Bonds aren't what they used to be
It used to be the case that the choice between the stock and debt markets was clear. Stocks are more risky than debt but over longer investment horizons stocks are more lucrative. In contrast, bond markets are illiquid and offer unattractive low real yields. If one wanted good performance there was no choice. It was the stock market or bust. However there have been three major developments in the fixed income universe in the past decade that make this sort of simplistic thinking misleading. Specifically, the development of macroeconomic policy, the euro and innovative debt securities have changed the fixed income market beyond all recognition from the debt markets of the early 1990s. My contention is that these developments have made bond investing more attractive relative to equities. It is time to rethink the role of bonds in pension plan investments.
Central banks, the European Central Bank, the US Federal Reserve and the Bank of England being the predominate among them, have learned how to deal with inflation. That is not to say that inflation is dead. Mistakes can be made and unexpected supply shocks – say a politically motivated sharp rise in the price of oil – can still push inflation beyond acceptable boundaries for a period of time. Nevertheless central banks have achieved a degree of independence from political control and have established information monitoring systems that allows them to make independent decisions on interest rates. In recent years central banks have proven their ability to keep inflation under control even in trying circumstances.
For debt markets, the obvious implication is that we cannot realistically hope for double-digit nominal yields on sovereign bonds in the major triple-A rated currencies. But on the other hand inflation risk is much more subdued, so it is not obvious that the low nominal yields of the present represent a poor return. Even in the high-yield environment of the 1970s and 1980s bond investments did not consistently obtain real returns in excess of 2–2.5%. Even so, if one was still worried about the impact of inflation, index-linked sovereign French and British bonds offer a real coupon rate of approximately 2–2.5% while protecting the coupon and principal from consumer inflation.
The euro is here to stay. This does reduce the number of triple-A currencies that are available for investment thereby reducing the possibilities of diversification. Nevertheless, the benefits of the euro more than outweigh the costs. From the non-euro investor’s standpoint, it is easier to invest in European bonds, as it is easier to hedge one currency rather than many. All investors will see important benefits in liquidity as European-wide trading platforms develop that promise to create a debt market of the depth and liquidity greater than that available today in the US. For example, Euro MTS has established a bond-trading platform where dealers can make parallel quotes in several national bond markets rather than just one. Improvements in liquidity will allow investors to adjust portfolios quickly and cheaply, thereby reducing much of the liquidity advantages of the equity market.
Finally, we have seen many new innovations in the fixed income market during the past decade. The range of choice available to investors in fixed income investments is astonishingly wide. We now have asset-backed securities and low grade corporate bonds as well as traditional sovereigns and high grade corporate and semi-government bonds. Credit risk is no longer the prohibitive barrier it once was now that the credit derivative market is just starting to attain the size and liquidity that we would expect from a mature market. Even within the traditional sovereign bond market we have a broad range of interesting securities such as very long-term bonds in the UK, inflation-protected bonds in France and the UK and zero coupon bonds in all major European sovereign bond markets. Moreover we have learned how to price these securities in a reliable way. Taken together, this wide range of fixed income instruments has created an environment where it is up to the investor to select the attributes they desire of a portfolio. The investor can quantify the interest rate and credit risk they are willing to assume and then purchase the debt instruments and fine-tune their selections to construct a portfolio that contains the desired level of interest and credit risk.
For example, supposing one was dissatisfied with low nominal yields on sovereign bonds and was willing to “reach for yield” by investing in corporate bonds. The problem used to be that corporate bonds were subject to default risk, so one would arbitrarily decide that bonds below a certain grade, or obligations of unfamiliar corporations, would not be an acceptable investment.
Nowadays one need not apply these unduly restrictive investment selection rules. Instead one could purchase a relatively low-grade bond, say BBB and hedge the credit risk of this bond by purchasing a credit derivative. There are a variety of credit derivatives; the most common is the credit default swap. Essentially the credit default swap is an insurance contract that will compensate the buyer of credit protection losses due to default. In the parlance of the credit default swap market the insured bond is the reference bond. Typically the credit default swap will pay par less the value of the reference bond post default. In return the buyer of credit protection will pay a premium quoted as a number of basis points. The cash premium is the swap premium multiplied by the amount of the reference bond that is insured. Premiums are quoted annually but typically paid in equal quarterly instalments. If default should occur the buyer of credit protection receives a payment of par, the flow of premium payments ceases and the defaulted reference bond is given to the seller of credit protection.
Of course, premiums can be outrageously expensive if the likelihood of default is high but there is a simple rule of thumb that can signal whether this is a problem. Obtain a quote for a credit default swap for the same maturity as the reference bond. The annual premium should be less than the credit spread between the reference bond and the corresponding sovereign. Since the credit spread represents the cost of liquidity as well as default risk, swap premiums close to or even greater than the credit spread mean that the credit protection buyer is paying more to hedge credit risk than the amount of compensation offered by the market to bear credit risk.
The global credit derivatives market is now large. However, there is still some legal uncertainty, as disputes regarding credit derivatives have not yet been tested in the courts. Nevertheless, credit derivative markets are growing exponentially. The corresponding improvements in liquidity and wide product choice in the credit derivative and underlying bond markets, combined with low inflation risk, suggest that fixed income investing will play a greater role in pension investing in the coming decades.