One of the principal features of the current, long running period of ultra-low interest rates and inflation has been the distortion of asset prices. Investors now seek returns from riskier assets because the prices of lower risk assets are inflated by the central bank intervention. This is nothing new and has been the case for some time but this week we will highlight how extreme some of the anomalies created by this effect have become.
In the perfect world envisaged by market theorists, particularly those in the efficient market hypothesis camp, all obvious anomalies would quickly be arbitraged away by return seeking investors. Anyone who has worked in financial markets for any length of time knows this is simply not the case. That is not to say that there are risk free profits available or that market participants are not aware of the market failures. The reason these inefficiencies exist are typically behavioural or structural.
In a later note we may focus on some of the behavioural inefficiencies we seek to benefit from in our process but this week we are going to look at some obvious structural inefficiencies. The vast majority of investors are constrained by a set of rules and most of the largest blocks of capital are run in ways that are highly constrained. This creates some of the most obvious mispricing.
Insurance and pension funds dominate the bond markets and these are subject to regulatory capital rules that require them to hold greater amounts of capital depending on the credit rating of a bond. This all sounds perfectly logical until you consider how it affects pricing and investor behaviour. Investors will prefer the highest returning asset in any rating category and these ratings are obviously imperfect. Hence, many investors are constrained to own only ‘investment grade’ bonds, so will prefer the highest yielding, lowest rated investment grade bonds. At the same time those investors running high yield (non-investment grade) funds will naturally prefer the higher yielding, lower quality bonds in that area as they also are return seeking. This creates a huge demand for BBB rated investment grade bonds but much lower demand for the highest rated non-investment grade bonds (BB). You get an average yield of 3.6% on US BBB bonds but 5.2% on BB bonds, simply because most investors cannot buy high yield.
At another boundary, between equity and fixed income, you get another anomaly. Again, investors tend to be either fixed income investors or equity investors and cannot consider the other asset class. The riskiest bonds issued by banks, known as AT1s, can be forcibly converted into equity in the event the bank has inadequate capital reserves. In practice, this means they suffer the same downside risk as the shareholders in exchange for a yield that in many cases is lower than the equity dividend yield. Admittedly, equity dividends will be cut before a bank falls into the position of failing to meet capital requirements but at the same time, over time dividends can also grow. The anomaly exists because equity investors rarely if ever look at the bond and vice versa, at times the situation has been the reverse.
The obvious example from equity markets is inclusion in indices, when a company’s shares get included in an index it creates a significant amount of new demand for its shares from ETFs, index funds and benchmark constrained active managers and, again, vice versa. Hence, great efforts are made by management to have a company’s shares included in the maximum number of indices and a change in categorisation can have a material impact on valuation. This goes a long way to explain the discount currently applied to smaller companies, which has widened as ever greater amounts of money has tracked indices.
None of this suggests that these, and other, anomalies will not persist for an extended period of time but it does suggest that being careful at the boundaries between asset classes is wise, and looking across those boundaries makes good sense. As multi asset investors we have the opportunity not just to look across the boundaries but either to avoid potential mistakes or achieve higher returns for the same or similar risk.
The value of stock market investments will fluctuate and investors may not get back the original amount invested.
Past performance is not a guide to future performance.
Currency exchange rate fluctuations may, when not hedged, cause the value of your investments to increase or decrease.
Changes in the interest rate will affect the value of, and the interest earned from bonds held within the Portfolio. When interest rates rise, the capital value of the Portfolio is likely to fall and vice versa.