An investment like high-rated, low-yield bonds may carry more hidden dangers than a basket of stocks.
FROM BARRON'S | JUNE 5, 2015
In today’s investing world, it appears that the search for safety is trumping risk. Although frequent commentary trumpets bubbles in riskier investments, that is not consistent with the hard data on money flows. The result of so much money chasing safety is quite the opposite of what we might want: So much money pouring into assets perceived as safe is actually making those assets riskier. Those riskier assets are attracting less money and fewer players, and as a result, may be safer than they appear. In short, today’s market presents a conundrum: There may be more risk in safety, and more safety in risk.
Risk in Safety
Risk is not only subjective. When investors hire a financial advisor, for instance, they are asked a series of questions, ranging from short-term needs to long-term goals, to determine where they fall on a risk spectrum. If the responses deem an investor “conservative,” the recommended asset allocation is heavily weighted towards bonds. And not just any bonds: Only sovereign debt of countries such as the United States or Germany that are considered very safe, and highly rated corporate bonds, are recommended. Perhaps this “conservative” investor also will allocate funds into what are considered high-quality, large companies paying a dependable dividend. But for the most part, conservative, and hence safe, in the investing world has become synonymous with certain bonds and a very specific and small universe of stocks.
Historically, these “safe” bond investments had a low probability of default. They also carried a perception that their face value would fluctuate less, and exhibit lower volatility, than either equities in general, or riskier fixed income instruments such as high-yield (formerly known as junk bonds) and emerging market bonds.
The problem now is that funds are flooding into bonds, and especially into highly rated, low-yielding bonds. Instead of occupying one end of a nuanced spectrum, bonds are an ever-larger percentage of investment portfolios. In fact, a recent survey by Bank of America Merrill Lynch showed portfolios were underweight equities by as much as 19%, and thus had even greater concentration in bonds.
Fund flow data is one of the best gauges of where investors actually are putting their money. Investor sentiment surveys can mislead, but money flows tell the true story of what is happening. And month after month, money has flowed out of U.S. equities and into bonds and bond funds. April of this year was a particularly stark contrast: More than $20 billion flowed out of U.S equities, and more than $10 billion went into bonds. The only category that did better was international equity, which has been buoyed by the quantitative easing and other measures recently instituted by the European Central Bank.
With money surging into assets viewed as safe, those assets, of course, have, become relatively more expensive, and thus the surge in bond prices and the drop in yields. It also helps explain the continued surge in worldwide real estate prices, an asset which may not be perceived as safe as bonds, but certainly seen as safer than stocks.
So much money concentrated in a relatively limited quadrant of the market cannot be a recipe for good things. The rush into safe assets may not end with a crisis, but it already has generated less optimal results in the form of very low yields and poor returns. Some banks have begun charging depositors for keeping money in savings and checking accounts, a sign that safety is creating costs.
Recent sharp moves in bond prices demonstrate just how risky safety can be. Yields on the supposedly staid and uber safe German bund dropped down and down and down to just about zero in April before shooting up nearly 70 basis points in the space of days. In bond land, that is about as volatile as it gets, and is hardly a sign of safety.
Safety in risk
If the massive concentration of assets on one end of the spectrum is creating potential risk, the substantial underinvestment on the other end may present significant opportunities. At the very least, the underinvestment in U.S. equities (and certain other types of bonds) may signal that there is less risk of investor panic and prolonged volatility.
Equities always have been on the riskier end of the investing spectrum. Advisors, who think in terms of risk buckets, as well as institutional and pension investors, all view equities as risky, because major loss is always a possibility. That scenario exists with bonds as well, but even if a borrower defaults, the risk of massive decline is rarely as great. That is why equities often are said to carry a “risk premium” compared to other investments.
Few investors approach equities with false equanimity, except in periods of exceptional euphoria (such as the 1990s, when stocks appeared only to move up). One thing that makes bond investing potentially riskier now than equity investing is that so many bond investors seem less sensitive to the potential for losses and volatility than equity investors. Being unprepared for risk is possibly the greatest one of all.
Other than international equities, stocks in general have seen investor flight, both retail and institutional. The recent surge of investments into international equities is impressive, but less so when juxtaposed with the past five years of their poor returns and tepid flows. U.S. equities have been among the world’s best performing assets over the past five years, and yet still carry the taint of risk. Although it has not stopped markets from rising, it certainly has stopped markets from going up the way they did from 1982 till 2000.
Suggesting that there may be more safety in risk does not mean that stocks and other “risky” instruments, such as emerging market debt, are free from the perils of sharp sell-offs and negative volatility. But it does mean that the space may be less prone to panic and systemic breaches, because investors are aware of the perils and the rewards, and are less likely to bolt at the first hint of trouble.
We all are part of herds, and today’s market herd mentality is to seek more safety and assume only dollops of risk. But the effect of such behavior is that too much money is being allocated to one corner of the market and not enough to others. It potentially can create a safety bubble, with some areas of the market called “risky” actually being far safer, in terms of dollars returned to investors over time.
If your portfolio is skewed toward supposed safety, therefore, consider that it may not be as safe as it seems. You cannot invest without risk, and the excessive pursuit of safety can be just as irrational as the exuberance in housing, equities, and derivatives that caused such tumult in the past fifteen years. Assessing risk tolerance is not the problem. The way we currently define safety and risk as synonyms for bonds and equities is the issue. It is one that we all should address now, rather than trying to do so if and when real volatility and turmoil once again rear their all-too-familiar heads.