The financial crisis of 2007-'09 presented challenges to investors, but it was the official response to that crisis that has truly turned the world upside down. As a result, fiduciaries responsible for guiding the investment decisions of pensions, endowments and other long-horizon institutional funds cannot rely simply on long-term capital market return patterns to form judgments on expected returns, relative asset valuations and asset allocation.
In particular, investors can no longer trust the signals provided by the fundamental cornerstones of financial markets, by which the relative valuations of other assets are judged: the risk-free rate and Treasury yields. The signals emanating from these key indicators have been severely distorted all along the maturity spectrum by the Federal Reserve Board's extraordinary intervention. Fed policy has pushed nominal and real interest rates to record lows in a bid to provide the requisite life support to a faltering economy. Furthermore, the Fed expects that it will need to maintain rates at these exceptionally low levels through 2014.
Faced with this prospect, investors need to rethink capital market expectations informed by long-run historical experience. Yields on 10-year Treasury notes are now negative in real terms, and real short-term interest rates are likely to remain in negative territory through 2014. Yields held at these levels call into question the role of Treasuries in an institutional portfolio and overstate the relative attractiveness of other assets.
As a result, long-term investors need to reconsider the usefulness and appropriateness of government bonds in their portfolios. A case can be made that such instruments should be reduced to the minimum required to provide adequate liquidity to meet rebalancing needs and flows out of the portfolio, and to hedge the risk of disinflation and depression. Warren Buffett put it bluntly: Government bonds should carry warning labels.
Treasuries are likely to deliver less than a 1% real return pretax over the next 10 years, unless the U.S. economy falls into a deflationary environment in the meantime, precisely the scenario that Fed policy is trying to avoid. Our estimates of the most probable pretax real returns for a constant maturity 10-year Treasury note over the next 10 years range from 10 to 100 basis points, depending on how quickly real yields return to long-term equilibrium levels of 230 basis points.
The faster the Fed disengages from a policy of negative real yields, allowing yields to revert to more typical levels, the higher the expected return on bonds. For example, if the reversion to a real yield of 230 basis points occurs in one year, the annualized expected real return of a constant maturity 10-year Treasury note over the next 10 years would be 110 basis points. If, in contrast, it takes 10 years, the annualized real return would be 10 basis points. Over the last 80-plus years, the real return has been 2% to 3%.
Bond returns over the next 10 years are thus very likely to fall well short of historical experience. Asset allocation policies based on return expectations informed by historical experience are also likely to fall short of their return objectives. On this basis, there is a strong argument that government bonds should be held only to meet threshold liquidity and portfolio rebalancing needs. As never before, they have now become a wasting asset.
|Estimated total returns|
|Asset class||Estimated real return|
|Emerging markets equity||8.3%|
|Directional hedge funds||4.2%|
|Market neutral hedge funds||1.4%|
|U.S. fixed income||0.4%|
|Non-U.S. fixed income||0.3%|
Given this, expectations for bond volatility as informed by historical experience might also be misleading. Allocations to government bonds on the basis of their historical characteristics need to be re-examined and new allocations developed on the basis of a more realistic assessment of expected returns for bonds as well as for other asset classes.
The table at left lays out Strategic Investment Group's expectations for asset class returns over the next 10 years.
The impact of lower expected real returns for government bonds on a total institutional portfolio could be significant. That said, liquidity and rebalancing needs in unleveraged portfolios create a natural floor for the allocation to Treasury holdings, which varies with the circumstances of the institution and the allocation to other illiquid or volatile assets in the portfolio. A 10% to 15% allocation to government bonds is a reasonably comfortable floor for many institutions with unleveraged globally diversified portfolios and a 20% to 40% allocation to less-liquid assets such as hedge funds, private equity and real estate. At that level, assuming the real returns implied by our expectations above, currently depressed real bond yields would reduce total portfolio returns by approximately 30 basis points annualized over the next 10 years. Institutions with higher allocations to government bonds would see their returns reduced more significantly, as the following table illustrates.
|Reduction in estimated return of broadly diversi- fied portfolios resulting from low Treasury yields|
|Portfolio bond allocation||Impact on total portfolio estimated return (basis points)|
Those institutions counting on historical returns to pay for long-term obligations should seriously review their assumptions and constraints to make sure they are not blindsided by the current realities of a market distorted by an uncommonly accommodative Fed policy. More precisely, a 30- to 70-basis-point reduction in annual expected returns over a 10-year period in an environment of, say, 8% average nominal returns means a terminal wealth that is five to 13 percentage points lower than would have been otherwise realized. It also means that such institutions would have roughly 5% to 10% less available to spend pretax on a yearly basis to meet spending and other budgetary needs.
The Fed chairman insists an accommodative Fed policy does not come out of the hide of taxpayers. It is hard to see how that statement squares with the facts. An accommodative negative real rate policy might be a necessary evil to avoid worse outcomes for the U.S. economy, but the cost to investors and savers is all too real.
Hilda Ochoa-Brillembourg is president and CEO of Strategic Investment Group, Arlington, Va.