Why we’re thinking about yield all wrong
An extended period of strong yields from fixed income has crafted a generation of investors shaped by the 'yield trade'. But times have changed and Greg Maclean, Head of Research (Infrastructure), provides 3 options for trustees investing for the years to come.
Sometimes it makes sense for individual investors to look to institutions for cues and clues to inform how they invest – or at least how they think about the world they invest in – and sometimes it doesn’t.
No doubt about it, institutions will have an edge over the Average Joe or weekend warrior when it comes to information and investment insights; financial institutions employ the best and brightest and draw on research garnered from all over the world using tools out of the reach of most of us individually.
But there are times when it makes sense for individual investors to play to their strengths rather than follow the lead of institutions and the behaviour I’m seeing around the so called ‘yield trade’ is a perfect example of where this is happening.
Indeed, the yield trade is, in my view, a defining characteristic of global financial markets in the last decade, ever since central banks started dropping interest rates in the wake of the global financial crisis.
Most superannuants today were brought up at a time when you could get strong yields out of fixed income, and for many self-directed superannuants, particularly those with their own funds in the rundown phase, having a cheque on a regular basis coming in without thinking about it is very nice.
As we know, times have changed. The trap investors are falling into as I see it is they’re not changing with the times.
Back in the day, when investment grade bonds were yielding north of, say, 5 per cent, and when equity markets were up bond yields were down (and vice versa), the simple arbitrage provided good and consistent returns throughout the cycle.
In financial circles, the bond/equities arbitrage is almost a religion. It started with Harry Markowitz who published the hypothesis for modern portfolio theory in 1952. Markowitz, who got a Nobel Prize for his work, was a pretty humble guy because he says he was only putting down on paper what any decent asset allocator and funds manager knows: when the risk-free rate goes up, equities come down and bonds go up, so if you have a mixture in your portfolio things tend to balance out you can reduce the volatility.
This simple concept forms the basis of much of current institutional regulation. However, with yields now around 2-3 per cent, there is hardly any ability to arbitrage.
Institutional investors are commonly mandated to hold minimum requirements for bond type investments in their portfolios, and this has in turn led to the yield trade, where these investors are paying big premiums for bond proxy investments.
Total return mindset shift
If you believe that low bond and fixed interest yields will persist into the future, then you need to start rethinking the traditional approach to asset allocation and income in retirement. My own view is that I’ll be planted in the ground for 50 years before risk free yields will come back to where they were pre 2008.
There are three options for superannuants as I see it:
1. Cut back expenditure. People will say “I have to have yield and I want to preserve my capital’”, but I seriously wonder whether that makes any sense if a reduction in living standards starts to impact your enjoyment of life.
2. You could be tempted to go to a riskier type of bond product along the lines of a junk bond or a hybrid, but, if you’re going to take more risks to get back to the income you once were earning, you should really be rethinking your strategy, especially if you are in the rundown phase when security should be a priority.
3. Or you could change your investment focus from yield to total return. Properly managed this will allow you to preserve your overall risk exposure, while liquidating assets as required to preserve your living standards. This makes by far the most sense to me if your achievable portfolio total returns comfortably exceed that of a traditional bond/equity portfolio.
In many cases, this total return-style strategy will allow you to enjoy both an appropriate living standard while still permitting overall capital growth.
The strategy of managed asset liquidation requires that your portfolio has a minimum requirement for liquidity. This can be achieved through an appropriate blend of equities and real assets.
Free of restrictive regulation, individual investors have a marked advantage over institutions and can be far more flexible in asset allocation.
Thinking about yield without considering capital growth and liquidity could lead investors to impinging on their lifestyles. If this is the case perhaps it’s time for people to shift their focus to total returns.