Part 1: Call for a new framework: Low bond yields render historical models redundant: Part 1
This two-part article discusses frameworks for how SMSF investors can start to understand asset allocation in the context of low nominal yields and what this means not just for bonds but also other asset classes.
Fixed income investments in a world of zero yields is in the spotlight as unconventional monetary policy has meant bond yields have shifted from low to zero to negative in some of the largest economies in the world.
This two-part article discusses frameworks for how self-managed super fund (SMSF) investors can start to understand asset allocation in the context of low nominal yields and what this means not just for bonds but also other asset classes. The role of duration, insights on how assets behave in different situations and the extent to which past behaviour can be considered as a relevant model are examined.
Lower Bond Yields: What does it really mean?
A bond yield has two components: a real yield and inflation expectations. While there are several theories on the evolution of lower neutral real yields, they all involve a rise in savings against a fall in investment.
Importantly, lower bond yields do not necessarily mean lower real yields – particularly when yields approach their lower nominal bound. But inflation expectations can become unstable, due to a lack of policy flexibility. In this environment, a new framework for portfolio construction is needed.
Inflation expectations are no longer stable in the context of lower bond yields. This means the nominal risk-free rate Treasuries is now an inadequate anchor for asset valuations. As such, the historical relationships between bond yields and other asset classes are no longer valid.
Policy options and limits
One of the downsides to the extent to which monetary policy has been eased is that in most cases, stimulating the economy today reduces, at least to some degree, the extent to which stimulus can be provided tomorrow. As more policy options are exhausted, the ability to further influence the cycle declines.
To model the degree of future policy choices left to support growth and inflation expectations, AMP Capital constructed a policy inflexibility index that considers the following:
- Does the central bank still have room to cut, or have has it reached a lower bound?
- Are long-term yields high enough they can be lowered through quantitative easing or forward guidance?
- Is the currency expensive – and so is there room for it to become cheaper?
- Is the budget deficit low, allowing room for more government spending?
- Are government debt levels low so fiscal policy can run bigger deficits for longer?
While these assessments are subjective, the aim in developing this index was to add systematic processes around what policy makers can still do.
Considering Australia, Europe, Japan and the US, Australia has the most room to move. This is due to higher policy rates and lower government debt and budget deficits relative to other countries. Recently, improvements in the budget and the rally in its dollar have given the US more policy options. The European Union (EU) and Japan are the most heavily constrained.
Pre-inflation versus post-inflation targeting
To understand the impact on nominal yields, AMP Capital modelled the performance of asset classes across two broad time horizons – the US Federal Reserve’s pre-inflation targeting covering the period from 1960 through to the first quarter of 1994 and post-inflation targeting following the first quarter of 1994.
The key findings are presented below.
During this period, inflation and inflation expectations were high and volatile; central banks’ inflation-fighting credibility was yet to be established. Hence, there was a significant inflation premium embedded in bond yields. Monetary policy was constrained in having to deal with high inflation while stabilising the output gap that led to policy often being pro-cyclical.
Bond returns were positively correlated with equity returns, especially when inflation was falling. Even during periods of recession, as the Fed cut policy rates over 1981 and 1982, long-end yields continued to rise.
In this period there was greater inflation credibility, with low and stable inflation and inflation expectations. A lower inflation premium was embedded in bond yields. Monetary policy was more flexible as it wasn’t restricted by high and volatile inflation.
Monetary policy became more effective when it was used in a counter-cyclical manner. The correlation between bond and equity returns switched in this period – bond returns became negatively correlated with equity returns providing defensive characteristics.
Correlations in a constrained nominal world
When bond yields are near the nominal zero bound, bond and equity returns become less negatively correlated. This period of increased correlations with equities can erode a balanced portfolio’s return. This was evidenced in the “US Taper Tantrum”, where bond and equity returns became positively correlated, and both delivered negative returns over the period.
In the US nominal yields have been falling and inflation has remained fairly stable since inflation credibility was established from the turn of the century to 2014. Since nominal yields are now close to zero, discussions need to move to real yields and inflation.
The correlations of both nominal yields and real yields to equities have behaved in the same way over past 15-years. More recently, though, they have diverged –when equities have moved lower, real yields have under performed nominal yields because inflation has been falling. Real yields no longer necessarily behave like nominal yields. This can be exacerbated in a zero-yield world where inflation expectations are falling.
Impact of correlations on total portfolio volatility
It’s important to note the effects of portfolio volatility under different scenarios. Where real yields have been increasing under either policy inflexibility or where there has been policy normalisation, then correlations are close to zero.
Consequently, the benefit of bonds in a low bond yield environment in the portfolio comes predominantly from volatility reduction since bonds have lower volatility than equities rather than from a negative correlation of returns between bonds and equities seen through the post 1994 inflation targeting era.
Defensive factors: duration and income
Sovereign fixed income has two basic aspects that make it a good buffer for risk assets in portfolios: as sentiment turns negative, nominal yields fall; and during periods where risk assets do poorly, the value of bonds typically goes up.
On the income front, stable coupons from an asset that won’t default stabilises the return profile of a portfolio. The virtue of bonds is that unlike equities, the dollar payments aren’t particularly dependant on earnings rates and so don’t decline as growth falters. Additionally, in the case of a drawdown, assuming income-generating assets don’t default, income can help get the portfolio back to its prior peak faster.
In part two of this series next week we look at how assets might behave under three different sets of circumstances:
- Diminishing inflation expectations
About the author
Ben Gorrie is a Portfolio Analyst at AMP Capital, Steve Hannaford is a Portfolio Manager at AMP Capital, Nam Nguyen is a Portfolio Manager at AMP Capital, Andrew Scott is a Senior Portfolio Manager at AMP Capital and Ilan dekell is the Head of Macro at AMP Capital.