By Nicolas Rigois and Steve Brice
The collapse of Japan’s Nikkei stock index from almost 39,000 in 1989 to 8,000 in 2008 has been well documented and was presumably traumatic for many Japanese investors.
However, the decline in the 10-year government bond yield from a peak of over 8% to less than 0% (i.e. a negative yield) has arguably been even more traumatic. While declining yields have, by definition, led to higher bond prices and therefore healthy returns for investors over the years, for today’s investors planning to reach their future retirement goals, they are hugely challenging.
For retirees, bonds – either directly or indirectly through savings and wealth planning products – have historically been the cornerstone of any portfolio due to their income-generating and low-risk characteristics. Of course, for a Japanese investor, their income-generating characteristic has totally disappeared.
For investors outside Japan, it may be worth looking at what drove Japan’s market dynamic over the past 30 years. A key characteristic of Japan’s economy during this period was a massive increase in debt, particularly government debt. Rising debt levels have many implications, but there are two that are particularly important. First, it means that even small changes in interest rates and yields can have a large impact on economic activity and inflation. The second, and a related, implication is authorities’ tolerance for deflation is reduced as deflation increases the real value of debt, making it harder to service the debt. This means that the central bank is likely to have a bias to cut interest rates and, if necessary, pursue quantitative easing at every sign of economic slowdown.
For Japan’s income-seeking investors, such a monetary policy bias leaves them with a dilemma: in order for their savings to earn a desired yield, they need to assume additional risk in one of the following ways:
- Stay in JPY-denominated bonds, but compromise on the credit quality of their investment
- Stay in JPY, but turn to high dividend-paying equities
- Invest overseas and assume currency risk
This third option is widely implemented and has led to brutal bouts of Yen appreciation in risk-off scenarios when Japanese investors repatriated their capital back home. Of course, this behaviour can, in turn, lead to increased volatility of JPY-returns.
“So what?” you might be asking yourself. “How does this affect investors outside Japan?”
First, this predicament is no longer uniquely Japanese. European and Swiss investors also live in a zero/negative interest rate environment (although it is a comparatively newer phenomenon there).
Second, the world has seen debt levels rise dramatically since the Global Financial Crisis. Therefore, while there are good arguments for higher bond yields in the coming months due to tight labour markets and reduced spare capacity across major economies, particularly in the US, there is also the risk that the long-term decline in bond yields that started in the 1980s is going to continue in the coming years.
While the probability of an outcome is one input into any decision, so too should be the impact of the outcome. For instance, walking across a road blindfolded at 2am may involve a low probability of being hit by a car, the potential consequences of doing so are severe enough for most of us (we hope) to not take the risk.
For an investor, let’s consider the risk of investing in bonds today. Of course, bond yields could rise, leading to a corresponding decline in prices. However, if you hold the bonds to maturity and the underlying issuer does not default, you will get your money back, along with interest payments along the way. Of course, inflation may erode the return on investment from a purchasing power perspective, but in this scenario the economy is probably doing pretty well and, therefore, other areas of your portfolio (equities), as well as your career prospects (earning potential), are likely to offset the pain significantly. Meanwhile, higher yields will increase the reinvestment returns going forward which will likely more than offset any short-term pain.
Arguably, the greater risk is not investing. Of course, by staying out of the bond market, you would avoid the short-term pain if bond yields rise sharply. However, if bond yields continue to decline in a secular fashion, it means that more investors will be faced with the Japanese income-seekers’ dilemma and need to take greater investment risk to achieve the returns to fulfil their retirement income needs. Alternatively, you will need to invest a much larger amount of money. Meanwhile, if bond yields decline on the back of economic weakness, then equities are unlikely to do well and career risks may be on the rise.
While we do not expect bond yields to fall significantly over the next 6-12 months, investors worried about this outcome over the longer term have ways to mitigate the risk.
For instance, an investor can identify an issuer with the desired credit quality offering the target yield and then invest a proportion of one’s allocation to the longest dated bond available from the issuer. This approach would require a slight shift away from conventional investment thinking where one tries to minimize portfolio volatility. Longer-dated bonds come with high duration (price sensitivity to interest rate moves) and therefore tend to see wider price swings compared to shorter-dated ones. However, in the context described above, that is the price you pay to mitigate reinvestment risks i.e. the risk that an investor holding shorter-dated bonds could be facing even lower yielding investment opportunities when the current bond matures.
Interestingly, accounting rules provide an exception to the so-called ‘mark-to-market’ gold standard that tends to accentuate a portfolio’s volatility. Bond investors can draw lessons from the “hold-to-maturity” accounting treatment and ignore short-term price fluctuations, since in the long-term they stand to receive the principal and regular coupons. Hence, if investors are reasonably confident about the credit quality of the issuer, extending bond maturity and locking in higher returns is a strategy worth considering to mitigate the risk of being confronted with the Japanese investors’ dilemma.
(Nicolas Rigois is Head of Wealth Management Product and Sales (Singapore) and Steve Brice is Chief Investment Strategist for the Private Bank at Standard Chartered)