The Future Ain’t What It Used to Be

When Yogi Berra famously declared that “the future ain’t what it used to be,” he proved himself to be oddly prescient. In a similar vein, he easily could have been describing the European debt crisis when he cautioned that “it ain’t over until it’s over.”

As PIMCO’s Bill Gross reminds us in his year-end Investment Outlook, it will be years before Europe, the U.S., Japan and other developed countries overcome the challenges of high debt and low growth, with financial market returns remaining low and volatile as a result.  He concludes:

“If you can get long-term returns of 5% from either stocks or bonds, you should consider yourself or your portfolio in the upper echelon of competitors.  To approach those numbers, risk assets in developing as opposed to developed economies should be emphasized”. 

Bill’s return expectation suggests a real return after inflation of 2 to 3%, or less than half what most foundations, endowments and pension funds are expecting, thereby raising the question of which asset classes to avoid and which ones to emphasize.

Fixed Income

In real terms, U.S. Long-Term Government Bonds returned 2.5% p.a. over the past 84 years[1].  Consultants and some CIOs bravely base their expectation of future fixed income returns on that number.  However, if you break down this long-term real return into seventeen 5-year calendar year periods[2], it becomes evident that the 2.5% was achieved because of the unprecedented drop in bond yields over the past three decades, which cannot be repeated, unless interest rates turn negative.

 

Before making a fixed income real return projection for the next decade(s), the brave forecaster should remember that for the 36 years ending September 1981, U.S. Long-Term Government Bonds suffered a negative real return of 2% p.a., which wiped out half of the real value of the bond portfolio.

Floating Rate Instruments[3]

This asset class is comprised of Index-Linked Bonds, like RRBs and TIPS, and Floating Rate Loans.  As index-linked real yields have dropped to 0%, leaving the investor with a return equal to the rate of inflation, they are no longer priced attractively enough to be considered.

Floating Rate Loans are usually priced with a yield spread of 3 to 5% over LIBOR.  Since the LIBOR rate is highly correlated with that of US T-Bills, we should look at the T-Bill real rate of return over the past 84 years which is 0.6%[4].  However, if we again break this down into 17 5-calendar year periods[5], we see that this long-term average was pulled down during the periods of World War II and the Korean War. 

 

The real return of U.S. T-Bills for the 50 years, from 1960 to 2010, was 1.2% p.a., or twice the long-term rate used by consultants and some CIOs.  In other words, floating rate LIBOR-based loans are likely to produce a real return of 4 to 6%, which is close to the most commonly used actuarial real yield assumption of 4.5%.  Institutional investors should, therefore, consider shifting at least part of their fixed income bond portfolios into floating rate debt portfolios with a meaningful loan exposure to developing countries where the borrowers are less levered and of higher credit rating. 

December 2011 

[1] Ibbotson SBBI 2011 Yearbook, page 32

[2] ibid., pages 254 to 259

[3] My June 2011 memo:  “Floating Rate Debt:  A Distinct Asset Class”

[4] ibid., page 32

[5] ibid., pages 266 to 277