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Monday, 18 December 2017

The NIRP asset allocation nightmare

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  • James Saft - June 2014

Policy looks to be closing the doors one by one for investors, who will simply have to live with less reward and more risk, says James Saft.

Negative interest rates are a nightmare for asset allocation, raising risks, lowering returns and upending convention wisdom.

At issue is how to earn an acceptable return with fixed income yielding little to nothing and quite possibly not acting as a stabilizing force in portfolios.

Negative interest rate policy (NIRP) is spreading rapidly among developed economies, now being employed by central banks in Japan, Switzerland, Sweden and the eurozone. Somewhere around a third of all developed market sovereign bonds now have a negative yield, meaning it costs investors to hold them.

While there has been much discussion of the negative impact of NIRP on equity markets, specifically due to the way in which it imperils the business model of banking, it also heightens a set of issues which long-term investors have faced in making asset allocation calls as interest rates decline.

Traditional asset allocation centers around diversifying among an array of assets in order to achieve the best risk-adjusted, long-term returns.

Bonds, which are imperfectly correlated with stocks, play a key role as they have traditionally allowed investors to be more courageous in taking on risk, secure in the idea that bonds don’t fall as much in value during market drawdowns.

Of course this situation is exactly why central banks have turned to negative or very low rates. They are a tool used to try and tempt investors to abandon traditional risk constraints and, hopefully, stimulate the economy by investing and lending more freely.

NIRP also causes huge problems for investors, like pension funds, which use bond yields as a tool, often specified in law, to help estimate their funding position. The lower market rates go, the more money a fund needs today in order to be sure of meeting future obligations.

NIRP may or may not be good medicine for the economy, but it also implies that a substantial part of an investor’s portfolio will throw off very little income, even if additional fixed income risks are taken on.

“For investors, the forward looking risk-return profile has significantly deteriorated. Simple measures for long-term expected real returns on their portfolios –  based on yields on assets and inflation expectations –  have substantially declined, mainly due to the fixed income part,” Guilhem Savry and Jerome Teiletch of Swiss money manager Unigestion wrote in a 2015 communication to investors.

“Risks have increased as well. While bond volatility remains near historical lows, the forward looking risk of fixed income has in our view increased significantly.”

Lower returns and higher risk, what’s not to like?

Last year when negative rates were inaugurated in Switzerland, Lombard Odier, a Swiss asset manager, ran a simulation on how a traditional portfolio of Swiss franc assets comprising 60% equities and 40% Swiss bonds or liquid assets might perform over a longer period of ten years or more.

Lombard Odier found that fixed income helped to maximize the risk/reward trade-off only in the event of a “severe deflation.”

Specifically, to make the traditional mix work you need a ten year horizon to allow you to recover from losses when bonds sell off as rates rise, and, you need bonds and stocks to behave in a highly uncorrelated way. That hurdle has only been met by Swiss stocks and bonds a few times in the past, and not, on average over the last 20 years.

To be sure, Switzerland may be a special case, but it doesn’t seem wise to bet as if it is.

The bottom line is that we are in new territory, and that there are good reasons to doubt that the usual allocations will work as we’ve always hoped.

One other potential side-effect of NIRP is that it raises the attractiveness of holding cash, which, though it has no yield and does cost money to manage, also does not lose value as do bonds when rates rise.

Note that the most recent Bank of America Merrill Lynch survey of fund managers shows they are now holding the most cash, 5.6% of portfolios, since 2001, though this may be in part a function of caution over equity losses.

It’s interesting also in this respect to note the growing movement to make holding cash, specifically the kind you might stuff under a mattress, harder to do.

Not only is the ECB considering ending production of the €500 note, which it says is too often used by criminals and terrorists, but none other than former Treasury Secretary Larry Summers has suggested the US do the same with the US$100 bill.

Policy looks to be closing the doors one by one for investors, who will simply have to live with less reward and more risk.

(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)

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