- 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.
Effectively, investors were borrowing to invest in risk assets and this did not work out well. Bond yields trended quite a lot lower, which substantially increased the amount of capital needed to deliver a given amount of secure income.
In addition, the longevity of the population in pension schemes increased materially and ahead of prior actuarial expectations, so that the total cumulative future payments were well above forecasts.
The three effects – lower bond yields, poor risk-asset total returns and longevity increases – combined to drive today’s large defined benefit (DB) pension deficits.
The final fuel on the fire has been QE, which has artificially lowered bond yields further, even in to negative territory. (Never believe the hype that QE is costless.)
Looking forward
Gilts and AAA corporate bonds do not, and will not, offer positive real returns for a long time.
One of the reasons for this is that post financial crisis, balance sheet rules for banks, insurance companies, exchanges and broader market participants have been tightened a lot and require systemically important institutions to hold large amount of liquid, high quality collateral to mitigate systemic risks.
In simple terms this means there is an ongoing, large, uneconomic bid for high quality bonds that will keep yields low.
This effect is amplified by the impact of the Bank of England QE programme, which includes more than £400bn of gilts and £10bn of investment grade corporate bonds. You do not want to be competing with that.
But, not unreasonably, many investors want to allocate a portion of their capital to assets away from equity markets that generate income and that will deliver a positive real return and with a high degree of certainty.
They are prepared to invest for more than one year, but do not want to give up all liquidity and do not want to be a forced seller at the wrong time to raise cash.
So, is there any part of the bond market that offers high income without very long duration and/or high risk of default?
