Welcome to the new world of investing. Newspapers, think-tanks, regulators and investors at large have been fretting about this new era of return-free risk in fixed income: with risk-free government bonds trading with negative to low yields-to-maturity, it’s easy to figure out the whole bond market (with few exceptions in high yield bonds) has become a source of concern for nearly all investors, private as well as institutional.
Small movements in yields can wipe out a whole year of returns: if considering durations (an alternative measure of maturity used to gauge interest rate risk) of long term bonds can range from 5 years upward, it’d only take a 20 basis-point increase in yield to maturity to smother a 1 per cent return (measured by the price decrease consequent of a yield rise).
This is an alternative view on this global liquidity glut (trap) caused by a (necessary) low-to-negative interest rate monetary policy worldwide that, with increasingly integrated financial markets, is tying central bankers hands. Government bonds, especially, and their yields are used by investors for a wide range of purposes: financial asset valuations by and large, allocation of conservative investment strategies, access to liquid reserves from central banks, immunization of insurance companies portfolios, etc.
Considering banks and insurance companies, for example, the former fund their lending activities by issuing bonds on capital markets and collecting deposits from the individuals and charge a spread on borrowers’ loans while the latter immunize their long term liabilities by investing mainly in government bonds. Interest margins (the difference between interests paid and interests earned in borrowing and lending) on a bank’s financial sheets are negatively affected by the sheer level of risk-free interest rates: the lower bound limit of zero imposed (or almost nearly imposed) by funding compresses the spread as interest rates decrease. Retirement benefits, on life insurance policies, promised only a few years ago by insurers have come to clash with nominal as well as real returns on long-term government bonds, imposing great stress on risk management operations to insure asset-liability matching goals.
If you compound the scenario of low returns on government bonds with the risk investors have to take on to fund their operations, you figure out how risky investing nowadays has become. Regulators and policy makers around the world – with a notable difference in the efforts and policies between the two categories – will come up with a suitable plan (the G20 meeting was a very good chance to lay down one). One wonders if policy makers will ever find the international agreement to come up with one that will likely work out in the end. Meanwhile enjoy this new and thrilling world of return-free risk investing. Good luck, explorers will be conquerors (with merciless bloodshed campaigns).