Wednesday 7 December 2016

Inside track: Bonds nearly bust, so re-assess risk

Daniel Moroney

Published 19/07/2015 | 02:30

Beyond the eurozone, the same historically low yields can be seen in many developed economies, including the UK, Japan and the USA
Beyond the eurozone, the same historically low yields can be seen in many developed economies, including the UK, Japan and the USA

As anyone with a deposit account knows all too well, interest rates are pitifully low at present. The same is true in the bond market, where yields on most developed market government bonds have recently hit all-time lows (in many cases that means multi-century lows).

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In the decade prior to the great financial crisis of 2008, on average, the risk-averse investor could buy a 'risk-free', five-year German government bond at a yield of around 4pc. At the time of writing, buyers of five-year German debt have to content themselves with a yield of about 0.20pc (and for much of 2015 this yield has been in negative territory).

Beyond the eurozone, the same historically low yields can be seen in many developed economies, including the UK, Japan and the USA.

By most measures, the government bond market appears to be in bubble territory.

There are a number of reasons for this, but perhaps the biggest influence on the ultra-low yield environment is the financial repression of savers by governments and central banks.

But why would the actions of the authorities have a negative impact on savers? The answer is that they are trying to tackle the massive stock of debt in their economies and ordinary savers are the collateral damage.

The total level of debt in developed economies is at eye-watering levels - so rather than having defaults, the major central banks are attempting to inflate away this debt over time by slashing interest rates and enacting ultra-loose monetary policy in order to stoke inflation.

It doesn't take an economist to realise that if your interest rate isn't keeping up with inflation, then your purchasing power will be eroded over time as the 'real' rate of return is negative.

This low-rate environment presents an unwelcome challenge for those already retired and those close to retirement. The traditional investment playbook for retirees has been to achieve income by allocating heavily to low-risk bonds and cash and to minimise exposure to riskier assets like equities.

But as we have seen, the current environment means that bonds and cash are priced to produce negligible returns over time - and, worse still, will cause a loss of purchasing power if the ECB hits its inflation target of around 2pc.

Faced with this dilemma, retirees are forced to re-assess their perception of risk.

Traditionally, risk has been equated with volatility, but this simplistic definition can be dangerous in an ultra-low interest rate environment. For a retiree, the danger of running out of income in retirement is arguably the biggest investment risk they face - and unfortunately the traditional no-volatility portfolio may well lead to that outcome.

We're living longer than ever before, so someone who has recently retired or is on the cusp of retirement most likely has a long-term investment time horizon (20-plus years).

Such investors need not avoid short-term volatility at all costs; the traditional aversion to volatile assets (such as equities) must be overcome. Diversified investment in high-quality equities should become a part of sensible, long-term retirement plan.

By no means should a retiree dive head-first into the equity market, but a sensible allocation of a portion of their retirement savings can help boost their returns over time.

The key steps are to choose high-quality assets, to ensure there is sufficient diversification and, hardest of all, to be patient.

By their nature, equities do not deliver returns in a smooth fashion - but, given time, a diversified allocation to high-quality equities in your retirement portfolio is a hugely important step towards countering the low interest-rate environment and achieving satisfactory results over the long-term.

Daniel Moroney is an investment strategist with Investec Wealth & Investment

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