Brent Sheather: Bond threat in oldies' gold

Mum and dad battlers, long-time Tauranga residents, having shifted down from Auckland well before the traffic got bad, officially retired about 10 years ago.

However both have continued working on and off so haven't had to touch their savings.

Now, well into their seventies, they have finally given up their part-time jobs and are getting used to the idea of sleeping a little later.

But this more relaxed lifestyle also means they will have to start dipping into their capital to pay for one-off expenses such as replacing cars, painting the house and the occasional holiday.

Tim Bond is an economist at Barclays Capital in London.

He hasn't met the battlers but is well aware of the tendency for retirees to finance their living expenses by running down their savings.

Bond sees that scenario and the fact that older people will comprise a much larger proportion of the population over the next 20 years as representing a headwind for both shares and bonds.

Demographers - people who study the characteristics of populations - tell us that over the next 20 years or so the baby boom generation will age into retirement.

The dynamics of this shift are the same across most industrialised economies with even some developing nations such as China moving in the same direction.

In a paper cheerfully entitled Dismal Demographics, Bond suggests that, based on the historic relationship between the number of retired people and interest rates, the rapid ageing of the Western world's population over the next 20 to 30 years is likely to be bad news for both shares and bonds.

The life-cycle theory of investing suggests that the young and very old don't save much whereas the middle-aged typically save obsessively.

So if the world is full of lots of old people selling their government bonds to fund holidays on the Gold Coast, all other things being equal, the price of such bonds will be lower than they are now. Simple supply and demand.

Bond's research confirms that in the past in both the UK and the US as the percentage of older people in the population roses and fell so did interest rates.

The particular significance of this finding is that as the number of older people increases as it is forecast to do in the next 20 to 30 years, long-term interest rates may rise and thus the price of those bonds will fall.

This will reduce the returns for those investors who hold long-dated bonds - such as all the big pension funds. (Remember, all other things being equal, higher interest rates means a fall in the price of the bond.)

In such a scenario investors might be better off holding short-term bonds such as bank deposits whose yields rise along with the market without suffering a fall in price.

If 30-year US Government bond rates rose to 12 per cent as shown on the graph, the price of those long-dated bonds would be around 50 per cent lower than today's level. Nasty.

But wait, it gets worse. Bond has also spotted a negative correlation between the growth in the retired population and share prices.

In other words, because the retired are more likely to sell shares to fund their retirement this process implies lower share prices.

Bond concludes: the long-run outlook therefore seems to be for some combination of slower economic growth, a gradual rise in inflation, weak real equity prices and rising long-term interest rates.

Now before everyone rushes out and sells their stocks ahead of that crowd of old people it's worth reflecting that Bond just might be wrong.

Even if he is right some sharemarkets, ours for example, might outperform cash in the scenario he describes.

In Bond's world shares pay dividends of between 2 per cent and 3 per cent (US and UK) whereas locally we are looking at around 6 per cent.

What is clear though is that with dividends on international shares close to historic lows even a small increase will have a big negative impact on share prices.

Some experts have also noted that the widespread belief that international shares will outperform in the future risks prices being pushed up today to such an extent that shares actually underperform.

Throw in the threat posed by demographics and fee structures which apparently permit some financial planners to earn as much as newsreaders and you soon start having intrusive thoughts like whether buying and holding international shares really is a one-way bet.

* Brent Sheather is a Whakatane-based investment adviser.