Brent Sheather: Less than zero

You don't know if your house is going to catch fire but you still insure it. Photo / Thinkstock

Earlier this year and the year before and the previous year experts were warning that bond markets were expensive. Amongst this year's most vocal advocates of the "sell bonds" strategy were no less than analysts from Goldman Sachs and the Chief Equity Strategist of Blackrock.

As with previous advice to this effect it has proved premature. Today as this graph illustrates 10 year US bond yields are close to the lowest level they have been since records first started back in 1791. Clearly the largest, most liquid financial market in the world is of the view that the future for the world economy is dire. Recall that, whilst share investors are optimistic fellows who like growth and a moderate amount of inflation, bond investors, in contrast, are cynical, glass half full types who get off on deflation, unemployment and recession.

However the luminaries from Goldman Sachs and Blackrock shouldn't feel too bad - many experts, and a good few non-experts, have been caught out by the continued decline in US bond yields. The fall in interest rates is not just a US phenomenon - it is happening all around the world, at least in government debt markets where the governments are solvent, including NZ where our ten year bond yield is currently just 3.3 per cent.

Professor Mike Staunton of the London Business School and co- author of the Global Investment Returns Yearbook advises that the all time low, since 1900, was 2.88 per cent in 1946. This column has warned about the implications of low interest rates for some time, most recently in "Financial Repression Coming Our Way" in May this year.

But the theory on what is happening with interest rates is developing all the time and a paper published in late July offers a new perspective as to why interest rates on bonds issued by governments which are not going to go bust are so low. The paper is entitled "Disastrous Bond Yields" and was written by two partners in the fund management firm of Fulcrum Asset Management (FAM) based in London.

The FAM paper presents a very simple argument that the risk of a worldwide financial disaster has increased markedly in recent times and in such an environment investors naturally gravitate toward assets that will protect their capital in even the most extreme environment. This is the reason that investors in short dated German bonds, for example are accepting negative interest rates at present. It is too easy and perhaps too convenient for financial advisors to dismiss current low bond yields as being caused by quantitative easing. Gavyn Davies of FAM writing in his blog argues that longer term bond yields have dropped by more than the QE factor can explain.

The FAM paper argues that bond yields are not low if one assumes "even moderately greater disaster risk". The FAM paper further argues that "provided bonds have a low risk of default then they have an insurance value relative to other assets. This insurance value rises as the risk of an economic disaster increases. Furthermore the reappearance of disaster risk increases the probability of a left tail event in economic growth and reduces the valuation of shares". I saw a graph of a disaster the other day wholesale prices in the UK fell by 60 per cent between 1920 and 1938. Anyone owning nominal government bonds over that period would feel quite pleased with themselves but imagine the pressure price falls of that size would put on companies with even a moderate level of debt.

A worse case scenario such as that alluded to in "Disaster Economics" could be particularly problematic for retired NZ investors. Many of whom have little of the "insurance" accruing to low risk bonds. This is in part because low risk is anathema to the finance industry which makes its money by selling investors risky assets and in the process pocketing a good deal of the risk premium.

Genuinely low risk assets pose a particular problem to finance intermediaries given they produce low pre-fee returns and, often, nothing after fees. Instead intermediaries tend to recommend junk bonds oblivious to the fact that at the slightest hint of trouble the bond market bifurcates and junk bonds start acting like shares i.e. they go down in price at a time when low risk bonds go up in price. For example in calendar 2008 when it appeared that the world was ending and the world stockmarket fell by almost half ten year US government bonds returned 26 per cent.

In addition some authorised financial advisers appear to have little idea as to the relevance of low risk bonds in a portfolio. This was amply illustrated in a newspaper article a few months ago where an authorised financial adviser advocated an investment strategy with "very little in bonds". His rationale, if you can call it that, was that interest rates were going to rise and that he knew the companies in his share portfolio very well.

Such misplaced bravado would be humorous were it not so irresponsible. This is not to say that the advisor is wrong he may be right interest rates might rise from current levels but uncertainty is a fact of life - you don't know if your house is going to catch fire but you still insure it. The point is the advisor is "betting the house" by eschewing safe assets in his clients portfolio and that sort of risky strategy is totally inappropriate for retired investors with relatively short investment horizons who have next to no ability to sustain large losses. Using the insurance analogy again if you insure your car then you should also insure at least part of your investment portfolio.

For some perspective on just how inappropriate a zero bond strategy is consider that the average pension fund in NZ has averaged a 40 per cent weighting in high quality bonds for at least the last 30 years and bond weightings in professionally managed portfolios overseas are being increased. Even the NZ Super Fund which has an investment horizon at least twice that of any retired person has a benchmark 20 per cent weighting in bonds, even if they get to it in an unorthodox manner.

Any fund manager with a balanced mandate who went to a zero weighting in bonds would be fired immediately and never work in the industry again. Oh, except maybe as a financial adviser.