It's become a frighteningly common headline that bond yields have yet again reached new all-time lows. While this is great news for some, it adds to the headache for savers and, topically, pension funds and asset managers – something the FT is exploring in increasing detail.
If you can’t even make 1% by investing in 10 year UK government bonds what hope do you have of hitting your annual 2% inflation target? You could look further to other asset classes with better historical returns such as equities, early stage small caps or unlisted companies. Yes, these assets are more volatile, but if you are tucking money away for 10, 15 or 20 years until retirement should this matter? As soon as you attempt to make an allocation shift however you are hit with a myriad of warnings; these assets are high risk – caveat emptor! Investors are then faced with a tough choice – remain in what are deemed safe assets at the expense of growth, or, take what is considered a more risky path.
This is where human behavior and emotion kicks in. Are you willing to go against consensus and make a call that could go wrong? To paraphrase an equity fund manager we met with this week, 'If you hold Vodafone and it goes wrong it's fine because everyone else will have got it wrong too, if you hold an unnamed small cap however your neck is on the line.' This sounds frighteningly similar to the now infamous words of Chuck Prince in the lead up to the GFC - “As long as the music is playing, you've got to get up and dance.”
This ties nicely back in to the idea of risk - do you trust a label and what everyone else is doing or do you trust your common sense? In 2007 you could have danced to the music and owned low risk CDOs stamped ‘A’ by US rating agencies and still have lost most if not all of your money. When funds are parked in a specific asset for the wrong reasons there can be a painful rush to the door when this reason proves false.
Risk, as labelled by consultants and allocators, is a function of volatility and the corresponding expected return. Volatility is tied to liquidity. Liquidity however is connected back to risk. So you have a circular system where each part relies on another to maintain the status quo. The status quo is that owning government bonds is less risky. This cyclical relationship with volatility combined with typical market pressures and current extraordinary low rate environment presents a huge challenge for investors in bonds. They find themselves is being unable to meet their obligations or grow their capital via operating a perceived ‘low risk’ strategy, since bonds are simply not yielding the returns they have historically. As investor in this space you then find yourself back where you started, or worse, as spelt out by industry titan Paul Singer.
If we are in a new financial paradigm where rates are to remain low for an extended period, then our idea of risk also has to change. In Finance 101 the value of a company is the present value of future cash flows. The discount rate you use is the ‘risk free rate’ (the government bond rate) with an additional equity risk premium. 10 years ago this risk free rate was roughly 5%. Therefore, not that long ago a ‘low risk’ portfolio would have held government bonds with an implied 5% risk. Equities, with their additional risk premium, were closer to 10%. Today government bonds yield effectively nothing so the equity risk has also fallen to around the same level government bonds used to be. Why therefore have our perceptions of risk in portfolio allocation remained unchanged?
What it all comes back to is the individual; understanding what your needs are and what risks you are comfortable taking weighed against the potential reward. In no way does this mean that an individual, without advice, should make a drastic allocation shift in their portfolio. Instead they should engage with their advisors and challenge labels that may no longer reflect what they once did.