BOND YIELDS AND DB SCHEMES

We all know investment theory. Bonds means low risk, equities mean higher risk. But the central banks have intervened in the market in a dramatic way, and this has skewed the risks return matrix, not least with many bonds now posting negative real yields and nearly every economist, amateur and professional saying that inflation is on her way.  If inflation does arrive, some bond holders stand to get wiped out. But why have they not quit – they can read the signs just as much as anyone else, can’t they?

It may now be the time to chuck the manual away, and guide investors into equities on the premise that they might just be lower risk than bonds right now. No one knows for sure, but former FT frontman John Authers has pointed out that U.S. Treasury issued  $1.73 trillion came from bonds of two years maturity and upward of which the Fed bought $320 billion, leaving $1.4 trillion searching for other buyers. We know that plenty of investors obliged.  What can possibly have possessed them to do so at deeply negative real yields?  Are people mad?  

A clue comes from Martin Wolf’s article this week in the FT 

The demand that DB schemes be made as risk-free as possible has also had a dramatic impact on their ability to hold the riskier assets that offer higher long-term returns. This makes meeting pension promises still more expensive. Between 2006 and 2020, the weighted average share of DB portfolios in equities fell from 61 to 20 per cent and the share of UK quoted equities in that total fell from 48 to 13 per cent. So, the latter make up just 3 per cent of DB portfolios.

So to be clear, DB schemes are 80-20 in bonds versus equities. No wonder the FTSE market has performed so poorly over recent years!  However, it is also true that regulation coerces these DB scheme funds into lending to them at near zero rates, instead of investing in industry.  

There is a regulatory zeitgeist that forces you to recite the investment commandment that bonds are low risk, equities high risk, and so it shall be for evermore.  Maybe it is time to revisit any of your clients who may be fearful of inflation and point out some salient facts.  

With this in mind, I asked Kirsty.turner@ifac.eu that million dollar question:  "So how can you go about this in a compliant manner?  Should you arbitrarily re-rate the risk profiles of your customers or re-categorise the funds i.e. have a low risk investor investing in 100% equities?"

There isn’t an easy solution nor a one size fits all answer but advice and documentation is key.  Discuss the current situation with your clients as part of your risk profiling process, check their understanding and find out their thoughts.  Most of all, document your conversations so it’s clear what was discussed; a client might be “traditionally” low risk but be prepared to take what would “traditionally” be described as higher risk in the current market. With advisers regularly reviewing portfolios, there is the option to move with the markets, so long as clients are advised in a clear, fair and not-misleading way.  Markets change and you as Advisers have the power to educate your clients and advise them on the most appropriate action.