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Low Bond Yields Test Investor Patience.


Low bond yields do not mean Individual investors should abandon their bond allocation.

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What is an investor to do when faced with the alternative paths of accepting a potentially inadequate return with low risk or accepting a potentially alarming amount of risk in order to eke out a marginally higher return?

In Sum

Investors are being influenced to move out of low yielding bonds. For example: Shift from bonds to stocksManager keeps focus on yieldAppetite grows for high-yield emerging-market debtDemand for REITs insatiable as investors chase higher returns. Unfortunately, articles like this appear at times when investor demand is already high and return prospects are already past their prime. Morningstar calls this classic performance chasing.

(This is not an indictment of the financial press. They deliver the information that their readers demand … by interviewing biased investment advisors. And bonds are, well, less interesting. Rob Arnott has written that the investment world is simply equity-centric. Bonds are like a dull cousin).

The traditional risk-averse investor is faced with a no-win decision as persistent low interest rates converge with demographics. “Competing pressures face aging baby boomers. On the one hand, there is the classic need as an investor ages to grow more conservative and risk-averse, to favour bonds over stocks. On the other hand, in today’s near-zero- interest-rate-environment, there is an increasingly intense search for yield which has of late ignited high-yield, real estate and corporate bond markets.

Low bond yields appear to be driving asset allocation decisions. As a result, Individual investors may be compromising their long-term strategy and assuming more risk than they would normally take. But just because yields are currently low is no reason for Individual investors to abandon their long-term asset allocation strategy. Both the Bank of Canada and the U.S. Fed Reserve have promised that rates will go up.

Investors may have to be patient … because the alternatives to low yielding bonds may be even worse.

Details

As Mawer Investment Management recently wrote “we don’t hold bonds strictly for return potential – they also provide valuable downside protection.” Investors use bonds to provide diversification and reduce risk. Sometimes, bonds deliver a bit of income as well. An important purpose of bonds in a portfolio is to provide stability in times of severe markets. Bonds are simply a safe haven when markets are stressed. In a panic, bonds have been the best among the worst.

Wharton professor Kent Smetters has said that “Stocks should not be the main workhorse vehicle for basic retirement needs. Bonds should be used for retirement and stocks for goals where falling short is more acceptable.

As always, Individual investors can look to Pension Plans as a reference point.

What are Institutional investors doing with bonds?

Institutional bond allocations have been relatively stable. The average Canadian pension plan (per PIAC) still has about 1/3rd allocation to bonds. The average U.S. Corporate and Public pension plan (per pionline.com) is similar. There has been some but not much change in recent times. US Institutional asset allocations per JPM, Empirical Research

(click on jpeg for larger picture).

To be sure there is some re-configuring of bond allocations. Some plans are buying longer bonds to better match long-term liabilities and pick up a bit of extra yield. Some plans use derivatives to change bond risk/return characteristics. Some skew allocations toward Corporate or Provincial bonds. Some add Global Bonds. For Institutions, bond interest income inflows look a lot like their mirror image; pension payment outflows. This they call Asset / Liability matching. But the bond allocation is relatively stable. Stock allocations are moving to alternatives but asset class movements are at an evolutionary pace.

For Individual investors, patience may be the prudent strategy more so than dumping bonds in a desperate hunt for yield.

If investors did abandon their bond allocation, where would they go?

Many investors are frustrated with low yields [but] they don’t have confidence in the [stock] market.”

Dividend paying stocks

Alliance Bernstein writes “High dividend paying stocks not as safe as they appear.”

Sionna Investment manager’s research says “valuations of high dividend paying companies are becoming stretched, and many of these stocks are trading at premium levels. Investors are ignoring other traditional valuation metrics entirely in the chase for dividend paying products. In some respects, it seems the market is valuing all yields equally and indiscriminately, regardless of the payout ratios (calculated as dividends divided by earnings) or debt levels that are supporting that income stream.

A Beutel Goodman / TD Securities chart shows the TSX Dividend Yield as a percentage of Long Bond Yields at ~135%. The average is ~40%. TSX Dividend to Long Bond yield per Beutel Goodman TD Securities

(click on jpeg for larger picture).

Blackrock (iShares) funds flow charts show a trend of redemption in dividend-themed (Exchange Traded) Funds.

Dividends currently appear to be pricey. Looking for yield in dividend paying stocks could mean entering a now overvalued market. Aka, buying high.

REITs

JP Morgan research says “utilities and REITs are at or near their most expensive valuations … the market is paying up for yield” and “static yield is an overcrowded space”.

Further, “Investors have driven the Bloomberg Canadian REIT index to a record high in 2012 with an almost 75% total return over the last three years.

Unfortunately, investors can’t buy historical returns. The easy REIT money may have already been made.

Global and Emerging Market Bonds

The price for higher yielding bonds is higher risk. By definition. In swapping Canada for Global or Emerging markets bonds, individual investors may assume a bond is a bond. But the accompanying credit, duration, currency and sovereign risks need to be considered in their portfolio context. I suggest that investors would rather not make the swap.

In recent years, massive inflows into Global and Emerging market bonds have once again bid prices up. Inflated prices suppress yields and distort markets. BCA Research writes that “Large portfolio inflows into global bond funds and the high popularity of EM assets over the past several years together have spurred investors to bid up corporate bond prices (suppressing credit spreads) despite deteriorating credit quality among EM corporate debt issuers. Nevertheless, strength driven by capital flows and not by healthy/improving fundamentals always turns out to be temporary. Investors will eventually realize that EM corporate creditworthiness is worsening, and the asset class will be at risk of a selloff.

Blackrock reports average daily EMB volumes in November were up nearly 50% over the 2012 average daily volume.

The Economist too has weighed in with their view of corporate bond risks.

Again, has the easy money been made?

(Note that according to PIAC, foreign bond holdings are still less than 2%).

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Bond yield are unacceptably low. But Individual investors might be better off exercising patience with their bond allocation. After all, a low bond yield is better than a capital loss from risks not considered.

Another reason to hang on to bonds? “Safe assets like bonds benefit as fiscal cliff negotiations in Washington get closer to the year-end deadline that will trigger tax hikes and spending cuts.

In March 2008, I wrote “Bonds? We don’t need no stinking bonds”. In May 2012, I wrote ‘Hang on to your bonds’. The points are, I think, still valid today.

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Next time? More Risk Management.
Doug Cronk CFA is Manager, Investments for a Canadian Pension Plan
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