Secrets of Success: Fancy bungee jumping without a cord?
Saturday 26 February 2005
George Stigler, one of the many great economists based at the University of Chicago, won a Nobel Prize many years ago for demonstrating the unfortunate fact that regulation, however well intentioned, tends over time to produce the opposite effects to that which its proponents intend. For further proof of this timeless theory, it is necessary to look no further than what is happening currently to the government bond markets, where conventional thinking is daily being turned on its head.
Time was when government bonds were rated highly for their capital guarantees, but feared for their exposure to the ravages of inflation. In an era when government spending routinely accounts for 35-40 per cent of national income, standard financial theory suggests that investors should normally pay more, the longer the term of a bond. For a so-called long bond, with a maturity date 25-30 years ahead, it is natural to assume that the risk that inflation will take away some of the real value of the principal when it is repaid increases.
Longer-term bonds traditionally, therefore, command a higher yield than shorter-term issues, in order to compensate for that increased risk. The result is a rising yield curve, with yields that are higher, the further out in time the bond has to be held. The exception to this normal state of affairs comes when short-term interest rates are being raised to prevent an economy overheating, at which point you can expect a temporary inversion of the yield curve.
A more straightforward way of expressing the same idea is to say that only an extreme optimist will lend money to a government at a rate that does not include a decent premium over the current and expected inflation rate. As a rule of thumb, long-term government bonds are generally held to be a risky buy, unless you are getting at least a 2.5-3 per cent premium over the expected inflation rate.
Yet, look around you at what is happening today in financial markets and the normal rules of thumb are being forgotten and ignored. While short-term interest rates have been rising on both sides of the Atlantic, long-term bond yields have been continuing to fall. The price of long bonds today is about 4.5 per cent in the United States and 4 per cent in the UK. To make any sense of this behaviour, you have to believe that inflation will remain at about 1 per cent per annum over the entire course of the next quarter of a century.
Yet, although the drive to eliminate inflation has been the great story of the past 25 years in all Western economies, you will not find many professional investors who think that it can now be safely ignored. Some experts still worry about the prospect of deflation, which could justify buying bonds at today's levels, but they remain a distinct minority.
The main reason behind the bizarre developments in the bond markets has been heavy buying of long-dated bonds by life companies and pension funds. These institutions, which are paid to look after the long-term savings of millions of ordinary investors in this country, have been steadily baling out of the stock market (which has been rising since its bear market nadir in 2003) and instead piling into bonds, as well as - tentatively and belatedly - hedge funds and other types of assets, such as commodities.
This is a complete reversal of their behaviour during the great bull markets of the 1980s and 1990s, when the typical pension fund had 70 per cent or more in equities and little money in bonds. (Life companies have always held larger proportions of their assets in bonds than pension funds, in order to match their longer-term liabilities, but the same trend is evident with them as well.) The proportion of equities held by the average pension funds has fallen from 66 to 45 per cent and that of life companies from 52 to 35 per cent since 1999.
There is no secret about why these purchases are taking place. The main drivers have been the bear market in shares and the efforts by regulators to require pension funds and life companies to match their future assets and liabilities more carefully. That this is so is evident from the fact that the most downward pressure on long-term bond yields has been felt in countries such as the UK and the Netherlands, which have pension funds most closely tied to equity market performance.
Yet, historical evidence suggests that the most likely return from a bond over time is related to its starting yield. A regression analysis of past experience suggests that an investor buying a US long-dated government bond can expect to make a real return of little over 1 per cent. For UK gilts, according to calculations by Barclays Capital, published this week, the expected return from long-term bonds is actually negative at these price levels.
In the words of Barclays Capital's Tim Bond: "From a total return perspective, the purchase of long-dated bonds at yields in the vicinity of 4-4.5 per cent represents risk reduction in the same way as bungee jumping without a cord lowers risk. The outcome is certainly more predictable, but not necessarily more benign."
Of course, we don't know what will happen in the next 25 years, and in the short term, it is possible that long bond yields could fall even further. Deflation is not impossible. But if you believe there is a link between demographic changes and investment yields, as many do, a more likely outcome is that yields generally (dividends and bonds) will have to rise over the next 10-20 years. (See chart.)
In that case, historians will record that, not for the first time, the investment institutions have been doing the wrong thing at the wrong time.
Their excuse will be that their own governments made them do it, but their clients will pay for it nonetheless.
Independent Partners; request a free guide on NISAs from Hargreaves Lansdown
Children's bookseller wins The Independent's new author search
Board creates magnetic field to achieve lift
- 1 Jack the Ripper: Scientist who claims to have identified notorious killer has 'made serious DNA error'
- 2 Banksy arrest hoax: Internet duped by fake online report claiming artist's identity has been revealed
- 3 Former East 17 frontman Brian Harvey turns up at Downing Street and 'demands to speak to Prime Minister'
- 4 Kentucky gang rape: 15-year-old boy left in critical condition after sexual attack by group at party
- 5 Paralysed man Darek Fidyka walks again after treatment by British doctors on brink of 'cure'
Cameron is warned 'no possibility' of UK reducing immigration and that bid to bring in quota on migrant workers would be illegal
Residents should throw a street party and mix with immigrant neighbours, councils told
Russell Brand threatened with arrest after filming outside Fox News headquarters
London bus driver 'kicks gay couple off for kissing'
Jose Manuel Barroso warns David Cameron against making 'historic mistake' over immigration reforms
Worst Airports of 2014: Poll names Islamabad airport in Pakistan worst in the world
iJobs Money & Business
£23000 per annum + pension and 22 days holiday: Ashdown Group: An established ...
£27000 per annum + pension, 22 days holiday: Ashdown Group: An established ind...
£23000 - £26000 Per Annum: Clearwater People Solutions Ltd: Our client is curr...
£25 - 30k: Guru Careers: A Corporate Actions Administrator / Operations Admini...
Day In a Page
This 17th century beauty is full of rustic cosiness, while the detached home office means you can also run a business
This five-bedroom red-brick beauty overlooks the village green and sits in just under two acres of land
Four exclusive apartments in a Grade II-listed former medical school with 2,275 sq ft of living space and 18ft ceilings
A five-bedroom terraced house on the popular Peterborough Estate, ideally located for both Eel Brook Common and South Park
A state-of-the-art farm-building conversion on the former Cliveden Estate, with 11,420sq ft of internal space, cinema and wine cellar
A three-bedroom, 15th-century cottage with original features in the picturesque village of Sissinghurst
A six-bedroom terraced house with large south-facing roof terrace, cinema room and wine cellar
A new seven-bedroom home built in Queen Anne-style with swimming pool and parkland views in Mortimer
A listed, four-bedroom farmhouse in the rural hamlet of Rushall with detached barn, four acres of gardens and paddocks
A first-floor flat with two bedrooms, a spacious reception room and communal grounds in a leafy part of London
A three-bedroom flat with a spacious rootop terrace and balcony, accessed from a private gated courtyard
A Grade II-listed pile with six bedrooms, stables and 39 acres of grounds in Standlake
A two-bedroom flat with boutique hotel-style interiors, close to the foodie haunt of West End Lane
A two-bedroom flat in a beautiful old vicarage, with many original features, close to the city centre
A three-bedroom 16th-century home with an aga kitchen, private gardens and heated outdoor pool, in Hadleigh
A three-bedrom home in sought-after Queen's Gate Mews, with Italian marble-finished bathrooms
Surrounded by glorious countryside in the village of Udimore, sits this impressive four-kiln oast and barn conversion
A five-bedroom house in the picturesque village of Kettlewell, north Yorkshire
An 18th-century former coaching inn with original staircase, open fireplaces and beams throughout
A Grade II-listed Georgian town house with three bedrooms and a south-facing courtyard, near Arundel Castle
Feel on top of the world at this über chic penthouse on the 37th floor of one of Europe’s tallest blocks.
A Grade II-listed Victorian villa with six bedrooms and two further cottages, all with spectacular sea views
A grade II-listed, Georgian cottage with mature 50ft garden, perfect for summer entertaining
A magnificent Georgian pile with turrets, seven bedrooms, a heated pool and four acres of gardens
Fairoak Farm has five bedroom suites, gym, outdoor swimming pool and golf course
Chic two-bedroom river-fronted flat with a private lift that delivers you directly to your home
A spectacular seven-bedroom Tudor pile, once owned by Henry VIII, with 18 acres of land
A seven-bedroom Georgian property previously used as a picturesque wedding venue
A split-level flat in a church conversion with two en suite bedrooms and 1,200sq ft of living space
A three-bedroom bungalow situated behind an impressive stone wall, £645,000
Windsor Castle overlooks this three-bedroom Victorian cottage located on one of Windsor's smartest roads
Chapel House is a former vicarage with nine bedrooms in the beautiful Upper Wye Valley
A five-bedroom B&B and separate owner's accomodation with potential for conversion
Enjoy summer by the Thames in this two double-bedroom converted warehouse in Rotherhithe village
A one-bedroom, luxury apartment with private gym and concierge service in Moorgate
A four-bedroom house in Hermitage Gardens with three reception rooms and landscaped gardens
A seven-bedroom Grade II-listed property with a separate self-contained apartment
A five-bedroom Victorian house with three reception rooms and galleried landing, £695,000
A six-bedroom farmhouse with five acres of land in a former cloth-making village