I wrote a blog post yesterday asking 'Where's the debt?' that pointed out that much of the world's riskly debt is pension balance sheets and this represents real risk in the event if another global financial crisis, which I think likely.
It seems this hit a nerve. Large numbers of those claiming to understand financial markets have turned up here for the first time saying that either a) there is no risk or b) I do not understand the markets or c) the risk has been priced into portfolios or d) this time its different, with some variations on the theme and an emphasis on (b).
So, for the record, there is risk. Marco Fante has noted it, here.
And I do not claim to be a market expert: I just use my sense to work out there is very real risk based on a) systemic issues b) experience c) knowledge of economic modelling and d) risk aversion that I think pension funds should share. This also means that I very, very much doubt that the risk has been priced appropriately.
Whilst noting that this time it is not different, and it never has been: markets crash. And they will again. I think fairly soon.
In other words, I have no faith whatsoever in the models that fund managers use that work on the basis, very largely of the known knowns, with a modest weighting for the known unknowns. I work on the basis of guessing the unknown unknowns using heuristics that have by and large worked well for me, and could for others.
And if you want to know what that heuristic says right now, the actual answer is hold cash, even though you will lose in the short term.
But I'll be derided again for saying so.
But I'm safe in knowing that I have seen pre-crash hubris from so-called professional fund managers many times now. And there was a rash of it on the comments page of this blog yesterday.
PS My favourite comment was the one that suggested there could not be risk in investment grade bonds. If that was not such a poor joke given the record in 2008 I might have laughed.
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Richard,
I see you are telling people thy should only invest in Gilts.
10y UK Gilts are currently yielding 1.15%, near an all time low. Inflation is currently 1.8%. So by buying Gilts I would be losing 0.65% a year. That excludes the very real chance that Gilt yields go higher.
How is anyone supposed to make money by investing in Gilts? Maybe you can explain.
Could you also tell me how much more money I would lose if Gilt yields rose to 2% – roughly the average of where they have been over the last 10 years?
Why are rates rising?
I do think you are being a bit simplistic here. I fully accept you may be personally very risk averse when it comes to investing in which case you are free to choose gilts. Though even there you still have options. For example, why UK gilts? They have a very poor track record in the post-1945 period and for much of the time the returns were negative due to inflation. I have a dim view of them as the money my grandmother left me in 1975 which at that time would have bought you a large house and grounds, had reduced to getting me one fairly average saloon car by 2005 when I finally managed to get it out of the clutches of the lawyer who administered the trust she set up. So that was a 95% loss of the real capital value over those 30 years. The interest income my uncle got for the 30 years was significantly less than the total erosion of the real capital value. Maybe that was just an exceptional period with consistently high inflation, but that could happen again when you are talking about 30 years (and I am not saying inflation is likely soon because it isn’t, but if climate change started to cause major problems with e.g. food production …). Had granny’s money been in a random selection of FTSE100 companies (and I know there wasn’t a FTSE100 index in 1975) the nominal value would have gone from around 500 to around 6000 index points, despite slumps in the ’80s, ’90s and the Tech Bubble. So if you are going for gilts maybe you should broaden your horizons and e.g. look at Germany, Finnland and the like? Insulates you against a Brexit run on the pound too (though the pound has been a consistent faller back to 1914. 1947 there were 25 Swiss Francs per pound and today only one.
I had a look at a few of those links, and it isn’t true that all large UK companies are up to their eyeballs in debt. Some are, some are not. So I saw 10% of all the corporate debt (FTSE companies) is actually £45 billion at British American Tobacco while one of the housebuilders has no debt and £1.2 billion of cash. Overall debt of those companies has actually been falling the last two years. Back in 1929, for example, not everything crashed. Had you invested in the new industries of consumer electricals (radios, etc), cars and the like you would actually have done quite well. Indeed anyone who bought one share in IBM in 1931 would have been a multi-millionaire by the 1980s. Also worth noting that the Dow Jones Index, which everyone quotes, was and is very narrowly based. If I remember right the 1929 boom in terms of changes to the Index was actually being driven by just two or three companies by August 1929. So yes if you held those it was catastrophic.
My wife is in the USS (university pension scheme) and that is currently 45% equities and 25% government bonds, with various things like property making up the balance. That really does not look like an impending disaster. Especially when you are looking at what you will have in 40 years time. For example pension contributions paid in 1998 might have then lost 40% in the tech bubble crash but by just sitting on them since then they would have made it all back and plus some, while having the dividends in the meantime. So the impact on the 1998 new employee due to retire in 2040 would not be significant. Obviously better to avoid things that lose value, but the real problems only come when you start buying at the top and then selling out at the bottom. That is where the ‘sheep’ argument comes in. I certainly agree a lot of the investment industry are sheep and just do what everyone else is doing, so personally I tend to be a bit contrary. Thus buying when everyone else is selling, but you have to be willing to sit on things and you can get caught out if you need cash at a fixed point and get forced to sell.
Even with your gilts you should not just buy them and sit on them to redemption. The current very low interest rates, for example, mean bond prices are very high. If and when rates go up (which might not be soon I agree) bond prices will fall sharply. So there is a very good argument for folk who have held bonds for some years (i.e. since rates were higher) should actually sell them now and take the profit. Otherwise you will eventually lose the gain, either because interest rates go up or because time runs out and your bond is redeemed at par. Keynes did become a millionaire by trading in gilts after all.
If gilts are so bad please tell me why there is such an enormous appetite for them?
Regulation, in a word.
The government forces banks to hold the bulk of their Tier 1 capital in liquid high quality assets, which basically means cash or Gilts.
The government (thanks to Brown in 2007) also forces pension funds to invest a large portion of their assets in – guess what – Gilts.
Of course, it also helps that thanks to the current government cutting the budget deficit down to quite small levels there simply isn’t a huge amount of net new supply of government debt. Far less than the £150bn invested in the pensions industry as a whole every year. QE has also reduced the available amount, as it was designed to do, which has also pushed up the prices.
Of course, the trend is still downwards. Back in 2007 50% of all UK debt was held by the pension and insurance industry. Today it is around the 20% level. Nobody wants to buy the stuff unless forced to do so, given how low yields are (negative in real terms).
“much of the world’s riskly debt is pension balance sheets”
Risky debt? Since when has investment grade debt been high risk? The average default rate over the last 30 years has been a massive 0.1%.
Much less than you would lose just to inflation when buying Gilts.
I despair
Another ‘it’s investment grade so nothing can go wrong’ idiot
We apparently leant nothing from 2008
They are a good short to medium term parking place for your cash, but I would not recommend them for the very long term. At least not UK ones. I would rather long term investors did something more productive with their cash than just park it with the Treasury. For example, pension funds should be the ideal folk to invest in major infrastructure projects, or to fund council housing (if the state won’t). However, that needs to be organised perhaps by some sort of state owned National Development Bank because a pension fund needs some sort of liquidity i.e. the option to get out. Generally if the economy has real growth of e.g. 2% pa then on average you would expect equities to reflect that with similar real growth in collective company values on top of the dividends. You never get that out of a gilt.
There is a strong demand for UK gilts not only because people want them, but because some investors are required or forced to hold them. For example the demand for pension safety has led to HMG forcing pension funds to hold a bigger percentage. Plus gilts are deemed to be safe. My grannies lawyer invested in gilts (and just held them to redemption) because it was easy (but that didn’t stop a large fee being charged!) and he could never be sued for negligence or mismanagement because gilts are approved by the Law Society as ‘safe’.
A time of very low interest rates is on balance a bad time to buy gilts because they will suffer a fall in capital value as soon as rates rise (and they are low even by 19th century values). A time of high interest rates would on balance be a good time to buy gilts as you would get a capital gain when rates fell. 2007 would have been an ideal time to pile everything into gilts as you would have seen as much as a 50% capital gain after the crash. But you would have to have sold to get the gain and not just continued to sit on them (any gain (or loss) disappears as you get to the redemption date).
I am sorry, but that’s an inade1uate explanation for 40% being held outside the U.K.
There’s a lot of bullshit going on here
Richard says:
“please tell me why there is such an enormous appetite for them (gilts)?”
Angela says: “Regulation, in a word.”
I say – no those regulations have been around for quite a long time (as Angela herself points out) but the growing appetite is a much more recent phenomenon. Hmmm.
And as I noted, it does not explain 40% foreign buyers
So, as an explanation, it’s pretty weak
Or worse
“Another ‘it’s investment grade so nothing can go wrong’ idiot”
As opposed to a moron who claims that anything that isn’t a government bond is highly risky.
“We apparently leant nothing from 2008”
Let’s just look at the data shall we?
https://www.spratings.com/documents/20184/774196/2016+Annual+Global+Corporate+Default+Study+And+Rating+Transitions.pdf/2ddcf9dd-3b82-4151-9dab-8e3fc70a7035
Pages 4 and 5 are the important ones. The pertinent data is:
Investment grade default rate 2007 = 0
Investment grade default rate 2008 = 0.42% (highest IG default rate)
Investment grade default rate 2009 = 0.33%
And those were the worst years. So if you can’t handle less than half a percent default rate on a diversified portfolio of investment grade corporate bonds, sure, go and lose money by buying Gilts.
But to claim that investment grade corporate debt is very risky is just totally wrong.
Actually, in case you did not note I actually said ‘And if you want to know what that heuristic says right now, the actual answer is hold cash, even though you will lose in the short term.’
But why bother with facts? They seem beyond you.
And why didn’t triple A default? Are you telling me you really don’t know? Maybe you should do some reading
Not sure if you were addressing your question to me, but the reason why 40% (if that is the number) of UK Gilts are held by foreigners would be similar to why lots of people put their money in Switzerland or US Treasuries. They are a safe haven compared to many many countries. Plus I suspect you could usefully investigate what counts as ‘foreign’. So if I stick my uk gilts into my Cayman Islands tax account (assuming I had one) would that make the gilt ‘foreign owned’? Angela was certainly correct about HMG manipulating UK demand and has looked up the details I could not be bothered with.
As I said you are being simplistic and you really have to distinguish between what sort of Corporate Bond you are talking about. And I am not saying anything about rating agencies, etc since I agree with you that they are fairly hopeless. It is a simple fact, though, that a £100 million bond from Vodafone is not the same risk as a £100m bond from Smashit & Run Hedge Fund Ltd. If you really think most FTSE listed companies are about to go bust in the next downturn (which is what would have to happen for them to default on their bonds) then you are talking about the end of life as we know it rather than a depression. Most large US companies survived the Great Depression and some even did well. Lots of banks went bust, as did lots of individuals, farmers, small business, etc.
Ah!
So gilts are a safe haven
Blow me if that was not one of the points I made in the first place
How long did it take for this to be appreciated?
Oh, and the reason why companies will not go bust is because markets will be bailed out again
As they were in 2008…..
And that’s what no one is saying here, but everyone is assuming
Since you are talking about risk here is a scenario for you:
You predict a disastrous hard Brexit and you may well be right. Robert Peston thinks so too. Anyway after Airbus, Nissan etc announce they are pulling out of the UK the pound goes into a steep decline. To try to arrest it the BoE has an emergency increase in interest rates to 5%. Your 4.75% 2038 gilt you just bought at £155 per £100 face value would slump to being worth £95. So you have just lost £60 or around 40% of your investment. To get back the £100 you are now trapped and will have to wait until redemption in 2038.
The current situation where £100 face value gilts sell for £150 or more is also another sort of bubble (and this one was caused by QE and emergency low rates).
Why on earth would they increase the interest rate if that was the consequence?
Interest rates cannot defeat fundamental economic truths
We learned that in 1992
It won’t happen
Next question?
I get the feeling that I’ve been wasting my time reading academic and institutional tea leaves whilst staring at bond yield curves. A better indicator might be right here in the overreaction to these blog posts.
They doth protest too much.
You are right
But what they all assume is that they will always be bailed out
That’s the missing factor you and I have ignored
I’ll address it tomorrow
Ah, yes, the old ‘Moral Hazard’.
You’ve hit a nerve alright.
Risk and reward is an interesting calculation and one we make in all manner of fields of human activity; crossing the road, picking a restaurant, making a purchase….the list is endless. Sometimes trivial sometimes life and death.
If your job is to manage money on behalf of other people your risk and reward calculation is twofold. Looking after your clients’ interests and looking after your own professional reputation (and self esteem) and this may be including the reputation of your employer.
It’s not difficult to figure-out where most people’s priorities would lie in terms of self-preservation.
If you are going to question people’s faith in the invisible hand of omniscient, omnipotent market theology you can hardly be surprised to ruffle a few a feathers amongst the priesthood. Furthermore since you haven’t been ordained in these holy mysteries how could you possibly understand ?
Have you even the slightest idea how many bond traders can dance on the head of a pin ? 🙂
I’ll preface this piece with: my preference is for equities – not gilts & I have been “investing” (taking bets?) on the stock market for circa 40 years.
One has to make money one way or another & engineers have been historically poorly paid in the UK – yes I know a poor excuse – but it’s the best I can offer for having a nasty habit.
A while back I had a chat with my broker about the corporate bond market – I’d seen a couple of bonds from solid companies that seemed to give a good return. His response was “the market for a given bond is often not very “liquid” i.e. not easy to buy – not easy to sell. So I put the idea to one side. Last year, the Bundesbank lost its ECJ case against the ECB’s QE. The core of the BB’s argument was that because bond markets are not very liquid – large-scale QE by the ECB (both gov & corp bond buying) greatly influenced (inflated?) the value of the bonds. The fact that the BB lost its ECJ case does not mean that its assertion (thin liquidity in corp bond markets) was invalid.
This brings me back to the ‘it’s investment grade so nothing can go wrong’ …………if there is already thin liquidity one wonders what happens when it becomes thinner?
As far as discussions on “when the next crash?” – perhaps one indicator is to answer the question: what is Goldman Sachs up to? (they certainly saw 2007/2008 US mortgages coming down the track).
Who is bailing out pension funds?
The state
You don’t know that?
But the Pension Protection fund ‘bails out’ failed pension schemes, which is funded by the Pensions industry.
Thought you might have known that.
So a statutory scheme has no link to government
Oh, come on
Shall we get real here?
Graham says:
“…… the Pension Protection fund ‘bails out’ failed pension schemes, which is funded by the Pensions industry.”
……aka added to the cost of the pension to the customer. It’s part of the cost of doing business, let’s not pretend it’s an act of corporate generosity….. nor that the Pension Protection fund would exist at all were it not for regulation (unless of course its principle function is to protect the fund managers)
However my real question is, had the government not bailed out the finance sector in 2008 (and subsequently with QE) what would any of these pension funds have been worth ? Much of the apparent growth on the equities portion of funds would probably still be on the floor, but It’s not clear to me where the corporate or government bond portions would have been by now.
“If gilts are so bad please tell me why there is such an enormous appetite for them?”
As no one else will I may as well answer: liquidity preferences under conditions of uncertainty (Keynes and all that). Nothing new really.
Agreed
So wrong, as ever.
You can’t look at the assets in ifilation, you need to look at them in conjunction with the liabilities.
So you either want liquidity, in which case you want cash or you want to match the liabilities, in which case you could use a gilt but you’d be better off using a corporate bond where the extra spread more than offsets the extra risk.
Which goes back to the previous discussion that you are do keen to avoid, what is the expected cost of defaults on an IG bond and how much are you bring paid to take that risk?
This is why you are fundamentally wrong with your claims, despite deliberately trying to pretend people have said something quite different to what they’ve actually said.
The weird thing is I suggested holding cash and you can’t apparently see that
So why should I answer your question when it is clearly for someone else?
I agree re liquidity preference but it a poor argument for a savy retail investor..you can own a Marcus account, earn 1.5% with a Govt guarantee up to 85k and you have instant access with no duration risk.. it is a no brainer to own this over long dated gilts.. anyone buying them st today’s levels could lose a lot of money in actual terms (aside from pretty much guaranteed losses in real terms).
So what you’re actually trading is government guarantees
You assume there is no down side….
Sometimes history is instructive. Perhaps the “masters/ms’s of the universe” can tell us how well the bondholders of GM, Lehman Brothers, RBS and others fared 10 or so years ago?
“Investment Grade” means some ratings company thinks they are a good buy and again while history may be useful, more recent voices are raising concerns: https://www.nytimes.com/2018/07/13/business/riskier-to-own-high-quality-corporate-bonds.html with an interesting comment at the end by an investment officer who has actually done some research.
Those bonds paid back all of their coupons and principal payments, did they not? No defaults.
‘Investment grade” does NOT mean that ‘some ratings company thinks they are a good buy’, this is just more nonsense from someone who clearly is out of their depth on this topic.
By linking to the article that you have done, I think you are confusing mark-to-market with actual returns when held to maturity.
And why did they pay back?
Have you asked that question? I suspect not. See this morning’s post.
But I have to say that so poor is your commentary that your time here may be up
Yes, pensions have greater risks because the safe “risks” of interest-bearing investments aren’t paying anything with interest rates so low, pushed down by Quantative Easing, so to prevent deficits in the pension scheme they have to invest in higher return investments, which by definition are higher risk – that’s why they have higher return. Pensions’ debts will be safer when interest rates rise, which is only possible after Quantitive Easing has been unwound.
Ah, and you’ll crash the economy, millions of households and our banks for that?
Oh Well, at least he kind of admitted it. Sort of.