In a world of low expected returns like the one we all invest in today, fortunately there are still choices in terms of how much portfolio risk to take.
At the time of the Global Financial Crisis (GFC), the RBA cash rate was 7.25 percent, reflecting inflation above the Reserve Bank of Australia’s target
band of 2 to 3 percent. We estimate that the “neutral” RBA cash rate – the rate that is neither expansionary nor contractionary for the economy – before
the GFC was about 5.5 percent, so in that “old normal” environment, investors could essentially earn a 3-4 percent real return without taking any
investment risk. Today, the RBA cash rate is 1.5 percent, yet the inflation target has not changed. Even with the inflation rate currently well below the
target band, the risk-free real return available to investors has fallen to somewhere between zero and 2 percent.
To earn a similar old normal return today, more risk must be taken in portfolios. The search for additional risk typically starts in the most obvious
places, like listed equities, and then migrates more and more towards off-the-run assets that often have less frequent revaluations and much less price
transparency. Whether they are global infrastructure projects, streams of securitized cash flows from royalties, leases on equipment, etc., they may indeed
be yield substitutes, but they are not risk-free substitutes.
Such assets that have been aggressively stress-tested for downside scenarios definitely belong in diversified portfolios, but their risks should not be
assumed to be uncorrelated with other risky assets in portfolios, and allocations should be sized accordingly. These types of assets are also illiquid to
the extent there is often only buyers or only sellers at any particular moment in time. Given the valuation infrequency, the true price volatility of many
of these investments is grossly understated, thereby overstating their risk-adjusted returns (Sharpe ratios) and making portfolios appear more efficient
than they really are.
The interesting conundrum in markets today is that while retail investors and superfunds have lowered their internal rate of return (IRR) expectations from
these off-the-run investments, the corporate sector is still reluctant to invest in their own businesses as they appear to have retained their old- normal
IRR targets. These management decisions to focus on dividends and share buybacks are essentially robbing future economic growth potential and are
consistent with asset price appreciation without economic growth generation. This is a common problem the world over.
If these high-yielding, off-the-run alternatives start to smell a little too much like “tulips”, then beware of getting caught in a yield-chasing mania. As
interest rates remain lower for even longer, the potential for the yield hunt to drag investors too far away from underlying fundamentals increases
significantly. When you consider that most central banks are approaching the end of their interest rate easing cycles but are still expected to remain
accommodative in their policy settings, the engine that has been driving risky assets skywards appears to be losing power.
Investors looking for higher-yielding instruments accompanied by sound fundamental underpinnings may also want to consider global bank capital securities,
bonds exposed to the US mortgage market and high quality global investment grade credit, which all represent excellent potential sources of income.
Finally, if you can’t resist the yield temptation and decide to allocate an outsized position in your portfolio, then first acknowledge that your portfolio
risks are rising, and second think about ways to offset these risks by doing things like increasing your allocations to low-risk, high quality intermediate
Robert Mead is a managing director at PIMCO in Sydney and head of portfolio management for Australia.