Bonds vs Equities – The Risk Debate Continues

Posted in Wealth
27/09/2012 Level One

Over the last few weeks we have seen much debate over the advantages and pitfalls of both bonds and equities; specifically with regard to the associated investment and market risks.

Some people believe that adopting a “risk-free” strategy by investing heavily into bonds, with little exposure to equities, is a sound idea. On the contrary, some believe that the yield premium of around 6-7% equities has over bonds is worth the risk.

We tend to agree with the latter. We also believe that bond strategies carry their fair share of risk as well and this should not be ignored.

We have included two articles from the Australian Financial Review that provide insight into the matter.

Yes, Bonds are a Risky Investment Too – Kevin Davis

Christopher Joye argues that the investment strategies of Australian super funds, with their heavy weighting towards equity, have been built on shaky foundations.

In particular, he takes aim at the conventional wisdom that the expected return on equities provides a significant premium over the risk-free rate on bonds.

If that is not the case, the higher risk of equities (volatility of returns) has been taken by super funds without sufficient benefits in the form of higher expected returns.

And if that is the case, members should (if they could) be voting out the trustees and management of their super funds for implementing bad strategies.

With the benefit of hindsight, that wonderful analytical tool, we would all have adopted different investment strategies over recent years. Shifting from equities to bonds could have given a double-whammy to overall returns under some trading strategies.

Not only have equity returns been abysmal in some years, but long-term government bond rates have been on a downtrend for 30 years. Good returns were there if an investor had been smart enough to buy 10-year bonds, sell them a year later when interest rates had fallen, and then reinvest in 10-year bonds and keep repeating the strategy. The reason for the good returns is that as interest rates fall, the price of existing long-term bonds increases, giving capital gains upon sale.

Of course this is a risky strategy – interest rates might subsequently go in the other direction.

Consequently, good returns on the “bond rollover” strategy were accompanied by relatively high risk, as Christopher Joye finds. Not as much risk, nor quite as high a return as investing in equities though. And on those numbers, the question can be raised of whether the game played by our super funds was worth the candle?

But they were not, and should not have been, playing the alternative bond rollover strategy game. Super funds should be long-term investors.

A “bond rollover” strategy involves taking the capital gains when rates fall, and reinvesting in now lower-yield bonds. That might turn out to be good if rates fall further but if they don’t, there is now a lower annual yield than if the original bond had been held.

In hindsight, the alternative risky “bond rollover” game was worth the candle – and perhaps smart investors should have seen the downward trend in long-term government rates. But that is a completely separate issue from what is the expected return on risky equities relative to passively investing in risk-free assets.

That equity (or market risk) premium (over the 10-year government bond rate) has been calculated, using long-term historical data, to be around the 6 per cent per annum mark. But those calculations compare the annual return on equities with the yield to maturity on 10-year bonds (at the start of the corresponding year).

That does not necessarily provide good information on a suitable investment strategy. It tells us (if we believe historical information is relevant) how much the expected return on an equity investment exceeds the current 10-year bond yield to maturity.

It is indeed an apples and oranges comparison that does not include possible capital gains or losses on bonds that are not held to maturity.

That worked well over the past three decades (in hindsight) because of the downtrend in interest rates.

But the market (or equity) risk premium is meant to give the expected differential between a risky (equity) investment and a risk-free investment (holding a bond to maturity). A more interesting calculation is to ask what would be the expected difference in returns from investing in equities rather than from adopting a “risk-free” investment strategy. Ideally this would involve comparing the annual return on equities with the yield to maturity on a one-year government bond.

We don’t have readily available data on one-year bond yields, although calculations of the annual returns from investing in a sequence of 90-day Treasury notes or bank bills, from 1980 to 2010, again shows a premium in equity returns very close to 6 per cent.

With hindsight, the bond trading strategy may have done very well on a risk adjusted basis relative to investing in equities. But without hindsight a strategy of investing in a “risk-free” manner in government bonds would have underperformed equities quite substantially.

If Australian super funds had invested heavily in corporate bonds or other structured “fixed interest” products, the blowout in credit (default) spreads (and resulting plummeting in prices) might have led to even worse returns.

And if they all were competing for the scarce supply of Australian government bonds, even 3 per cent might start to look high!

Super Shares Bias Makes Sense – Sam Wylie

For all the changes in superannuation over the past 10 years, one salient feature of super funds remains the same – the proportion invested in equities.

In 2002, a little less than 60 per cent of super fund assets were in Australian and global equities and the same is true in 2012. Self-managed funds allocate less value to equities and industry funds allocate more, but the overall allocation to equities by super funds has been a little under 60 per cent for a long time.

The fact that Australian super funds have higher equity allocations than their counterparts in some other countries is well known to Australian fund trustees and advisers.

However, most of these trustees see the relatively high allocation as matching Australia’s circumstances in terms of tax law (dividend imputation), fund structure (defined contribution) and investment opportunities (small fixed income market).

Those equity allocations have recently been criticised by senior figures, including former Treasury boss Ken Henry and superannuation system review chairman Jeremy Cooper, who have said super funds that are heavily exposed to equities should reweight their asset allocation towards bonds.

Those statements have not yet been accompanied by a compelling argument for changing the current levels of super fund equity investment. Instead, the need for change has been asserted as if it were obvious.

The lack of a compelling argument is not surprising because any such argument would face a lot of opposing data and inconvenient questions.

Reasonable records of Australian stock and bond returns exist back to Federation and show that since then, stocks have on average outperformed bonds by about 5.8 per cent per year.

To get to a lengthy period in which bond returns match stock returns, we must ignore 80 years of valid data and focus only on the period of the “great bond rally” that started in the early 1980s when then United States Federal Reserve chairman Paul Volcker began his crusade against inflation.

Christopher Joye’s piece, “Super funds miss mark in bias to equities” (AFR, August 14), was an example of the selective amnesia often exhibited by bond proponents. In arguing that super funds over-allocate to equities because they overestimate how much stock returns exceed bond returns in the long run, he uses only data from 1982, the very start of the great bond rally. He then regally declares all data before 1982 to be invalidated by survivorship bias, which of course it is not.

Never mind that investors in Australian government bonds earned a negative average real return over the first 82 years after Federation.

Advocates of higher bond allocations by super funds must also ignore that the high bond returns of the past 30 years cannot be replicated in the next 30 years: 1982 was the high water mark for government bond yields, with 10-year bond yields reaching 16.4 per cent. Today they yield 3.5 per cent. It was that 13 percentage point fall in bond yields that delivered high capital gains to bond investors over the past 30 years.

How can any investor in super reasonably expect a similar decline in bond yields of 13 percentage points to minus 9.5 per cent a year over the next 30 years? No, it is likely that yields will rise in the long term and bond investors will experience a capital loss.

Critics of super fund equity allocations must also ask: who will bear the risk of owning shares if not households through their super funds? The deeper the layer of equity to absorb bad outcomes, the more innovative and risk taking companies can be.

The finances of households plug into companies at two levels. Households are both employees and shareholders of companies. As employees, households are undiversified – they have just one job, so they demand their employment claim on the company has seniority to banks, bondholders and shareholders.

But as shareholders in a company through their superannuation, they are highly diversified – the super fund holds a large number of shares and exposure to any one firm is low. They have a low-priority, high-risk, high-return claim on the company.

No compelling argument for super funds to make a major reallocation to bonds has been made. The advocates of bonds over equities need to make their case, stop being selective in the use of historical data, explain why investing in bonds at the top of the cycle makes sense, and explain who will absorb the riskiness of investments made by local companies if not households saving for retirement by holding equities.


Get In Touch

We welcome you to contact us for more information
about our services.

Follow us