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A challenge to long held investment orthodoxy

11th July, 2022

Published in The Sunday Times on July 10th 2022

Boring bonds

No investment should be as sleepy as the Government bonds of rich countries. In exchange for the investment equivalent of watching paint dry, investors accept low returns. 

At least that is supposed to be how it works. But investors in Austria’s 100-year bonds are getting a crash course - excuse the pun - in duration risk.

We have become very accustomed to easy credit conditions over the last decade, but nothing quite said cheap credit like the two-billion-euro century bond Austria issued in 2020 (not due to be repaid until 2120). Despite carrying a paltry yield of just 0.88%, it was 10 times oversubscribed at auction.

That bond is now trading at 42c in the Euro. It seems extraordinary to write this, but owners of this bond have endured a peak to trough loss similar to equity investors in Netflix over the last year. Equity investors where upside is limitless, accept, even expect significant volatility. AA rated Government bonds offer no such return prospect, so a quiet life is anticipated. You pay to come along for the equity ride. Austrian Century bond investors will feel like they’ve been taken for one. 

The fact that Austria’s century bond was issued with a long timeframe and a very small coupon makes it particularly sensitive to rising rates. And this year has been all about higher rates.

TAPAS

For the past five years, TINA — There Is No Alternative – encapsulated the notion that investors had no choice but to buy risky stocks because boring old bonds were yielding so little, or indeed were costing money to hold even before you take inflation into account. 

With bond yields now much higher, the market mood has turned somewhat. Talk has turned to TAPAS – there are plenty of alternatives! You don’t have to extend your timeline too far these days for what many would view as an acceptable return. A portfolio of European investment-grade corporates with an average duration around 4 years provides a yield of up to 3 per cent. Yes, if interest rates keep on rising, the face value of these bonds will decline, but only modestly. 

But the not-so-sleepy bond corner of capital markets raises a broader issue for investors that have historically relied upon bonds to provide much needed diversification in a balanced portfolio. 

Much has been written about how historically low bond yields have sounded the death knell for the 60% equity/40% fixed income portfolio. The so-called 60/40 portfolio’s prevalence is due to its simplicity as well as the theory that this combination of stocks and bonds provides the optimal balance of asset volatility. 

Target date funds

The most popular variant on the 60/40 theme is the target-date fund. The idea is that savers are offered a fund with a target date for retirement, and asset allocation will be kept at appropriate levels according to how long there is until retirement. Younger people will automatically be given a higher weighting in equities. Each quarter there is a rebalancing to maintain the desired asset allocation, which mostly means selling stocks and buying bonds after stocks have risen. Over the last decade this has guaranteed continuing flows into bonds, despite their low yields. 

Recent research by the Investment Company Institute and Employee Benefits Research Institute shows that target date funds have become the backbone for retirement saving in the US. 

The problem is that this is predicated on the notion bonds and equities will not fall at the same time. But 2022 has raised questions about that assumption as conservatively invested funds have endured almost as steep a decline in value as more aggressive portfolios given the steep bond sell off. 

And data suggests that when Central Banks are priming the pump with quantitative easing (QE), 60-40 does well, and when it attempts to tighten by reversing QE, 60-40 plans do badly. That pump is about to be reversed.

For people saving in target-date funds, any continued pattern of falling bonds and equities is going to look awful - and feel even worse. 

The challenge for 60/40 funds in future

For asset allocators who’ve relied successfully on 60/40 portfolios that balance bonds and stocks, a shift in the dynamics of how the two interact is unwelcome news. But an interesting paper by DE Shaw shows that the aggregate relationship between bonds and stocks has not changed much over the last decade. However, the dispersion in sensitivity to changes in interest rates across different sectors has become much more material in the last decade. Some companies are affected positively by higher rates, and others negatively. So, it’s not enough to assume an aggregate relationship anymore. 

Stock and bond correlation and duration risk are not topics that will stir the soul and certainly not ones I thought I’d ever get an article out of.  But at a minimum, recent developments in bond and equity markets speaks to the importance of a more active approach to asset allocation and indeed retirement planning. 

 

Market Data: Calendar year returns

  2017 2018 2019 2020 2021
Netflix 55 39 21 67 11.4
Austria Century Bond N/A N/A N/A N/A -36%

Source: Bloomberg. Figures in USD. 

Gary Connolly is Investment Director at Davy. He can be contacted at gary.connolly@davy.ie or on twitter @gconno1.

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