Understand what is most risky in fixed income – 01/27/2024 – From Grão to Grão

This coming Wednesday, the Monetary Policy Committee (COPOM) of the Central Bank (BC) is expected to reduce the Selic Meta rate by another 0.5% to 11.25% per year. This will be the fifth reduction since August 2023. However, it is far from the last. This movement raises an important question: do you understand what risk is in fixed income?

From March 2021 to August 2022, that is, in less than a year and a half, Selic went from 2% to 13.75% per year. The intensity of the upward movement surprised everyone.

At this moment, we are in the opposite direction, that is, downward. At least four more cuts must still occur by July this year, when the Selic rate must reach 9.25% per year. But, it shouldn’t stop there.

Just as in 2021 few imagined a Selic above 9% per year, now, few imagine a Selic below this level. We know the first ones were wrong.

When we talk about risk, Nobel laureate in economics Daniel Kahneman defines a risk-averse investor as one who prefers a certain outcome to an uncertain one with the same value.

So let’s understand if you are a risk-averse investor, or prefer risk. What do you prefer?
a) a return of 6% per year right?
b) a return that can vary between 10% and -5% per year, but which expectedly, that is, when considering the probabilities, should be 3.7% per year?

Looking at it this way, you wouldn’t need a Nobel Prize to express what seems to be the best alternative. The expected results are not even the same to have any doubts.

However, currently, many still prefer alternative “b” when we talk about fixed income, that is, the greatest risk.

Yes, although you may have preferred alternative “a” in the question above, last year and, perhaps, even now you still have doubts or in practice you are opting for the higher risk alternative when investing in fixed income.

In fixed income, the nominal return is always made up of two parts. One is the real return, that is, that above inflation. The other part is inflation itself.

We know that inflation is just the replacement of purchasing power, so it does not count as income in practice.

Therefore, what counts is the real return.

Over the last fifteen years, the real return implied by bonds referenced to the CDI or Selic varied between -4.74% and 10% per year. The average return was 3.74% per year above the IPCA.

As of this next Thursday, the real return on Selic or CDI is still at 6.97% per year.

It still looks very attractive. But, this is a return with risk. At the end of the year, this real CDI return must be less than 5% per year.

If you really are a risk-averse investor, that is, one who prefers less risk to obtain the same result, you should take advantage now to lock in the real returns that still exist above 6% per year for the long term.

Understanding what the risk is in fixed income investing is essential so that you do not fall into the temptation of the comfort of a security that only varies little, but will pay you less over time.

Michael Viriato is an investment advisor and founding partner of Investor’s House.

Speak directly to me via email.

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