Following Ben’s introduction to this topic, I’m now going to dig into the behavioural responses to low bond yields – the mistakes being made and what we might expect in the future.
To start, it’s useful to ask a question: when facing financial losses, how should investors respond?
A strong temptation is to increase risk to try to recover the losses. Often, however, this is the wrong response. Past wealth is an irrelevant anchor – the investor should accept any sunk loss and invest in a way that pays no attention to how they arrived at their current position.
A type of sunk loss many investors have faced over the past few decades is that caused by a fall in real interest rates. Unless fully hedged, a fall in real rates reduces future spending power. This is because future expected returns (net of inflation) fall across all asset classes, but the current value of assets does not rise enough to compensate. This is not always an obvious loss – unless you are a defined-benefit (DB) pension scheme with an actuary supplying you with regular liability updates – but it is a loss nonetheless.
The appeal of taking risks when the chips are down (yields now look pitiful), and in the face of losses generally, is well documented in behavioural science – people like to maintain a chance of keeping objectives they’ve previously set. But this is a bias. The question then arises: if the fall in real yields has, all else equal, made you poorer, how should you react?
In many contexts, investors are found to have diminished risk capacity when they have poorer prospects. This has a fancy name – “Decreasing Relative Risk Aversion” or DRRA – but the idea is intuitive. Those who are asset rich generally have a high risk capacity so can hold a relatively large proportion of their wealth in equities and other risky investments. In contrast, individuals with less to invest cannot afford to risk such a high proportion of their savings.
Investors arguably should respond to a fall in real yields in the same way they should respond to any sunk loss. If anything, DRRA suggests that investors should do the exact opposite of what feels tempting: they should de-risk.
Falling real yields generally have a detrimental impact on under-hedged DB pension schemes. Notwithstanding the above, the way that such schemes are run often encourages risk taking in such circumstances. This may partly be driven by an irrational fear of regret: trustees might feel silly if they were at 99% funding, hadn’t de-risked, and markets tanked leading to the funding level dropping to 89%. This isn’t worse than if the funding level fell from 89% to 79% but the sense of snatching defeat from the jaws of victory would be hard to escape!
However, one good reason is that an inability to transact instantly on reaching 100% buyout funding means there is a risk of “useless” surplus, which encourages de-risking at higher funding levels (and conversely re-risking at lower funding levels).
Another interesting aspect is the hedge level for interest-rate risk. As yields fall, under-hedging may be considered less risky compared with history. However, thanks to liability-driven investing (LDI), it may be worth fully hedging this unrewarded risk, regardless.
DC and retail investors
In general, defined-contribution (DC) pension and pure retail investors are capital constrained (i.e. they can’t or won’t leverage growth or bond exposure), which has two interesting consequences in a low-yield world.
The first arises from the existence of the state pension and other DB pensions. It could make sense for them to take more risk within DC assets if they expect a smaller DC pot relative to the state pension, essentially to compensate for a relatively large safe asset.
The second is that reducing your bond exposure at lower yields is seen as less risky. DB schemes with access to LDI can still hedge all their interest-rate risk without necessarily impacting expected returns. However, DC and retail investors, who don’t have LDI, might switch out of bonds because the sacrifice in expected returns is no longer worth it.
Feeling the squeeze: sensible actions, whatever the weather
So, what should investors do?
In this blog, I’ve highlighted that increasing risk when faced with lower yields is not necessarily the right response. That said, many long-term investors suffer from reckless prudence in practice and it’s possible that two wrongs can make a right.
Likewise, some actions – such as scrutinising costs more closely or increasing diversification – are not really a response to low yields because they are also sensible actions in a high-yield environment. However, these are still worth reviewing. Psychologically, if not entirely rationally, low yields may have a silver lining, acting as a catalyst for investors to improve their strategies.
In a forthcoming blog in this series, my colleague Chris Teschmacher will review a number of options that multi-asset investors can take.