Is higher risk paying enough?

The recent share price rally and interest rate decline have paradoxically increased your investment risk at a time when the world of finance seems a less risky place.

Here I’ll ponder whether you are being paid enough for the risks you are taking, and the more practical question: “Should you take on more risk when future returns are expected to be lower?”

Higher share prices and the risk of lower future returns  

The price gain in local and overseas shares since recent lows about a year ago is due mostly to the reduced concerns about government and bank defaults that worried the market this time last year. The VIX index, sometimes referred to as a “fear index”, shows this below. In my opinion, this risk hasn’t gone away; it’s just been pushed out into the medium term, which the 30 day forward VIX index doesn’t worry about.

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A year ago the Australian sharemarket traded on a 20-year low P/E of 12 (see A pointer to higher returns), and now it’s trading on an above-average 18 (based on trailing earnings). In Australia, company earnings haven’t been growing much in aggregate, so we can simply say the multi-billion dollar movement in the local market is driven by investors now comfortable paying 18 times to own past company profits that they were willing to pay only 12 times for a year ago. They paid less earlier because of a worry that company profits might fall. Apparently they are more certain they won’t, and are certainly more desperate to share in them.

Unfortunately, with a higher P/E comes the greater chance and room for a price fall. US academic Robert Schiller points out that investing when prices (P/E) are high means you are more at risk of earning lower future returns.

Australian bank shares have especially outperformed as investors chase their dividends. Their price is collectively up 40% since last May. This also means their dividend income (before franking) has fallen, from 7% to 5% (and from 9% in early 2008). Their P/E is now at about 16 times, compared to an average 13.

Just because the prices investors are willing to pay for company profits (and property trust rent) have risen doesn’t mean they will fall. They could simply have reached a new and justifiable plateau in a low inflation environment, and we could even see a “melt-up”, which means further rises.

Regardless of which way share prices move from here, you are now being paid less in terms of future returns owning shares at today’s prices than you were earlier. I’m not sure risk has fallen enough to make this a fair trade. 

A lack of interest

The second reason sharemarkets rallied, especially here recently, is that low interest rates have reduced future cash and bond returns (see left side chart below). This has made it nearly impossible for most institutions and private investors to meet promises planned for their money – as discussed in Prepare for modest medium-term growth. Investors unhappy with traditional bond returns and deposit rates have been happier to consider dividends. In fact, many rolled over their term deposits into owning the bank.

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Yield and swap spreads on three-year maturity Australian government and corporate bonds. Source: RBA

The right hand chart shows the incremental yield earned by investing in bonds that are less secure than federal government bonds – which too are shrinking. The reason these “spreads” are contracting is because bond investors are reacting to declining yields by trading down, buying riskier bonds and driving their price up and yield down. I suspect this spread is actually thinner than shown because overseas institutions have exclusively bought ‘AAA’ rated government debt, pushing its yields unusually low and widening the spread artificially. However, spreads aren’t as low or thin as they were pre-GFC, when it was clear investors in low-credit quality bonds weren’t being paid enough for the risk taken. This was sadly true also for investors in Fincorp, Westpoint, Estate Mortgage and many other failed funds.

Today a lowly rated ‘BBB’ corporate bond (the lowest category of investment grade bond before “junk”) is yielding on absolute terms what an ultra-safe government bond did two years ago, and 1% less than it did normally before the GFC. As a spread over inflation, these are also far less generous. While conditions have improved in recent months, they aren’t so rosy to make me think a bond investor (and to a lesser extent a depositor) is being paid fairly for the risk taken

This isn’t surprising, because benchmark interest rates aren’t set to compensate you for risk. They instead are being set by a committee of career central bankers, economists and industrialists (and no self-funded retiree representative) to fulfil a mandate that seeks to achieve things like “full employment” and “financial system stability”. It is often the case that when economic conditions are poor and risks are the highest, like in the depths of the GFC, you are paid less income on your deposits than you deserve. For this reason, I’m not sure “new record low interest rates” is something the Federal Treasurer should have taken credit for in his recent budget speech. 

Bond substitutes

To complete my survey of asset classes, in between buying riskier bonds and buying more shares, professional investors have also been searching for “bond substitutes”. Globally, listed commercial property and infrastructure and utilities (see Infrastructure’s game plan) have filled this role. Such has been the interest in these assets that, over the last 12 months, these returned more than 20% to investors, outperforming shares. Unfortunately, after this price rise the yield on Australian Real Estate Investment Trusts (AREITs) specifically has fallen also from about 7% to 5%. 

Of course, term deposits yielding above 4% are still a fine bond substitute for the individual investor.

Perhaps the only things left with a bit of gas in the tank is Asian and emerging market stocks, and betting on a falling Australian dollar – which is by no means a low-risk strategy.  

So no matter what asset class you look at, after recent price gains and interest rate reductions (welcomed by past share and bond investors), current yields have been compressed. Only by taking on more risk can you expect to earn the income you used to. Which brings me to a critical question: Should you?

Manage your portfolio for income or total return?

Many retirees prefer to live off portfolio income rather than capital.

In the current environment, if you are a conservative investor with most of your money in cash and bonds, the only way to maintain your past income is to invest in lower credit quality bonds or income securities. Doing so could set you up for later failure and wouldn’t make you a conservative investor anymore. Investors who solely invest in income assets need to be careful not to live off all the income from their investments early in retirement, as they need to leave some to grow future income to counter inflation. At times like now, many will find this hard to do.    

If, on the other hand, you are a more volatility tolerant investor, investing substantially in shares and living off only income, I wonder if you aren’t spending enough! After a 15% price rise, perhaps you should consider taking some profits to enhance your retirement quality as well as to keep your portfolio in balance, as I discussed recently in A time to take profits. An issue with designing a share portfolio for income is that you can bias your portfolio towards high-income stocks, which generally offer lower prospects for capital growth. Another issue is that you may concentrate your investments into only a few sectors – like banks.

The alternative to living off income is to target a total return for your portfolio and to live off both capital and income. This strategy works very well if you practise periodic rebalancing of your portfolio. Dividend, rent and interest income, and trimming of over-appreciated assets, can be used to pay you and buy more under-appreciated assets, thereby also keeping your portfolio in balance. With this approach you can also plan on paying yourself a fixed income, which you adjust only with inflation, rather than fluctuating interest rates and sharemarket returns. In good years you leave a little bit in the portfolio for the bad years. In 2008, in How much is enough, I shared with you some historically based benchmarks for what you might take out from a balanced portfolio at the start of your retirement, depending on your age.

Yield down, risk up?

Investors in the US have been living with lower interest rates and dividends longer ,and it may be prophetic for Australians to see how they are adapting the way they spend and invest. In short, about half are spending less, and about a third are taking on more investment risk and investing in things they would otherwise have avoided. (Click here to read the full article).

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ASIC chairman Greg Medcraft is worried about the latter strategy. At the recent Australian Shareholders’ Conference, he warned that: “in the search for yield, people invest in products that are probably inappropriate for their needs or they don’t understand ... that’s going to be a very, very important thing that we focus on”. 

So should you take on more risk when future returns are low? For most investors, I think the answer should be no. Doing so is almost like putting up a bigger sail in a strong headwind or storm, hoping to keep your average speed up. If, however, your starting position was being underweight in risk assets, as many including institutions were, then taking on more risk is necessary. Unfortunately, if you are doing this now, you are likely to get paid less return for the risk of doing so. 

Dr Doug Turek is principal advisor with family wealth advisory and money management firm Professional Wealth (www.professionalwealth.com.au).