When does Low Risk become High Risk?
Future of Fixed Income
Traditionally fixed income or bond investments were attractive because they provided an income stream and [in the main] moved in the opposite direction to stocks. Any asset in a portfolio that moves in the opposite direction to stocks offers enormous benefits to investors that want to avoid excessive volatility. On the flipside those that have full conviction that stocks for the long-term offer the best opportunity to grow their wealth may shun bonds and just stomach the inherent choppiness of the journey. The fact of the matter is however that the majority of investors prefer a smooth and linear return profile. In fact the best thing that advisers can do for most clients is to create robust portfolios that include negatively correlating assets. This offers protection from the psychological warfare that emerges when a portfolio drops by 60% on a cold wintery February morning. Most recently, how many investors panicked and sold their equity and other risk assets in March 2021? There is an old saying when purchasing a property in this country: “the day you buy is the day you sell”. The significance being that all factors need consideration including the probability of having to sell same property in the not too distant future. From an investing perspective, we could use the same analogy but ponder whether the day you sell is the day you buy.
When do you get it back?
If the premise of your decision to sell at a particular point is that you have supreme market timing ability then surely you will be able to predict the best opportunity to re-enter the market. This is a fool’s lottery and goes against the basic principles of successful investing. What has this to do with Bonds? In short, it has everything to do with bonds because in order to understand the current fixed income market we need to understand the motivation behind what makes the asset class attractive. Market commentators are quick to say that the current environment of ultra low interest rates is dysfunctional. It is but so too were the nominal 10-year treasury yields in late September 1981 when they stood at 15.84%. Today real yields remain in negative territory. For the past 40 years investors holding bonds made money through capital appreciation as interest rates made the slow long march south to the current historically low rates we see today. Unlike stocks which move on sentiment, fear and greed, fixed income movements rely on basic maths. The cumulative deterioration of the yield available means the mathematical upside for capital appreciation has left the station. This brings enormous challenges with it for investors.
The predictament
We hear a lot of talk these days about “accommodative monetary policy”, “easing” and “liquidity facilities”. In plain English, the main global central banks are using the tools at their disposal to keep downward pressure on interest rates. The motivation is simple enough to understand. By keeping rates low, consumers and businesses are more inclined to borrow. Perhaps more importantly the repayment conditions on existing debt remain manageable also and general confidence is supported. All sounds like great news until we consider the implications for investors. It is important to highlight that we are talking about Bond investors in particular but all investors in general. This latter point is key to understanding the real problems that are being stored up for us. Investment portfolios need bonds. Investor portfolios need counterweights to offset the inherent choppiness of equities, commodities, property investments and all of the other weird and wonderful constituents of their portfolios. The bottom line here is that central bank policy interventionism has had a devastating impact upon the three distinguishing attractions of bond investing as mentioned at the start of this piece: (i) income (ii) capital appreciation and (iii) portfolio protection. The future income streams from bonds going forward are negligible and capital losses seem inevitable once the policy stance shifts back towards normal [increased] interest rates. Bonds simply no longer provide the protection historically offered to investors with moderate to large equity holdings.
When Good news is Bad news
The broader economic recovery through the welcomed roll-out of the vaccination programmes has forced yields higher and this is healthy, even normal. Unfortunately as the economy recovers, inflationary pressures emerge and interest rates & yields rise severe pain is on the horizon for bond investors. Central Banks have effectively signalled to investors that there will be no compensation available for investing in longer-dated fixed income or higher yielding corporate bonds. There is a deeper debate ongoing about the implications of the massive debt burden, normalisation of interest rates and inflation.
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