Friday, June 26, 2015

What are you going to do with all of those bonds?

The expected real returns for bonds do not look very attractive for the next 10-years.  Long-term bonds are expected to have a real return of zero with double digit volatility. This is just one expectation, but the numbers are not at all odd when you walk through some scenarios. If the current 10-year nominal yield is 3% and we have 1.5% inflation over the next year, the real yield will be 1.5%. If we have any increase in rates, that yield will be chewed up quickly. A 10-year Treasury with a duration of a little less than 9 years will have a negative return for a rise of 35 bps.  The question is why are investors holding any bonds. 

If a pension fund has an expected return for actuarial assumptions of 7.5%, it will have to be a very good investment manager to get a real return better than in the chart or it will be in for a significant surprise.

So what are you going to do with all of those bonds? The pension still needs yield for cash flows. One could say that the hedge fund explosion has been about finding bond substitutes and not about beat the stock market. Hedge funds are supposed to provide the diversification and yield or steady return. Every hedge fund has to be bench-marked against its ability to provide stable return and its degree of diversification. If you cannot do one, you better provide the other.

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