This is the introduction to a series of posts that will consider various possible responses to the current environment of low or negative fixed-income yields. To read the first in the series, on stock market indexes, click here.

How long does it take for an anomaly to become normality? For investors hoping to ride out the weird new world of negative rates, it might be time to admit that they're here to stay. Central bank rates in the Eurozone, Japan and Switzerland have been below zero for the past five years; the UK yield curve only gets out of negative territory at a ten-year tenor; and even US treasury bills (with a maturity of one year or less) are only yielding a measly 8 basis points above nothing. However fast the post-coronavirus economic recovery might turn out to be, it's hard to construct a compelling argument that yields will recover as quickly - especially in Switzerland and the Eurozone, where anemic yields have become a fact of life.

The problem is that zero or negative yields turn conventional investment wisdom inside-out. The basic investment portfolio has always been a mixture of stocks and bonds - with the allocations depending on the investor's risk appetite and tolerance. The logic was simple. Investing in stocks could generate higher returns, but comes with significant risk to your capital; parking your money in safe, sovereign bonds might have only yielded 2%-3%, but came with far lower risk to your initial investment. What's more, it was sometimes assumed that stocks and bonds were negatively correlated - when the equity market fell, investors would shift their money into bonds, raising the price of your fixed-income position. Allocating a sizeable portion of your portfolio to bonds (often, the majority) made a lot of sense: you'd make a slightly lower return, sure, but you'd be protecting that capital and have something of a hedge against falling stock prices.

In a world of negative yields, though, that logic has been hollowed out. Instead of earning a modest return for parking your money with sovereign bonds, you're now being charged for the privilege - so that capital is being slowly but surely eroded. With the fixed-income portion of your portfolio effectively acting as a drag on its overall performance, your equity investments need to generate higher returns for your portfolio to hit its targets. There have also been some signs that the stocks-bonds negative correlation is fraying, though the extent of that is disputed. Either way, negative yields have pulled the carpet out from underneath traditional portfolio management.

There's one more characteristic of fixed-income investing that's important to consider: the predictability of the securities' cash flows. Consider a simple five-year bond that pays a coupon of 1% each year. Unless the issuing body goes bust - unlikely, if we're discussing sovereign governments in the developed world - you have perfect visibility on what the security itself will generate, and when, assuming that you buy and hold until maturity. You'll receive the coupon each year, and the entire principal at the end of five years. There are still many unknows, of course. The price of the bond will change according to shifts in the yield curve, market dynamics and geopolitics, which is important if you plan to trade the bond as opposed to holding until maturity. The context in which you receive those predictable cashflows is also unknown; 1% per year could look much better, or much worse, depending on what else is available at the same time.

At least you know some rough parameters though: the tenor and characteristics of the bond are fixed, and can be planned for. This is why institutions like pension funds have historically looked to fixed-income: when looking to generate enough return to meet liabilities at certain points in the future, it helps to be working with assets that also generate cashflows in an orderly, regular fashion.

With equities, all that goes out of the window. Unless your strategy is only to hold dividend-paying stocks, and hope that they survive indefinitely, equity investing requires more constant decision-making. Should you sell now - realizing any gains or losses - or hold out a little longer? If your strategy is to buy and hold, of course, you'll spend less time figuring out when to cash out - but even so, how can you have any real idea of whether your gains from a certain stock will be 1%, 10% or -25%?

From the above, we can tease out a few distinct advantages that fixed-income investing ought to offer:

  1. Relatively low level of risk for the capital invested
  2. Low but positive return
  3. At least a partial hedge against falling equity markets
  4. Predictability, with the security offering defined time horizons and cash flows

In the following posts in this series, we'll be examining some alternative candidates for bonds' place in the traditional investment portfolio. We'll be assessing each one based on the criteria above, and considering whether, in a world of negative yields, it might offer at least a partial solution.

To read the first in the series, on stock market indexes, click here.

The above does not constitute investment research, and should not be considered as either advice or an inducement to invest in any particular product or service

All text and graphics Copyright © Gold Grain Capital Ltd 2020

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Joe Gamse Author
AVP

Joe analyses macroeconomic trends, focusing on the impact of global affairs on the financial markets.

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