Over the past two years, investors have become (sometimes unwillingly) acquainted with the mechanics of the bond market, with all eyes on the US and the actions of the Federal Reserve in particular.
In the face of runaway inflation figures coming hot on the heel of years of near-zero interest rates, we have been confronted with the reality that in many “risk-free” instruments we are in fact losing money on a real basis – this is also known as negative real yields.
Real Yield = Nominal Yield – Inflation Expectation
When real yields are negative on an asset such as a 10-year government bond, the outcome is guaranteed that the investor will lose purchasing power on their capital by holding the bond till its maturity. This can come as a shock to investors who see 10-year yields above 3.0% and think “that’s the highest coupon in years, I can’t afford not to own it!”
As US real yields turn slightly positive after a long stint below zero, we have to still prepare ourselves for an investing landscape where they are negative. What forces may keep real yields lower for longer, and how will investing be affected if they return to negative?
An age-old problem
As of 19 August, the market is pricing in a real yield on US 10-Year Treasuries of 0.01%, despite the nominal yield being 2.87%. This yield is derived from taking the yield of the US 10-Year Treasury Inflation-Protected Securities (TIPS)
10-year TIPS have been negative since the start of the COVID pandemic, and we can see that they have been structurally declining since the late 1990s, with two major periods of negative real yields. We can see an even more pronounced pattern of low/negative real yields in the 5-year TIPS:
Many factors come into play when considering the nuances of the bond market but one inescapable reality of our human experience may also be structurally changing the investment landscape: we are ageing.
To set the stage on how age is changing the dynamics of the market, this is the current distribution of the US population:
And here is that same distribution from back in 1980:
The working-age members of the past two generations have aged, leaving the workforce and changing the composition of productivity within the economy. Notice that there is far less pronounced “bulge” in the 15-29 age bracket in 2020 as there was in 1980, meaning that as an entire generation of workers retires, there are fewer and fewer people to fill their shoes.
This is commonly referred to as an issue of “poor demographics”, which is contributing to the prevalence of low-to-negative real yields. The below chart from Bloomberg demonstrates that most regions are actually experiencing demographic issues (including Asia), with only Africa projected to grow its total workforce over the 21st century.
An ageing population means a shrinking labour supply and skews the amount of workers (see: productivity) relative to the amount of non-workers. As we can see below, the ratio of total employment to overall population has been steadily declining in the US since the 1960s, thanks to a combination of aging and a declining labour force participation rate.
This means that the productivity output from the labour force has to increasingly stretch further and further to meet the demands of the total population – excluding any technological breakthroughs, an ageing population puts this relationship in an ever-declining path towards lowered productivity – something which has a relationship with low/negative real yields.
Productivity in an economy is a long-term driver of returns on capital (which is intrinsically linked to interest rates) – you could also look at this from the perspective that interest rates are the baseline return expected by risk-averse investors, and so therefore establish the minimum productivity required for these returns.
Rates are also about capital access – if the business who is only outputting so much can’t find cheap capital (in real terms), then eventually they will exit the market. Less growth means that real yields need to drop even deeper to entice market actors to take up debt and spend – and so the cycle continues.
How does this influence the investing landscape?
Before we tackle the topic of negative real yields as investors, we should consider who is taking the other side to these yields and how it affects them.
Negative real yields can act to the advantage of governments and central banks who issue debt at those negative levels. If you consider the mechanics of interest rates over time, negative real yields mean that debt loses value over time as inflation erodes away its value. So, if said governments/central banks engage in accommodating monetary and fiscal policy which builds up their own debt liabilities, negative real yields can help to inflate those liabilities away over a sufficient period of time.
Note: this is excluding the impact of currency which we will leave for another time.
However, when we allocate to sovereign bonds as multi-asset investors, we find ourselves on the other side of this equation.
We have lent these governments our capital, and in a negative real yield environment, the value we initially placed upon extending that line of credit is getting reduced as time goes on. In fact, to look at this more starkly, we are guaranteed to be losing purchasing power, with purchasing power being a key measure of how we should value our capital as investors over strategic time periods (generally 5-10+ years).
This loss of purchasing power has forced investors to chase yield up the “risk curve” (see the diagram below), moving from government bonds and bank deposits to corporate bonds, hybrids and of course equities.
This was a key driver in the market phenomenon known as “TINA” or “There Is No Alternative", which particularly in the past few years drove large swathes of capital towards equity markets as there was simply no other asset class to find sufficient return profile required for many investors.
The logic is simple: if you are guaranteed to lose money in real terms over a decade with government bonds, why would you invest in this “risk-free” instrument and take the loss, rather than move up the risk curve to try and preserve your future purchasing power?
Even the legendary Howard Marks of Oaktree Capital was pointing out in late 2020 that investors were engaging in such an aggressive rally because negative real yields were distorting valuations on risky assets, such as growth stocks.
Negative real yields, therefore, present a challenging landscape for many investors. Your traditional defensive allocation is losing you money in real terms, whilst your growth allocation is spurred along by valuations that most managers/data models would suggest is unsustainable.
Though inflation remains at historically high levels, it is a year-on-year figure, so the probability is high that over the next few years it will moderate - whether down to the 2% Fed target, or to a higher 3-5% range is up for debate. When inflation does moderate, real yields will increase in response, which means certain positioning within fixed income may set investors up for an attractive yield profile over the long term.
For example, we consider investment-grade corporate credit to be more attractive in this market environment, pricing in a higher yield over Treasuries and having the potential for capital gain (as well as income) should credit spreads tighten – a scenario which would be likely to occur if and when markets price for a post-recession US economy.
To summarise, negative real yields encourage investors to take more risk, by decreasing the attractiveness of traditionally defensive and “risk-free” securities such as US Treasuries.
Though in the short-term this may be sustained, as risk assets have less gravity on their valuations, over the long-term this type of allocation strategy leaves portfolios vulnerable to sharp corrections, pull-backs and valuation mean-reverting back to more reasonable historical levels – we suspect many investors may have felt this first-hand over 2022.
With careful and robust portfolio construction, it is possible to navigate a negative real yield environment and still maintain capital purchasing power for the future. If our current demographic profile is anything to go by, investors throughout the developed world may be forced to navigate such an environment for decades to come.
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This document has been prepared by Innova Asset Management Pty Ltd (Innova), ABN 99 141 597 104, Corporate Authorised Representative (402207) of Innova Investment Management Pty Ltd, AFSL 509578 for provision to Australian financial services (AFS) licensees and their representatives, and for other persons who are wholesale clients under section 761G of the Corporations Act.
To the extent that this document may contain financial product advice, it is general advice only as it does not take into account the objectives, financial situation or needs of any particular person. Further, any such general advice does not relate to any particular financial product and is not intended to influence any person in making a decision in relation to a particular financial product. No remuneration (including a commission) or other benefit is received by Innova or its associates in relation to any advice in this document apart from that which it would receive without giving such advice. No recommendation, opinion, offer, solicitation or advertisement to buy or sell any financial products or acquire any services of the type referred to or to adopt any particular investment strategy is made in this document to any person. Opinions expressed are valid at the date this document was published and may change. All dollars are Australian dollars unless otherwise specified.
Max is an Investment Analyst at Innova Asset management, involved in multi-asset and macro analysis and research, manager selection and portfolio construction. Max has a background in bespoke portfolio construction, multi-asset analysis and...