Investment portfolios: a new normal? Risk-free return, or return-free risk?

 

11th December 2020

Over the past century academics and practitioners have increasingly espoused theories that have become part of almost every investment doctrine one could name. Theories that have tested and refined over time but now essentially taken as simple fact.

One of these relates to the construction of an investment portfolio, where the asset allocation is dependent on an investor's attitude to risk. As Investopedia explains:

Over the decades, this has been borne out repeatedly. Equities are the most volatile asset class but produce the highest overall returns. Money is the most stable but the returns are the lowest. Bonds fall in between these two.

Increasingly, however, people are querying whether this is still accurate. 

Equities certainly still produce the highest returns, money still the lowest, and bonds in between the two. But what about the associated risk?

Since the dawn of Quantitative Easing (aka QE. Massive bond-buying by central banks) in 2008, the bond market has been rather benign. Previously when market participants spotted an opportunity, such as a substantial fall in a company or country's creditworthiness, hordes of traders (referred to as "Bond Vigilantes") would swoop in and punish the issuer by selling the bond so that it's true worth was reflected. They typically did this by "shorting" the bond, so as to make a profit.

The seemingly limitless buying by central banks has effectively neutered the vigilantes. They can't fight such a wall of money. So leads to bizarre situations such as economies such as Italy where national debt is sitting (pre-COVID) at almost 140% of GDP, but they can still borrow for ten years paying a yield of less than 0.6% per annum (source: CNBC 11/12/20). Previous guidance stated that a debt to GDP figure in excess of 90% was viewed as somewhat unsustainable, so there is little obvious logic behind such a low return being demanded. For comparison, back in the year 2000 the yield was over 5%.

So bond yields have fallen and the implied risk has fallen. The former is certainly true, but is the latter?

Most market misjudgements stem from humans assuming that what happened in the past and today will continue into the future. However history has shown that changes can be sudden, dramatic and unexpected. 

For example what would happen if the German Constitutional Court finally ran out of patience with the European Central Bank's (ECB) QE program and prevented the Bundesbank from participating in it. What would that do? Would the market still accept the validity of the program without it's main backer?

What if the rating agencies got tough and started down-grading bonds (previous blogs have discussed this)? Pension funds, for example, often cannot hold bonds that are not investment-grade and must sell them immediately. Previously the banks would provide the oil in the market, by buying the bonds and taking the longer term view. But the Volker  rule now prevents this. So imagine that no central bank was able to purchase corporate bonds at that point. Who would? Perhaps only hedge funds offering ten cents on the dollar. To my mind the bond market would fall into chaos at that point with investors sustaining huge losses, particularly retail investors.

Perhaps the low risk image of bonds is no longer accurate. As James Grant noted in 2008, perhaps instead of "Risk-free return" one should talk about "Return-free risk"!

This new normal has been noticed. Bonds typically make up much less than they used to in, say, a balanced portfolio (the 60/40 rule no longer really applies). But I would argue that this has been driven more by their falling yields than by their increased risk profile. So I would suggest that their inclusion in a typical portfolio is still arguably too great.

For example, one of their stated benefits is the manner in which their prices move inversely to those of equities (due to the reaction to inflation news and interest rate moves). However increasingly their prices move in lock-step. For example in the teeth of the pandemic sell off this year (in March), bond prices fell sharply along with equities. Investors did not view them as a safe haven. The safe havens were cash and gold.

As I say, while the central banks are buying and the rating agencies are quiet, all is well. However one day both those factors may change. I would suggest that if that day comes, the music in the bond market will stop and investors will be left scrambling for a chair.

Dunotter disclosures

 Disclaimer: This communication is purely meant as information for general interest. It is in no way to be taken as financial advice or relied upon in any way for investment decisions.