For decades, investment grade bonds issued by governments of developed countries have been thought of as almost ‘risk free’. The ‘risk-free rate’, which is essentially the lowest return any investor would accept, has traditionally been priced off these assets.
However, as investment strategist at Citadel, Maarten Ackermann, told the audience at a JSE Power Hour briefing in Cape Town last week, investors are having to re-think this position in an environment where these bonds are offering negative interest rates.
The current yield on German three-month bonds is around -0.8%. In Japan it is -0.2% and in Switzerland -1.0%.
US three-month Treasury Bills are at least offering a positive nominal yield, although it is marginal at 0.30%. With inflation at around 0.8%, though, the real yield is still negative.
Even longer dated bonds are offering negative yields in many of these markets. In Germany, the interest rate on ten-year government bonds is -0.08%, and remarkably in Switzerland even 30-year bonds are yielding -0.06%.
The question this raises is whether any investment that guarantees that you will lose money can really be called risk-free. Particularly when any upward movement in rates would mean that investors would suffer further capital losses. And with rates artificially low already, one has to assume that over the long term especially there is a lot more room for them to go up than to go down.
“There is no investment opportunity in developed government bonds,” Ackermann argued. “They used to be considered risk-free, but now there is no return, and there is a lot of risk. That is why investors are looking for alternatives.”
This search for yield is what has forced money into equity markets around the world. With the S&P 500 currently offering a dividend yield of 2%, this seems common sense. Just investing in the benchmark US index will offer a better return in the form of dividends alone than one can get from government bonds.
This is also a world where some companies have become incredibly substantial. Apple’s market capitalisation is now $585 billion. According to figures from the World Bank, only 20 countries in the world produced higher GDPs than that in 2015.
For it’s last full financial year to September 2015, Apple generated revenues of $234 billion. That is about the same as the GDPs of Ireland or Finland. The company also has cash reserves of over $200 billion.
“In today’s world, a lot of companies are actually safer than countries,” Ackermann suggested. “They are bigger, have more cash, and pay higher dividends than interest rates in the West. So the perception that investing in companies is risky is slowly disappearing. It depends on what companies you buy.”
The last part of that statement is very important. Even if we have moved into a world where we have to reconsider our understanding of investment risk, equities are not suddenly less risky than bonds across the board.
Investing in the stock market has always been higher risk than putting money into bonds because of the chance of suffering significant short-term losses. The market crash of 2008 is not that long ago for investors to have forgotten how severe these can be.
That risk hasn’t gone away. However a market crash does not look likely in the short term, and therefore the stability you can find in huge companies like Apple may well be higher than anything you can find in developed market government bonds.
“In a global recession like we had in 2008 companies can’t keep making profits, and that’s when equities go into a bear market,” explained Ackermann. “But over the next 12 months we feel that the risk of a global recession is low. There is no reason why companies should make severe losses in the short term, which means that equity markets will be sustained at these kinds of levels.”
He accepts that there will be continued volatility, and investors can expect markets to move as much as 10% one way or the other in the space of just a few months, but these tend to even out. One can therefore take the dividend yield and have reasonable security that the chance of major losses is low.
“Right now, when you can get companies paying 2.5% to 3% dividend yields, and you still have a bit of a hedge from central banks keeping rates low and therefore supporting prices, equities are the preferred asset class,” said Ackermann. “You can invest in great global companies, not even thinking that prices will necessarily go up, but because you know what they are putting on the table and over time that dividends will be paid. But you do have to choose carefully. You need to make sure of their profitability, and the sustainability of that profit stream.
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