- The current low interest rates correspond to a long-term trend of falling real and nominal interest rates.
- Central banks are not to blame for the low yields, rather they have reinforced and accelerated a long term trend.
- Even if monetary policy normalizes, interest rates - and thus yields - are likely to remain below the long-term average.
- Does it still make sense to invest in government bonds or low-risk bonds with negative yields? The answer is “YES”. First-class bonds diversify and stabilize the portfolio. They belong in the portfolio, even if this involves paying a premium.
- Investors should not compensate for the low/negative bond yields with additional risk or more complexity. It is better to improve the efficiency of the portfolio through optimized risk management.
- An efficiently diversified equity portfolio allows for a higher equity exposure without exceeding the risk budget. It thus also delivers a higher expected return.
Central bankers are not superheroes
As a high school student I was fascinated by the central banks and their power to print money. In my naive vision of the economy, they would be able to solve the world's problems with their "seigniorage power". Later, at university, disillusionment followed: I realized that my supposed superheroes could neither do magic nor print money at will without risking doing more harm than good. The greatest risk would be to lose their highest attribute, namely their credibility. I have also learned that the interest rate cannot drop below zero: Why would anyone give up consuming today and instead lend money to consume tomorrow, if tomorrow they will receive less than today?
... or are they?
Today even orthodox principles are crumbling: The central banks' money printing machines are running relentlessly, leaving a quarter of the world economy (measured by GDP) with a negative interest rate. Was my once naive view of the role of central banks correct after all? Are they superheroes after all? The economy is doing well, unemployment is relatively low, there are no inflationary pressures, the financial markets are delivering substantial positive returns and the credibility of the central banks is not being put into question (yet). Do we really have to throw out the classics among economic textbooks? There is a lively debate in the media right now between those who are concerned about the nonchalant attitude of central banks and those who see the banknote press as the solution to the world's economic problems. Among the latter are the advocates of Modern Monetary Theory. Regardless of who is right and who is wrong: If the central banks stop the printing press and bring the real interest rate back to at least zero, most investors, especially institutional investors, will have more sleepless nights.
Investment emergency postponed
Supported by the ultra-expansive monetary policy, the financial markets have continued to rise unabated over the last ten years. In 2019, most stock markets recorded historically high returns. At the same time, the term pénurie de placements or Anlagenotstand, in English “investment plight” has been circulating in the Swiss media for about five years and the term is ubiquitous at every institutional investor conference. Given the juicy returns of the last five years, one may ask: What pénurie de placements?
Have the investors who have had to deal with the anomaly of a negative risk-free interest rate for almost five years learned how to deal with it, despite the fact that no textbook provides for such a possibility? Negative interest rates affect Switzerland as well as the Eurozone and - for some time now - Japan. The USA is still recording slightly positive interest rates.
The good portfolio results were possible because of capitalized future returns, i.e. they are already included in today's prices. However, this means that the returns expected in the future will be correspondingly lower. Indeed forward looking, investors are facing higher challenges than in the past years.
Replacing unrewarding investments?
For a long time it was important to avoid "Japanization" - an economy with negative or near-zero inflation, permanently low interest rates and low growth. Well-known analysts considered this scenario impossible for the European or North American economy. Today, 15 years later and with negative interest rates, we are in an even more difficult situation than the Japanese asset managers were back then.
The question is: Is it wise to invest in assets with a zero or even negative return? Shouldn't such unrewarding bonds simply be removed from the asset allocation? There is a strong temptation to replace them with substitutes that have a positive return and a recurring income. Typical candidates for substitution are real estate and corporate or high-yield bonds from debtors with poor credit ratings. In addition, alternative investments such as infrastructure investments, private loans or private equity are also considered substitutes. What most of them have in common is that their value is based on expertise and appraisal value - and not on a daily market price. The danger of forgetting the risks - implicit or explicit - is huge.
Learning from Japan
We advise investors not to switch negative risk-free returns for greater complexity and risk, as we explained in last year's research note. Rather, we recommend sticking to the risk budget until the possibilities for risk optimization have been exhausted. Japanese portfolio managers stoically continue to buy Japanese government bonds, even if they have a negative return. So what is the motivation for investing in these assets? The answer is very simple: consistent management of portfolio risk and/or decorrelation.
Decorrelation and risk dilution
A key feature of investments in risk-free government bonds for a multi-asset portfolio is risk mitigation. Apart from the decorrelation effect, which is also common in other asset classes, the so-called risk dilution effect also contributes to risk reduction, and in a significant way. It arises when we combine high-risk investments with bonds that have little or no risk (measured by standard deviation). First-class (risk-free) government bonds have the lowest volatility and thus the highest risk dilution effect. They are the only investments that guarantee (nominal) capital repayment at maturity. At the same time, the low or even negative correlation to equities, as we have experienced over the last 20 years, offers a further contribution to risk reduction via the decorrelation effect. Especially in times of crisis, risk-free government bonds continue to be a safe haven. They are therefore important for stabilizing the portfolio. Figure 1 shows that the correlation between government bonds and equities has remained relatively low over time and their volatility ratio (a measure of risk dilution) stable.