Last year was one of limited choices and much anxiety for investors.
With the potential for a collapse of the euro and sluggish global economic growth, along with large debts to service, investors faced a great many challenges.
To smooth the deleveraging transition, the world’s large central banks have put the monetary system on life support by keeping official rates at close to zero and experimenting with balance sheet expansion through unconventional monetary policy measures. This has meant that bond investors have had to choose between returns of near zero per cent on cash, roughly 2 per cent on ‘safe-haven’ government bonds, or more than 6 per cent on riskier assets such as sub-investment-grade corporate bonds.
In fact, as we enter what many observers expect will be a prolonged period of financial repression, the real rate of return on cash and government bonds when inflation is taken into account is negative.
However, we have been here before – the debt overhang from World War II and the Great Depression led to a highly regulated global financial system with capital controls and yield caps and ceilings. Savers were subjected to negative real (inflation-adjusted) returns as debts were repaid. The deleveraging of the developed world’s debt mountain in the next few years is a similar task and, once again, savers will be expected to take a hit, potentially through negative real yields.
In 2013 the returns available on cash, government bonds and sub-investment grade corporate bonds are likely to remain roughly at current levels. Similarly, the main macroeconomic risks are likely to remain broadly unchanged.
The longer term deleveraging theme that has dominated markets since 2008 will remain the most significant influence on world economic growth. However, as we move through 2013, it may be possible that some economies start to see an end to their deleveraging process, and even find that their banking systems begin to work normally.
The US could fit into this category of starting the process of ending its private sector debt deleveraging. It is likely that bond markets are going to be a hostage to this debate. If deleveraging is coming to an end, then ultra-loose monetary policy is inappropriate and inflation concerns will rise rapidly, as will bond yields.
Investors heavily weighted in indexed-bond products face a tough journey, while those that manage portfolios close to benchmarks may struggle to produce a positive return for clients. Alternatively, if some of the tail risks mentioned actually materialise, then default risk is likely to rise once more and parts of the bond indices will produce significant capital losses.
So, how does an investor stay involved in markets that offer decent return potential but also come with great volatility?
Avoiding a slavish adherence to an index that is weighted according to market capitalisation would be a good start. For bond investors, one of the most dangerous places to be is wedded to an issuer that has to borrow more. Generally speaking, the more a country or company borrows, the lower its credit quality and the weaker the performance of its bonds. Furthermore, the rally in bond markets since 2008 has led to lower yields and a higher duration risk. In other words, investors end up being more exposed to rate risk when interest rates are about to change.
