How much risk do you need to take to achieve your return objective – aka what is volatility even?
Our job became quite easy as interest rates fell and approached zero, and if anything, it became even easier at 0% cash rates because of TINA. "There Is No Alternative" was a great time as the only way to generate a return was to take undue risks. The concept of a risk-free return was practically non-existent and you could justify almost anything!
But as rates have gone up, our jobs have become much more difficult as we can finally begin to explore the answers to some very tough questions that everyone has been ignoring.
I ask everyone who reads this - what kind of risks do you need to take to generate a return or a yield to meet your liabilities? And before anyone says "well, I'm just trying to outperform the market", that response simply isn't good enough. We all die one day and we all want to pay for our retirements without eating into capital.
Luckily, we have left the time of ZIRP and investors can finally match liability while meeting risk objectives. Below is a chart from Verdad which is a great example of this and what "risk" you need to take on to generate decent returns above base rates to meet liability requirements. For someone who needs 7% a year to meet their pension payments, in a tax-free environment that can be achieved by holding securities with a "Single-B" credit rating average.
Source: Verdad
How is "risk" even defined appropriately when you are targeting a yield or return? I don't have the answers but some questions to think about:
- Does the variability in capital value matter as long as there is no erosion in capital over the long-run if yield is the only goal?
- Specifically, if you can manage default risk, does credit market volatility even make a difference if there is no/lower risk of a permanent loss of capital?
- If you hold infrastructure assets that have regulatory capture, strong earnings, pricing power and lots of sunk capital, does the value over a short time-frame (less than a year) even matter because really only the cashflows matter?
- If we take the view that cashflows/yields/dividends/earnings are the only thing that matters, then is measuring the "value" of an asset that is used to meet liability requirements at any given time irrelevant?
- So, does this mean the change in value, or how we traditionally measure risk, is completely and utterly irrelevant?
Well maybe not irrelevant; the concept of "value" and "asset valuations" when talking about meeting liability obligations I argue sometimes creates moments of opportunity. Seldomly investors are presented with opportunities like we have experienced recently:
- A 30-year bond trading over 5%
- REITs (representing real assets!) that trade on discounts to their net tangible assets
- Listed fixed income LICs on the ASX trading at wild discounts to their net tangible assets,
- Listed core infrastructure assets (which have a natural put as institutional investors demand these assets).
Base rates are above zero, so why not hold assets where there's no to little volatility on income?