The Fallacy of a Risk-Free Asset

12/16/2012

Andreas Utermann, global chief investment officer of Allianz Global Investors, reflects on the market’s indifference toward the euro-zone debt crisis, an overcrowding in benchmark bonds and why stocks should continue to earn their risk premium.

I am on the final lap of a series of year-end presentations, press conferences and media interviews. I am struck by the apparent complacency of markets with respect to the euro-zone crisis. But even more so when repeatedly questioned about whether I thought that there was a risk of a bond bubble and the apparent end of “the cult of equity.”

We are in a bond-market bubble for benchmark (Bunds, Treasuries, JGBs and Gilts) bonds. With nations’ respective quantitative easing measures in place now for a number of years, and supported by legislation forcing banks, insurance companies and pension funds to shed risk assets in favour of supposedly less risky (domestic) bonds, yield levels have been compressed to below long-term average inflation—and in most cases below actual and expected inflation—along the entirety of the yield curve.

Markets have been told that central bank action to force the remaining market participants into “riskier assets” would continue until such time as a recovery was firmly in place. This means that the normal adjustment of the yield curve to improvements in economic activity will be delayed, leaving central banks “behind the curve” on purpose.

Much is also being made of the supposed death of the cult of equity, which I have previously commented on. Unfortunately, this statement leads most investors to draw the wrong conclusion, namely that it will no longer be attractive to invest in equities in the future or that equities will no longer earn their risk premium. And after nearly 15 years of outsized returns on fixed-income securities and a sideways equity market, this is perhaps natural.

Moreover, I agree that the fixation on capital appreciation at the expense of dividends, the manifest neglect of sustainability issues—maximizing short-term profit at the expense of the long-term sustainability of the business model—are probably best left six feet under. However, as I have argued before, the capitalist free-market system will not survive without risk assets earning their risk premium—and survive it will. All of these factors add to my moderately bullish sentiment for 2013.

I will return to this topic and the attendant risks to the more positive outlook, including the euro zone, in next month’s official 2013 outlook.

The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.

A Word About Risk: Equities have tended to be volatile, and unlike bonds do not offer a fixed rate of return. Bond prices will normally decline as interest rates rise. U.S. Government bonds and Treasury bills are guaranteed by the U.S. Government and, if held to maturity, offer a fixed rate of return and fixed principal value.

The yield curve, a graph that depicts the relationship between bond yields and maturities, is an important tool in fixed-income investing. Investors use the yield curve as a reference point for forecasting interest rates, pricing bonds and creating strategies for boosting total returns. The yield curve has also become a reliable leading indicator of economic activity.

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