One of the most basic elements of the economics of retirement is the role of fixed-income investments in your clients’ portfolios. Some parts of this have changed over the years: clients in retirement today are more likely to continue to hold more equities than they would have in the past, when the standard model prescribed a retirement portfolio all, or nearly all, in fixed income.
The basics though have remained the same: almost every portfolio needs some fixed-income investments in order offset the (potential) volatility of equities, with the weighting shifting toward fixed-income as the client moves toward, and then enters, retirement. The relevance of fixed income isn’t related just to its structural importance in your clients’ portfolios: as this article is being prepared, the financial press is taking note that investors are sharply favouring bonds over stocks because of expectations for a better relative return.
The basic portfolio strategy may not have changed but I would argue that the execution has, in the sense that there are both more opportunities and more risks in fixed-income securities than there used to be. Let me suggest three things that have changed – and their implications.
An ever-expanding universe
The days of picking from a selection of Government of Canada bonds, with the odd foray into provincial or corporate fixed income issues are long-gone. The availability of fixed-income issues has increased in three different ways. First, there are more issuers in the traditional space of governments (at all levels) and corporations, and there are new issuers, including non-profit entities such as hospitals and universities.
A recent glance at the issues included in the DEX Universe Overall Bond Index showed 1093 securities.
That number is up by over 60% in the past 17 years. And, within the traditional federal-provincial-municipal-corporate space, provincial and corporate issues now play a significantly larger role than a decade ago. Second, there are more new types of fixed-income security issues such as asset-backed securities. Third, there is a much greater geographic selection of fixed income securities – part of the globalization of financial markets – representing a huge increase in the investable universe. That has been accompanied by loosened restrictions on foreign holdings by Canadian investors. It also brings currency fluctuations into the fixed-income selection process.
In general, an increase in the available selection of securities for a portfolio is a good thing. However, there is a potential downside in the sense that it requires more knowledge of what is available and the bigger the selection, the more time it will take to analyze the relative merits of the various alternatives and make a selection for an individual portfolio.
New and more complex risks
If risk isn’t on everybody’s mind after the financial market events of the past three years, it should be. The failure to remember that risk always exists (even in apparent good times), the failure to recognize emerging risks in financial markets in the years before the crisis broke and the outright failure of some risk assessments were all contributors to the global financial crisis, and to the financial pain that many investors have endured in its wake.
That the global financial crisis has passed, and that its aftershock in the form of the sovereign debt crisis in Europe has apparently been placed on the back burner of markets’ stove of worry, should not blind us to the fact that risk continues to exist – and always will. While the cyclical risk attached to the global financial crisis seems to have abated, there are remaining risks and some new ones to consider. Put more bluntly, how sure can we be that all the things that went wrong around security creation and credit assessment have been fixed? And, are there new problems being created?
In addition to the sheer increase in numbers, which makes it more difficult in itself to select securities, risk assessment is also much more of an issue than it used to be. Among the reasons: a lack of understanding of structural changes in credit markets, a lack of understanding, transparency and market-based pricing in a number of financial instruments, more complex issues around the performance of issuers, especially private issuers, as more and more firms do business globally. Add in currency volatility mentioned previously, default risk, solvency risk and the economic risk that is with us at the moment and you have a full plate of risks to assess.
The future direction of interest rates
It‘s been a great 30 years for bond markets. A brief glance at rates on long-term Government of Canada bonds shows a peak in rates in 1981 – a period of very tight monetary policy fighting to bring down a long period of very high consumer price inflation, followed by a long and steady decline to the present day.
Of course, interest rates on bonds have not come down in a straight line – they never do – but the difference between the DEX Universe Bond Index’s peak yield of 19.1% in September 1981 and 3.0% at the end of July 2010 pretty much tells the story. As bond yields have come down, prices have gone up, and fixed income investors have been well-rewarded from a capital gains point of view. Particularly, short-term rates experienced a bigger decline, having been part of an inverted yield curve in 1981 and more recently having been strongly influenced by the Bank of Canada’s near-zero benchmark interest rate policy, a policy only recently reversed.
Is the trend of the past 30 years likely to be the trend of the next 30? It wouldn’t seem likely. Admittedly, deflation, not inflation is the topic du jour these days. Whether you believe, as I do, that deflation is unlikely to occur, or not, if history is any guide, inflation is likely to be the more relevant topic going forward.
With a slowing economic recovery, lots of spare industrial capacity in North America and the aforementioned popularity of discussing deflation, it is hard at the moment to get people meaningfully engaged in a discussion of the likelihood of inflation. But, inflation, especially the long-term variety, is arguably one of the biggest threats to the viability of your clients’ portfolios.
Why should we expect inflation to become an issue going forward? The recurrence of somewhat higher inflation is likely as the result of continued economic recovery, even if that recovery continues to be slow. And, while central banks have clearly indicated that they are conscious of the need to (gradually) withdraw the very potent stimulus they injected into financial markets and the economy in response to the 2008-09 global financial crisis, the slow speed at which they may do that and the amount of stimulus already injected is likely to be enough to restart the inflation engine.
If you read central bankers’ public statements carefully, you will conclude that they are far more concerned with restraining inflation going forward than fighting deflation, despite the recent commitment of the U.S. Federal Reserve to a modest round of quantitative easing.
Finally, there is evidence of inflation already in some of the faster-growing emerging markets countries – India and China come to mind, and their respective monetary authorities have already reacted – some of which is likely to find its way to North America and Europe.
None of these arguments are intended to suggest that we are likely to enter a period of high inflation. The Bank of Canada has done a sterling job of keeping inflation within its 1 to 3% target band since the introduction of these targets in the early 1990s. Moreover, the Bank gives every indication that it will continue its successful policies. For those who observed Ben Bernanke as Fed Chairman prior to the global financial crisis, the picture clearly emerged of a Fed Chairman who intends to keep inflation subdued. Finally, history tells us that the incidence of inflation is many times that of deflation.
So, we are looking at a future of at least some inflation. If that does occur, one would expect interest rates to rise, the short rates being driven up by central bank benchmark interest rate tightening, the longer rates by market adjustments to these inflation expectations.
Conclusion
Of course, none of the changes described above are intended to suggest that fixed income shouldn’t continue to have its rightful place in your clients’ portfolios. They are intended to highlight that the fixed-income world is becoming trickier to navigate than in the past – we haven’t even discussed the yield curve, possible changes in its slope and the risks around making bets on duration. What I think it all means is that advisors are going to need to be aware of the potential issues and feel very comfortable when purchasing individual bonds for clients or partnering with fixed income portfolio managers to help manage their clients’ portfolios.