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“The market can stay irrational longer than you can stay solvent.”
This much-used and abused market saying is often dusted off when pundits perceive that some actions on the part of investors are irrational in the face of data. But being irrational can sometimes be the “rational” thing to do.
I recently pondered the long-term outlook for government bonds. For years, I have wondered why investors keep investing in these assets despite their extremely low yields. If you buy a 10-year gilt today and hold it to maturity, the total return will be around 0.9% per year, way below the going 2.4% rate for consumer price inflation in the United Kingdom or the 10-year expected average retail price inflation of 3.3%.
The situation is even worse for investors in government bond portfolios that try to match an index, which essentially means keeping the duration of the portfolio within a narrow range. The modified duration of the current on-the-run 10-year gilt is 8.8. So an upward shift of the yield curve by 1% will lead to a loss of 8.8% in a portfolio with that duration. A small rate move can destroy more than seven years of returns.
Given that the current yield of gilts and government bonds around the world is so low, lower yields in the future are much less likely than higher ones. So why would any rational investor hold government bonds in their portfolio? They may think that with the right adjustment path it will still be possible to beat inflation with government bonds by reinvesting coupon income at a higher yield. I demonstrated years ago that this is practically impossible.
Institutional investors typically argue that they need to invest in long-dated government bonds to match the duration of their liabilities and neutralize interest rate risk in an asset-liability context. But with interest rates close to zero, there is an opportunity to improve the funding ratio of an existing pension fund. If a pension fund stops investing in long-dated bonds and interest rates rise, the present value of the liabilities will decline substantially but the value of the assets will not. Hence, the funding ratio increases. On the other hand, if interest rates stay low or decline a little bit more, the present value of the liabilities will increase while the present value of the bond portfolio will not. However, if the long-dated bonds are replaced by equities or alternative investments, chances are that lower interest rates will boost the returns of these asset classes and limit the decline in the funding ratio.
The seemingly rational thing for institutional investors to do would be to reduce their government bond holdings and slash the duration of their bond portfolio. Yet few institutional investors are doing that. The irrational thing to do is to invest in bonds with next to no return and lots of downside risk. And that is what most institutional investors continue to do today.
It may look like we are facing an “idiocy of the masses,” but I believe we are simply facing a “mass of idiots.” It is a crucial difference. If an investor faces a mass of idiots large enough to drive the overall market, the rational thing to do is to join the mass, no matter how stupid that may seem. Assume you run a pension fund and you have long-dated liabilities. If you stray from the herd and reduce the duration of your fixed-income portfolio, you might become a hero if interest rates rise but face career risk if they drop.
If you follow the herd, on the other hand, you not only reduce your career risk, but you might also eliminate your downside risk altogether. If interest rates rise and the majority of institutional investors face a sinking funding ratio — due to declining equity returns in reaction to rising rates, for example — the problem for the pension system quickly becomes systemic. And as we saw during the global financial crisis, once an economy faces a systemic risk, governments and central banks are quick to bail out the troubled investors. Hence, your decision to keep holding long-dated bonds becomes a “heads, I win, tails the central bank loses” position.
These kinds of “moral hazards” are surprisingly common in the economy today. Take the mortgage market. In the United Kingdom, most mortgages have floating rates so that homeowners are directly exposed to interest rates. So to protect yourself from rising rates, you should invest in a fixed-rate mortgage. But these tend to be more expensive. Instead, you can continue to hold floating rate mortgages, hoping that as long as enough people do the same, the central bank simply cannot hike interest rates too quickly or too much without triggering a nationwide credit crunch. The “masses of idiots” in this case restrict the policy leeway of the central bank.
Or think of retirement savings. In just about every developed country, private households don’t save enough and face significant declines in income once they retire. Personal finance specialists thus rightfully encourage people to save more. But if enough pensioners face poverty, the government has a strong incentive to help them out of their misery by increasing pensions from an already underfunded pension system. Then who is going to look stupid? Those who saved more during their working years or those retirees who spent their income and then relied on a government bailout?
Finally, doomsday prophets tend to mention the massive US deficits as a highway to hell. Combine the current mountain of US debt with unfunded liabilities like Social Security and you have a debt-to-GDP-ratio that surpasses 1,000%. What happens if the United States can’t pay those liabilities? Well, to me the least likeliest scenarios are that the country defaults or investors sell government bonds in large quantities. A default on US Treasuries would ignite a global economic catastrophe and everyone knows it.
So investors, both foreign and domestic, continue to buy Treasuries, no matter the risks associated with them. And the longer they buy Treasuries, the bigger the US debt load becomes, and — ironically — the lower the risk of default.
For more from Joachim Klement, CFA, don’t miss Risk Profiling and Tolerance: Insights for the Private Wealth Manager, from the CFA Institute Research Foundation, and sign up for his regular commentary at Klement on Investing.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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