Brian Weber cautions investors to examine the real level of risk they are taking on.
The practical difficulty of managing a diversified client portfolio in the current era of low to negative interest rates is increasing. In the last 35 years, the return profile provided by fixed-interest investments made it relatively easy to diversify equity market volatility.
With large tracts of the developed-world government bond market now offering negative yields, this is becoming more of a challenge. The use and dependence on risk measurement tools developed in recent decades is not helping this problem as many rely on historical data and probabilities of certain patterns being repeated. Given where bond yields currently sit, and with the eventual prospect of interest rates normalising, some of the low risk and diversification qualities of bonds will be challenged.
Put simply, if the yield to maturity on a 10-year German government bond was to climb to 2.5%, then the value of the bond would fall by just over 20%: hardly low risk. I am not predicting this in the short term, but it does highlight the potential pitfalls built into some risk measurement tools.
Common sense suggests that advisers and clients should pay much more attention to the asset allocation solutions these tools are throwing up, especially given their increased usage since the crisis. When they are recalibrated for a ‘normalisation’ of interest rates, they are likely to show that certain bonds are not ‘low risk’ and may not offer the diversification benefits we have previously relied on.
As a result of the declining yields in government bonds and fixed-income markets, many have looked to the absolute return or alternatives space to reduce portfolio risk and volatility. It is being recognised and accepted that many absolute return funds have struggled to produce positive returns in recent years as some of the anomalies they had been able to exploit have been competed away.
Common sense suggests that advisers and clients should pay much more attention to the asset allocation solutions these tools are throwing up, especially given their increased usage since the crisis
We are increasingly seeing money being diverted from the poorer-performing absolute return funds towards the better performers, but availability and access can be a problem. By definition, low-risk investments should not produce negative returns and many absolute return funds are proving they are not the panacea many had hoped they would be.
The era of ultra-low interest rates has resulted in an increase in demand for all assets that generate a real income. Some of these assets have traded up in price, resulting in a compression of the yields. We recently came across a case where a property investor budgeted for an exit yield on a student residence of 8-10%. He was delighted to receive a price that reflected a yield of 5.2% when he sold the completed building a couple of years later.
The profit on the project was more than double what he had originally forecast. To our sceptical minds, we wonder where the yield will end up when interest rates eventually normalise and how much of his gain will end up as the investor’s loss.
In summary, not only has the decline in yields increased the risk in the bond market itself, but it has spread to other asset classes. This means that it has become very important to scrutinise the constituents of a fund or a portfolio as they may carry much more risk than the label suggests.
A rise in interest rates and an end of QE may not happen soon – especially in Europe and Japan – so patience and discipline will be required
The return-and-risk relationship has polarised over the last few years. We previously warned that ‘no risk=no return’, but central bank policy means we may be moving to a point where ‘low risk = negative returns’.
In defence of government bond markets, it is possible to quantify the level of negative returns when a bond is held to maturity. However, as with all other investments, I would urge high levels of caution and investors need to examine the real level of risk they are taking on.
The solution for most investors is to allocate the risk portion of your investments to areas like equities and property, while allocating your lower-risk portion to securities that are truly low-risk and unlikely to be closely correlated with stock markets.
Within fixed income, this would mean avoiding very long-dated bonds and possibly diversifying into highly-rated corporate debt or overseas fixed interest where the yields are more attractive. A rise in interest rates and an end of QE may not happen soon – especially in Europe and Japan – so patience and discipline will be required.
About the author
Brian Weber is head of the Dublin office of Quilter Cheviot. It is part of Old Mutual Wealth, one of the UK’s largest discretionary investment firms, with 12 locations across the UK, Jersey and Ireland.
The Dublin branch is regulated by the Central Bank of Ireland for conduct of business rules. Contact firstname.lastname@example.org.