Does gold offer a better protection against losses in sovereign debt bonds than other metals?

Abstract

It is a commonly held view that gold protects investors’ wealth in the event of negative economic conditions. In this study, we test whether other metals offer similar or better investment opportunities in periods of market turmoil. Using a sample of 13 sovereign bonds, we show that other precious metals, palladium in particular, offer investors greater compensation for their bond market losses than gold. We also find that industrial metals, especially copper, tend to outperform gold and other precious metals as hedging vehicles and safe haven assets against losses in sovereign bonds. However, the outcome of the hedge and safe haven properties is not always consistent across the different bonds. Finally, our analysis suggests that copper is the best performing metal in the period immediately after negative bond price shocks.

Introduction

The financial media normally regard gold as a safe haven asset. Its characteristics as a financial asset have also been widely explored in the academic literature. Gold has been a traditional investment vehicle since it serves as a hedge against inflation and a safe haven in periods of market crises (see Cai et al., 2001, Baur and McDermott, 2010, Daskalaki and Skiadopoulos, 2011, Batten et al., 2013). It has also been widely documented that gold protects investors’ wealth against fluctuations in the foreign exchange value of the US dollar (Capie et al., 2005, Pukthuanthong and Roll, 2011, Reboredo, 2013; Ciner et al., 2013). The observed increase in the value of gold during the recent financial crisis has motivated other researchers to test explicitly its viability as a safe haven from losses in other financial markets. Baur and McDermott (2010) show that gold protects investors against stock market shocks in major European countries and the US, but does not serve as a safe haven for Australia, Canada, Japan and emerging stock markets. Similarly, Baur and Lucey (2010) find that gold is a safe haven for stocks, but not for bonds, in the US, the UK and Germany.

The main objective of this study is to investigate whether gold is a special investment vehicle or if it has become relegated in status to the same standing as other metals, which are primarily for industrial purposes and traded as commodities. There is no sound theoretical model to explain why gold may act as a safe haven, but a major explanation often put forward is that gold was among the first forms of money and has traditionally acted as an inflation hedge (Baur and Lucey, 2010). However, since the collapse of Bretton Woods system and the move to floating exchange rate regimes, the market for gold and silver have changed dramatically (Hillier et al., 2006). The monetary element of these precious metals has gradually been replaced and their industrial use has been extended. Furthermore, the extensive use of gold as a hedging vehicle has also sparked the utilization of other precious metals as risk management tools and diversifying commodity portfolios (see, e.g., Marshall et al., 2008, Belousova and Dorfleitner, 2012). Since gold has more characteristics in common with other metals, particularly precious ones, than it does with any other commodities, investors may treat metals as a separate asset class (Belousova and Dorfleitner, 2012). This, in turn, would cause gold prices to comove more with metals than other commodities (see Pindyck and Rotember, 1990, Pierdzioch et al., 2013 among others).^1,2

Consistent with the comovement evidence, Daskalaki and Skiadopoulos (2011) show that the returns on major precious metals, including gold, silver, platinum and palladium, exhibit low correlations with stock returns. Morales and Andreosso-O’Callaghan (2011) find that the precious metals markets are less affected by the recent global financial crisis than other major financial markets around the world. Erb and Harvey (2006) and Roache and Rossi (2010) also find that gold and silver prices are counter-cyclical, implying that precious metals other than gold may also protect investors’ wealth in the events of negative stock market conditions. Furthermore, observed marked data (see Fig. 1 and Panel B of Table 2 below) suggests that industrial metals also comove with precious metals. Thus, industrial metals may also serve as a place of safety in the events of negative economic conditions and this leads to the following important questions: (i) to what extent does gold protect investors’ wealth against sovereign-debt crisis? (ii) does gold offer a better protection against sovereign-debt crisis than other metals? and (iii) is the protection, if any, offered by gold and other metals against sovereign credit deteriorations short- or long-lived?

While the hedge and safe haven properties of gold have explicitly been examined in the context of both stock and bond markets (Baur and McDermott, 2010; Baur and Lucey, 2010), the role of other precious and industrial metals as hedging vehicles and safe haven assets has not yet been explicitly explored. This study investigates the relative abilities of industrial and precious metals to protect investors’ losses in the sovereign debt markets. Existing studies tend to focus on assets that provide protection against investors’ losses in stock and foreign exchange markets, with government bonds typically seen as relatively safe assets. However, recent evidence suggests that sovereign debt markets, particularly in the Eurozone (except for Germany), have recently become more volatile due to the “flight to safety” syndrome that has gripped financial markets (Schwarz, 2008). Furthermore, the (unreported) finding that the correlation between the conditional volatility of government bonds and that of the world index increases significantly during crisis periods suggests that the extreme movements in sovereign bond markets may be representative of the crisis episodes.³ Thus, since government bond markets are affected by the economic downturns and since sovereign debt crisis (e.g. the recent European sovereign debt crisis) and government defaults (e.g. Russia in 1998 and Argentina in 2001) are not uncommon, it would be useful for investors to identify asset classes that can protect their wealth against the sudden deterioration in the government bonds.

While metals may not be the only place of safety,⁴ we choose to focus on safe haven properties of these assets for, at least, two reasons. First, metals are the closest related assets to gold (a traditional “investment of last resort”). Second, metal prices are driven by the global demand as opposed to domestic demand in the case of many domestic bonds and stocks. In some cases, such as the recent European sovereign debt crisis, investors face losses on both (domestic) stocks and bonds and may, therefore, seek refuge from other asset classes.

By investigating the role of metals in protecting investors against sovereign debt losses this study makes three important contributions to the literature. First, it provides a detailed analysis on the hedge and safe haven properties of gold and other selected metals against the deteriorations in the credit quality of sovereign bonds. Second, it tests whether the outcome of the hedge and safe haven properties of the metals against sovereign bonds is consistent across different sovereign bonds. Finally, it examines the performance of metals in periods following large negative bond price changes to evaluate the speed at which investors recover losses from extreme negative bond price movements and the profit (or loss) associated with holding different metals in periods of high bond market turmoil.

Our empirical analysis focuses on sovereign bonds in the US, the UK, the EMU and ten Eurozone countries (Austria, Belgium, France, Greece, Germany, Ireland, Italy, Netherlands, Portugal and Spain) and yields the following interesting findings. First, we find that gold serves as a strong hedge only for bonds in Belgium, Greece, Italy, the Netherlands and Portugal and a strong safe haven for bonds in Finland, Spain and the EMU. Second, other precious metals, palladium in particular, outperform gold both as a hedge and safe haven asset and bond investors are even better off holding industrial rather than precious metals in periods of extreme negative shocks. The superiority of industrial metals in protecting investors against losses in the US and European bonds may be attributed to increased demand for these metals from major emerging countries, such as the BRIC, which have not been strongly affected by the recent crisis. Third, we show that gold commoves strongly with both UK and German bonds in periods of high bond market volatility. This evidence is consistent with the “flight to safety” argument, and that investors may view high quality bonds, such as the UK and German bonds, and gold as substitutes in protecting themselves against the downturns in the government bond markets. Finally, we find that copper (palladium) is the best performing industrial (precious) metal in the period immediately after extreme negative bond price changes.

The remainder of the paper is structured as follows. Section 2 provides a brief review of the literature on the role of metals in the financial systems. Section 3 presents a description and summary statistics of our data. Section 4 describes the methodology. Section 5 contains the results of our analysis and Section 6 offers our concluding remarks.