Investments 

Hybrid solutions for risk-averse investors

  • To learn about the challenges facing bond investors
  • To understand about the advantages of hybrid capital
  • To see a different side to bond investing
CPD
30min
Hybrid solutions for risk-averse investors

Risk-averse investors are in a tough environment. Creating a portfolio that can both beat inflation and genuinely protect hard-earned capital is a difficult challenge. 

The perfect storm of creeping inflation, ultra-low base rates and quantitative easing (QE) – a mechanism firmly maintained by the Bank of England’s MPC as a continuing firewall almost a decade on from the financial crisis – have effectively repressed returns from ordinary investors’ portfolios.

After inflation, a large proportion of low risk investment options are guaranteed to deliver a loss.  

At times like these, investors will be looking to their financial advisers and wealth managers for answers.

It is far from straightforward, but a judiciously balanced hybrid capital portfolio might just do the trick, delivering above inflation returns – so anywhere north of 2.75 per cent net – while maintaining the key tenet of capital preservation.

Where we are today

The 2017 Barclays Gilt Equity study provides a clear, if somewhat disconcerting, snapshot of where inflation, cash and gilt yields are today in an historic context.

UK cash rates have averaged 1.3 per cent a year above UK inflation over the past 50 years, but that current real rate is about –2.5 per cent. The value of cash is eroding rapidly. 

Similarly, UK gilts have delivered about 3 per cent real over the same period, but 10-year gilt yields are about 1.5 percentage points below inflation at the moment.  

Last10 years20 years50  years117 years*
Equities2.53.765.1
Gilts4.34.53.11.4
Corporate bonds3.1   
Index-linked4.34.4  
Cash-1.30.61.30.8

Note: *Entire sample. Source: Barclays Research – Equity Gilt Study 2017

The current period of very negative real cash rates and gilt yields is therefore somewhat unusual, but more importantly it provides a challenge for investors who want to earn a positive real return without taking too much risk.

How did we get here? 

Global inflation rates and bond yields have been trending lower for about 35 years, effectively since the early 1980s. Along the way the low in bond yields has been called over and over again and forecasters have falsely predicted large and sustained losses for bond investors.

For example, in early 1994 the global bond markets did sell off heavily, but there was in fact 20 years of the bond bull market left and yields across all major bond markets subsequently reached new lows.  

As bond yields and inflation trended lower, many investors with long-dated liabilities remained short of duration. That is, the income streams on the bonds they owned was scheduled to run out earlier than the payment schedule they had to meet.

This was intentional, but flawed: being short duration represented a mistaken and very expensive bet on being able to re-invest at similar or higher rates in the future. 

Key points

  • Creeping inflation, ultra-low base rates and quantitative easing have repressed returns from ordinary investors’ portfolios.
  • Global inflation rates and bond yields have been trending lower for about 35 years.
  • Hybrid capital shares risk with investors.

There was also a doubling down of that bet that was even more costly: the asset-liability mismatch of an underweight position in secure cashflow was compounded by using the cash to buy other investments such as public equities, which were mistakenly expected to deliver the total return necessary to meet the known future long-term liabilities. 

Comments

CPD
30min
  1. According to Peter Doherty, what is the current real cash rate?

  2. According to Peter Doherty bond yields have been trending lower for 35 years. True or false?

  3. According to Peter Doherty, which of the following is not offered by hybrid capital bond?

  4. Hybrid capital provides an issuer with a lower cost of equity on an after-tax basis, true or false, according to Peter Doherty?

  5. What is an advantage of hybrid capital over high yield bonds, according to Peter Doherty

  6. Why has the hybrid capital market grown substantially since the financial crisis?

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