In Search of Lost Yield!

It is not a scoop! Yields on traditional asset classes have reached historical lows, not to mention that these low yields imply already high valuations and point to low returns going forward. Consequently, in this market environment, investors must accept to lower their expectations of gain…which is not easy!

But how did we get to this point?

Looking back, we observe that over the past 30 years, the fall in interest rates has been accompanied by high returns (albeit decreasing over time), on both equities and bonds. In hindsight, a simple portfolio comprised of 60% equities and 40% bonds would have generated fabulous results over the past 30 years.

However, interest rates have now reached historical lows: long bond yields are even negative in real terms (adjusted for inflation) in many countries.

Moreover, as these rates make up the base of yields on risky assets, all these asset classes are impacted. For example, at the beginning of the 1980s, French government bonds were yielding between 14% and 16%! The subsequent fall in interest rates was an essential driver for pushing up the prices of all asset classes, first of all bonds, leading to high returns over the period. Therefore, one of the key reasons why the performance of a very large number of asset classes has been excellent over the past 30 years is that entry points (30 years ago) were very low. Indeed the entry level/purchase price of an asset class are essential for generating yield.
 

So what can be done today in the context of low rates and high valuations? What have investors done, or what will they do, to make up for this general decline in yield?

Not surprisingly, to obtain the same level of yield as 30 years ago, the natural reflex of investors is to take more risks (consciously or unconsciously!) and in this way they are exposed to future returns that are potentially satisfactory…but also potentially disappointing! Indeed, whereas in 1995, it was possible to generate a return of 7.5% with a 100% allocation in bonds and low volatility (6%), i.e. little uncertainty on the generated performance, in 2015 it was a completely different kettle of fish. With only 12% invested in bonds and the remaining 88% in “risky” asset classes: 63% equities, 13% real estate and 12% private equity, it has become necessary to take substantial risk (volatility of 17.3%) to generate a 7.5% yield (see chart below, source: Callan Associates).

On the other hand, the logical collateral effect is that this movement towards “risky” assets is driving up the price of these assets.

In short, this famous quote by the late American financier, Raymond DeVoe, Jr sums it up:  “More money has been lost reaching for yield than at the point of a gun.”
 

Finally, how can this difficult equation be solved?

The solution is certainly not simple but the best way to tackle the question of asset allocation in a context of low rates, and thus low yields (or high valuations), is to start following these rules:

1.       Be realistic about return objectives and reduce your expectations of future vs. past performance.

2.       Reduce the overall risk of your portfolio, particularly the sensitivity to interest rate risk.

3.       Diversify by including every asset class.

4.       Focus on capital preservation through a relevant strategic allocation before taking any tactical decisions.

5.       Know how (and when) to seize long-term, structural investment opportunities.
 

These rules do not provide a miraculous solution, far from it! But at least they will help to prove Raymond DeVoe wrong for many more years!