The interest rate markets (bonds and deposits) have changed radically during the last ten years and this has meant that the old portfolio policies based on diversification have been subjected to new forces which challenge their validity.
After the financial crisis of 2007/2008, there has been a dramatic, and apparently long-term, fall in interest rates. This has been followed by the policy of “Quantitive Easing” by the big Central Banks in the US, Europe and Japan have purchased many trillions of government bonds. This policy forced long-term interest rates of the best investment grade bonds to fall to near zero and below, as well as keeping short-term rates at close to zero and below.
The results of this situation is great for investment banks, issuers and borrowers, but poison for investors and depositors.
This means that an investor’s bond portfolio needs to take these changes into consideration and the conclusion of this paper is that most of the current holdings of this bond portfolio need to be changed because of the following reasons:
- Portfolios have very low current yields. The current yield or running yield is the interest rate payments divided by the buying or current market price.
- Bond portfolios have very limited upside value because only highly rated bonds may increase in value, meaning that the selling price can increase above the buying price if interest rates fall. The opposite is true when interest rates rise, and interest rates cannot and should not be at these levels for very long…
- Most investment grade bonds are more sensitive to interest rate movements than high-yielding bonds because they trade in liquid markets. Price changes up or down are large for long-term bonds while bonds with a short duration, (less than 3 years) do not move much.
- Holding low quality bonds (high-yield bonds) is foolish now because they probably will not yield a return higher than high quality government bonds. To put it in perspective, a portfolio of investment grade government bonds would have yielded us a significantly better return without any credit risk over the last few years with a significantly lower credit risk.
- High yield bonds incur real risks of losses and are not a true diversification for most portfolios today. Their credit rating is either non-existent or below BBB-. That means the companies may not even be able to pay back all or part of their debts if and when they encounter financial problems which are already indicated directly in their rating or lack of! And recall that we are currently entering a new period of economic turndown!
In many countries, like Finland, pension funds are holding large portfolios of bonds – high grade and low grade. The high grade bonds are earning now less than the inflation rate and the low grade, earn more but contain huge risks. Above you can see the new graph from Ilmarinen, Finland’s largest pension investor. They are the people that invest your money for your retirement – they have a huge bond portfolio! Some 35% of their portfolio or €165 billion in bonds…
It appears that they know something that the reasonable man is ignorant of! It would be interesting to hear why they want to invest in bonds in today’s markets. Do not hold your breath. They will not say anything more than what they we taught by their famous portfolio theorist professors who claim that portfolios need to be diversified this way.