Quitting equities or bonding to bonds? Conundrum for asset managers

In this blog we have already touched on the debate between so-called ‘active’ and ‘passive’ investment strategies. For vehicles investing in public securities, another debate lies in the choice of the asset class mix between equity and bonds.

 

What is the core trade-off between equity and bond?

Credits: Tectona Partnership

If we go back to corporate finance theory, this choice represents a trade-off between risk and expected return for the investor:

  • Bonds are generally safer (because they are repaid first in case of financial distress) but upside is capped in case of great performance as the lender is promised a fixed coupon which is set ‘once for all’.
  • On the other hand, equity holders capture all the upside if the company overachieves but are the first to get swept if the company goes under.
Historical returns for S&P500 (annual and 5-year trailing average) and 3-month US Treasury bills. Source: Aswath Damodaran, NYU

Historically equity returns have tended to be more volatile than bond returns – which reflect the risk that security holders bear. For a particular year, it is difficult to predict which class will perform best, although equity tends to offer a better return when considered over a sufficiently long period of time – equity investors are rewarded in the long-term for their acceptance of short-term risk. This phenomenon is captured in corporate finance theory by the ‘Capital Asset Pricing Model’.

An illustrated summary of the CAPM principles

 

Why is this debate making headlines again?

The general public and the asset management industry have reignited for a few months now. Today’s environment offers a mix of extremely low interest rates (UK 10-year government bonds yield less than 1.5% p.a.) and the lack of worldwide economic growth (3.4% in 2016 according to the IMF’s latest forecasts). In that context asset managers struggle to deliver satisfactory net returns to investors – who claim that the meagre returns they could get are almost entirely eaten by management fees.

Furthermore US market indexes all reached all-time highs over the last quarter, which has led investors to believe that the inflection point is approaching. Money has been fleeing equity funds to feed the bond market. The fact that some governments and even companies manage to borrow at negative interest rates only means that investors are ready to take a ‘sure, but small’ slap rather than risking of being hit much harder by leaving their money naked in the unpredictable turmoil of equity markets. In September BlackRock was estimating that $10trn of cash was earning a negative yield while $70trn was staying ‘on sidelines’, waiting for worthwhile investment opportunities.

Historical evolution of S&P 500. Source: Yahoo Finance

Low interest rates are also becoming problematic for ‘defined benefit’ pension funds, which guarantee a certain amount to their contributors. Those guarantees are based on assumptions regarding the evolution of interest rates, inflation, stock market performance etc. whereas the future promises are set in stone. Given the compounding nature of interests, a small drop in interest rates relative to expectations translates in billions of pounds of deficit: £710bn to be precise, according to a recent PwC report quoted by The Guardian.

 

How are investors reacting?

As explained above, to maintain a similar level of expected returns in an environment offering diminishing interest rates, investors need to take on more risks. In particular, following the 2008 crisis financial services regulators have forced banks to withdraw from riskier types of lending (taking the form of ‘high-yield bonds’) and this void is now filled by asset managers ready to finance more financially fragile companies in exchange for a decent return.

More risks from the same expected return, as explained by the CAPM

This obviously does not go without bad surprises. Lenders to the energy sector for instance took a hit earlier this year as commodity prices have suffered ups and (more often) downs.

 

If bonds are such a safe heaven, why are we hearing about a ‘bond market crash’?

Interest rates in developed economies have been running close to 0 for years now. As explained earlier, asset managers have massively bought bonds maturing in years in order to protect their capital. Although interests are indeed protected, the market value of the bond may be at risk if interest rates go up again – a move that the US Fed has already initiated.

To be clearer, let us assume you buy a bond (called ‘Bond A’) for $100 in order to get an annual (fixed) coupon of $1 for the next 10 years. Let us also assume that immediately after you purchase this bond the interest rates go up by 1% and that now for $100 you have a bond (called ‘Bond B’) paying an annual (fixed) coupon of $2. If you try to sell Bond A in this new environment, you will never receive an offer close to $100 – why would an investor pay the same amount to get a $1 coupon and a $2 coupon? In simplistic terms, the yield difference is approximately $1 over 10 years, i.e. $10, so you should expect this $10 difference to be reflected in the initial purchase price. If Bond B is still worth $100, Bond A will now trade around $90, i.e. you will suffer a c.10% loss on your investment.

If you scale this phenomenon up, it is easy to imagine that asset managers do not want to be left with their bonds when interest rates move up. As Central Banks start quivering, investors are preemptively selling their bonds, lowering the value of the existing bonds and possibly precipitating the collapse of the bond market even before Central Banks begin to move – one of the numerous ‘self-fulfilling prophecies’ that markets contain. In this case the situation would be even more difficult to stem as the market for bonds is significantly shallower and therefore more unstable. Although we have not come to this extreme (yet?), the fact that debt trading now represents the largest profit driver for banks should make us think.

 

How will this all end up?

Credits: www.digital-reporting.com

Unfortunately no one knows. Optimistic experts believe in a soft landing where fiscal initiatives would revive economic growth (‘a la Trump‘) while interest rates would go up, progressively drying the excess market liquidity and enabling the markets to come back to more normal levels in a seamless manner. Pessimistic observers do not believe in such a smooth transition and believe that painful losses will have to be taken and bankruptcies will be unavoidable. What is sure, though, is that the world we are evolving in is uncharted territory.