Secrets of Success: Fancy bungee jumping without a cord?

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.

jd@intelligent-investor.co.uk

Independent Partners; request a free guide on NISAs from Hargreaves Lansdown

PROMOTED VIDEO
News
Teeth should be brushed twice a day to prevent tooth decay
education
News
Bryan Cranston as Walter White, in the acclaimed series 'Breaking Bad'
news
Sport
footballChelsea 6 Maribor 0: Blues warm up for Premier League showdown with stroll in Champions League - but Mourinho is short of strikers
News
Those who were encouraged to walk in a happy manner remembered less negative words
science
Arts and Entertainment
Princess Olga in 'You Can't Get the Staff'
tvReview: The anachronistic aristocrats, it seemed, were just happy to have some attention
News
Renee Zellweger as Bridget Jones
i100
Life and Style
tech

Board creates magnetic field to achieve lift

News
There have been various incidents of social media users inadvertently flouting the law
news

Life and Style
Stack ‘em high?: quantity doesn’t always trump quality, as Friends of the Earth can testify
techThe proliferation of online petitions allows us to register our protests at the touch of a button. But do they change anything?
News
Bourgogne wine maker Laboure-Roi vice president Thibault Garin (L) offers the company's 2013 Beaujolais Nouveau wine to the guest in the wine spa at the Hakone Yunessun spa resort facilities in Hakone town, Kanagawa prefecture, some 100-kilometre west of Tokyo
i100
Sport
CSKA Moscow celebrate after equalising with a late penalty
footballCSKA Moscow 2 Manchester City 2: Premier League champions let two goal lead slip in Russia
Finacial products from our partners
Property search
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

ES Rentals

    iJobs Job Widget
    iJobs Money & Business

    Helpdesk Analyst

    £23000 per annum + pension and 22 days holiday: Ashdown Group: An established ...

    Senior Helpdesk Analyst / Service Desk Co-ordinator

    £27000 per annum + pension, 22 days holiday: Ashdown Group: An established ind...

    Senior Pensions Administrator

    £23000 - £26000 Per Annum: Clearwater People Solutions Ltd: Our client is curr...

    Corporate Actions Administrator / Operations Administrator

    £25 - 30k: Guru Careers: A Corporate Actions Administrator / Operations Admini...

    Day In a Page

    Indiana serial killer? Man arrested for murdering teenage prostitute confesses to six other murders - and police fear there could be many more

    A new American serial killer?

    Police fear man arrested for murder of teen prostitute could be responsible for killing spree dating back 20 years
    Sweetie, the fake 10-year-old girl designed to catch online predators, claims her first scalp

    Sting to trap paedophiles may not carry weight in UK courts

    Computer image of ‘Sweetie’ represented entrapment, experts say
    Fukushima nuclear crisis: Evacuees still stuck in cramped emergency housing three years on - and may never return home

    Return to Fukushima – a land they will never call home again

    Evacuees still stuck in cramped emergency housing three years on from nuclear disaster
    Wildlife Photographer of the Year: Intimate image of resting lions claims top prize

    Wildlife Photographer of the Year

    Intimate image of resting lions claims top prize
    Online petitions: Sign here to change the world

    Want to change the world? Just sign here

    The proliferation of online petitions allows us to register our protests at the touch of a button. But do they change anything?
    Ed Sheeran hits back after being labelled too boring to headline festivals

    'You need me, I don’t need you'

    Ed Sheeran hits back after being labelled too boring to headline festivals
    How to Get Away with Murder: Shonda Rhimes reinvents the legal drama

    How to Get Away with Murder

    Shonda Rhimes reinvents the legal drama
    A cup of tea is every worker's right

    Hard to swallow

    Three hospitals in Leicester have banned their staff from drinking tea and coffee in public areas. Christopher Hirst explains why he thinks that a cuppa is every worker's right
    Which animals are nearly extinct?

    Which animals are nearly extinct?

    Conservationists in Kenya are in mourning after the death of a white northern rhino, which has left the species with a single male. These are the other species on the brink
    12 best children's shoes

    Perfect for leaf-kicking: 12 best children's shoes

    Find footwear perfect to keep kids' feet protected this autumn
    Anderlecht vs Arsenal: Gunners' ray of light Aaron Ramsey shines again

    Arsenal’s ray of light ready to shine again

    Aaron Ramsey’s injury record has prompted a club investigation. For now, the midfielder is just happy to be fit to face Anderlecht in the Champions League
    Comment: David Moyes' show of sensitivity thrown back in his face by former Manchester United manager Sir Alex Ferguson

    Moyes’ show of sensitivity thrown back in his face... by Ferguson

    Manchester United legend tramples on successor who resisted criticising his inheritance
    Two super-sized ships have cruised into British waters, but how big can these behemoths get?

    Super-sized ships: How big can they get?

    Two of the largest vessels in the world cruised into UK waters last week
    British doctors on brink of 'cure' for paralysis with spinal cord treatment

    British doctors on brink of cure for paralysis

    Sufferers can now be offered the possibility of cure thanks to a revolutionary implant of regenerative cells
    Ranked seventh in world’s best tourist cities - not London, or Edinburgh, but Salisbury

    Lonely Planet’s Best in Travel 2015

    UK city beats Vienna, Paris and New York to be ranked seventh in world’s best tourist destinations - but it's not London