Buh Bye Bonds?
Keith Ambachtsheer has made a living advising pension funds on the best way to meet their obligations to retirees. In 2000, he warned funds to reduce their exposure to stocks, which had reached nose-bleed valuations after a two-decade bull run, and add long-term government bonds. Since then, bond prices have risen about 10 per cent a year on average, while stock markets have treaded water.Got that? Those of you that are lucky enough to be working, put away more and prepare to live on less in retirement. When the new depression hits, hopefully you'll have enough savings to rough it out. The rest of you who won't have enough to retire in dignity can eat cat food.
Today, his advice has flipped around. With the yield from long-dated bonds barely outpacing the inflation rate, the director of the Rotman International Centre for Pension Management says the safer investment for pension funds – and any long-term investor – is blue chip stocks.
“In this environment, it’s plausible that for long-term investors, their safest investment is buying and holding a diversified international portfolio of dividend-paying stocks” – companies such as Nestlé SA, pipeline utilities and Canadian banks, he said. “It takes a while to wrap your head around that.”
Indeed, it does. Trading in dull but dependable government bonds for inherently riskier stocks seems contrary to sound risk management. Yet, Mr. Ambachtsheer has a lot of company. The Caisse de dépôt et placement du Québec and GMO LLC, the Boston asset manager led by famed investor Jeremy Grantham, recently have said they are substantially reducing their holdings of bonds with long maturities.
“I’m pretty sure the odds of making money on bonds over a five-year horizon are zero,” added Leo de Bever, head of Alberta Investment Management Corp., the province’s public investment fund manager. “I agree being in high quality stocks is probably a better alternative to bonds. Five years ago I wouldn’t have said that.”
The shift in attitude among leading investors is an outcome of one of the most significant business stories of 2012 – record low interest rates. Not only did rates hit multidecade lows in Canada, the United States and elsewhere this year, many expect them to stay that way for a long time. Such a shift would reward borrowers at the expense of savers and pose an enormous challenge for pension funds, investors and anyone else attempting to finance a comfortable retirement.
“The one lesson I’ve learned is everyone will say: ‘This can’t last long,’” said Malcolm Hamilton, a long-time adviser to Canadian pension plans, who is retiring as a partner with Mercer LLC this month. But, just as rates were unusually high for roughly 20 years in the 1980s and 1990s, “it may be that rates are low for a long time.”
Four years after the global financial crisis, central banks continue to push down interest rates in the hopes of spurring economic growth. Many observers fear that tepid GDP growth of 2 per cent or less will be the new norm for developed countries, not the 3 per cent-plus that has been the standard for decades.
With declining population growth, rising resource costs, limited productivity gains from a declining manufacturing base and other factors, “you have this basically stuck economy in real terms,” Mr. Ambachtsheer said. “The canary in the coal mine is Japan [which has experienced weak growth for a generation]. This is what things look like down the road for the rest of us.”
While low rates have so far been unable to spark the global economy, Meanwhile, the collateral damage has been considerable. Bargain-basement borrowing rates have spurred Canadians to rack up record levels of debts and removed their incentive to save money.
Low rates have hit pension funds especially hard. As interest rates fall, the amount of money that funds have to put aside to meet their future obligations increases. Even solid investment returns in recent years haven’t been enough to offset the impact of low rates, which have mired many pension funds in deficits, said Jim Leech, president and chief executive of Ontario Teachers’ Pension Plan, consistently one of the country’s top performing pension funds.
The cost of funding a typical pension for a teacher in Ontario has risen to close to $1-million from about $600,000 in the mid 2000s, Mr. Leech said. “[Low interest rates are] penalizing all the savers in our society and rewarding the consumers. It’s putting a whole bunch of the burden on to people like pension plans who don’t have any choice. I’m not saying monetary policy should take an about-face – it’s just the reality of what’s happening.”
To make up for their deficits, pension funds have moved into what used to be called alternative assets, such as real estate and infrastructure, which take them into riskier areas of investing. Some, such as Teachers and the Healthcare of Ontario Pension Plan, have had success by employing a complex derivatives investment strategy. In other cases, governments have bought some time for plan sponsors, allowing them to use IOUs such as letters of credit instead of injecting cash into their pension funds to make up for deficits.
But these strategies will go only so far to help pension funds – and besides, prices for some alternative assets have already crept up to what some fear are unsustainable levels. “To be honest, there isn’t much to invest in, and as a result, pension funds are getting desperate,” Mr. de Bever said.
The dim outlook for investing returns has prompted most companies to move away from defined benefit pension plans, the traditional arrangement that gave retirees the security of knowing how much they will collect in pension benefits down the road. Defined contribution plans, which set out how much an employer will contribute to the pension pot but put the onus for investing the money on the employee, are the new standard.
The minority of working Canadians who still enjoy defined benefit plans will either have to pay more in contributions or see their benefits decline. Ontario teachers – who are engulfed in a labour conflict with the province – have already seen their mandated contributions climb to roughly 12 per cent of their salaries from the old level in the high single digits, or “about the maximum level people [and the government] can afford,” Mr. Leech said. Meanwhile, the fund has clawed back on indexing, so only half of pension payments are guaranteed to rise with inflation, while the other half depends on the fund’s performance.
“Plans aren’t in financial crisis, but these are very, very challenging times,” Mr. Leech said. “We need to address the issues now. The effect of making a small course correction today will be amplified over time.”
It’s a choice Canadians face with their own retirement nest eggs, Mr. Hamilton said. “Defined benefit plans are no different than RSPs. If you constructed your plan on the assumption you’ll earn 8 per cent a year, you have to look around and say: ‘That 8 per cent isn’t there any more.’ You’ll have to construct a plan that works at 4 per cent.”
That means putting away more, or preparing to live on less in retirement. “People don’t want to have to deal with that for obvious reasons, and you might get lucky,” he said. “But you’re taking risks. The adjustments you make later on might be more abrupt and painful than those you make if you get ahead of it now.”
But don't worry, the end isn't here, at least not yet. Now that Congress has managed to avert another fiscal cliffhanger, we can all breathe a collective sigh of relief and focus on the post-fiscal tiff melt-up.
I wrote my outlook for 2013 last week, explaining why those receiving a lump a coal for Christmas were luckier than they think:
As far as sectors, I'm still long US financials, technology and energy but my focus remains on coal, copper and steel ('CCS' sectors). It will be volatile but these sectors have tremendous upside. Here are some companies I track and trade in CCS sectors: Alpha Natural Resources (ANR), Arch Coal (ACI), Cliff Natural Resources (CLF), Peabody Energy (BTU), Freeport-McMoran (FCX), ArcelorMittal (MT), Nucor (NUE), Walter Energy (WLT), Teck Resources (TCK), and US Steel (X). I'm also tracking some specialized metal and rare earth companies like Allegheny Technologies (ATI) and Molycorp (MCP).What about those "blue chip" stocks Keith Ambachtsheer and others are recommending? Proceed cautiously. For example, Canadian banks and pipelines he recommends have had huge run-ups in the last four years. I'm much more bullish on US banks than any Canadian bank because I'm concerned about our vulnerable housing market and think growth prospects are much better down south.
Over the next year, I remain convinced the US recovery will gain further momentum and China's growth will surprise to the upside, which is why my focus is on coal, copper, and steel ('CCS'). The key thing to watch is inflation expectations. If growth surprises to the upside, there will be a backup in bond yields and surge in risk assets. Sectors tied to global growth will do better than others.
But is the bond party really over? With all due respect to Leo de Bever, Michael Sabia and Jeremy Grantham, nobody really knows where long bond yields will be in five or ten years. True, historic low yields make bonds seem like a poor and risky investment but the world is suffering from an employment crisis and it won't take much to spark a new depression. This scenario will be bullish for bonds, bearish for risk assets.
Below, Gary Shilling, a long-time advocate of bonds, says he's not changing his tune as the market heads into the new year. He still favors long bonds, saying he "only buys Treasuries for appreciation." Shilling thinks the deleveraging cycle "probably has another five years to run" and there are real risks to earnings in the new year.
And Bloomberg's Scarlet Fu reports on today's top stories including housing bonds get a boost from investors with a rosy forecast for 2013, Intel delays the announcement of its TV set top box, Manhattan office space jumps to a 19-year high and Medicare cuts for doctors were among the changes averted in the fiscal cliff deal. She speaks on Bloomberg Television's "Bloomberg Surveillance."
Finally, Pimco's Bill Gross, manager of the world’s biggest bond fund, expects stocks and bonds to return less than 5 percent in 2013 as high unemployment persists, he wrote in a Twitter post. Deirdre Bolton reports on today's "Movers & Shakers" on Bloomberg Television's "In The Loop."