now a self-fulfilling, snowballing network effect, eating up bonds and the monetary premium that other assets carry as stores of value.
If bitcoin is delivering an average return of 155% per year on a 10-year basis as of December 18, 2021, or let’s say around 60% to 70% per year going forward for the medium term (Livera, 2021), it’s clear why you want to maximise your bitcoin exposure. I understand that bitcoin’s volatility is problematic for the investment strategy of most funds and financial institutions, which are measured by short-term performance. If you are a professional managing other people’s money, I suggest allocating 2-5% of your funds under management to bitcoin. This allows you to participate in bitcoin’s upside potential without being negatively impacted by its volatility.
PS: I often read criticism from supposed financial experts that bitcoin, unlike bonds, does not generate any income. That’s true. It is not supposed to. It is designed to protect its purchasing power in the long term. A yield-oriented mindset is the result of a society used to money that is constantly depreciating. Sound money, like bitcoin, which is limited in supply and in high demand due to its monetary properties, does not need any additional yield, the increase in its purchasing power is the “yield”. Once you understand this, you will understand why bitcoin is superior to a bond. In his book “The Bitcoin Standard: The Decentralized Alternative to Central Banking”, Saifedean Ammous (2021) presented data for 167 counties showing that the average annual growth rate of the money supply from 1960–2020 was 29%. Switzerland had the lowest average growth rate in this period at 6.5%, the US had the second lowest growth rate at 7.4% per year and Sweden had the third lowest average growth rate with 7.9% per year. How is a bond with a 5% yield supposed to help?
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Other Resources
This article incorporates part of an article I published in Bitcoin Magazine on the 29th of November 2022, titled „Why Bitcoin Is The Ultimate Wealth Preservation Technology“. I wanted to build on that and go into detail because the topic is so multifaceted.
