Han Dieperink: The risk of bonds

October 17, 2023

^{This column was originally written in Dutch. This is an English translation.}

By Han Dieperink, written in a personal capacity

Risk in the financial world is often defined as volatility.

We can easily measure this volatility by calculating the standard deviation. An advantage of this is that risk in one category is comparable to risk in another category. The problem is that volatility has nothing to do with risk at all. It is a source of return rather than risk. Volatility makes it possible to buy things low and sell high.

The risk mainly lies in things that seem safe, but are not. These are investments that do not volatile. The perceived safety makes it possible to work more and more with foreign capital and if such a category suddenly starts to move, everyting goes south. Then assets have to be sold and the real risk of investing reveals itself, namely permanent loss of purchasing power.

Volatility is not a risk

Volatility is measured by looking back. The further back one can look, the more confidence in the future one can have. Due to the great bull market in bonds since the early 1980s, bonds were labeled as the risk-free alternative to equities. Based on forty years of history, bonds offered more return per unit of risk.

The fact that the interest rate on those bonds was at a historic low could not convince the accountants that the risk of bonds was perhaps greater than everyone expected at the time. Even when there were negative interest rates, there were still plenty of investors operating on the buying side. At that time I spoke to people at pension funds who proudly said that they invested more than 100 million euros in bonds with a negative interest rate. Anyone who pointed out the great risk of bonds was one of the many voices crying in the wilderness.

Value at Risk is not a risk

In line with the standard deviation, the concept of Value at Risk emerged. The special thing is that this concept was one of the causes of the Great Financial Crisis, but nevertheless survived that crisis. All compliments to my former colleague who entered the risk management department from the mailroom in the late 1990s, because when the Value at Risk phenomenon was embraced as a risk concept by the largest asset manager in the Netherlands in the late 1990s, he knew exactly what to do with it.

Value at Risk is a dangerous concept, especially for private investors. Investing simply involves risk and by determining limits in advance based on volatility, a distinction is made between accepted risk and non-accepted risk.

For example, for those who accept 10% Value at Risk, a decline of 9% is no longer a risk. Accepted risk is no risk. A decline of more than 10% does not fit within the accepted risk and calls for action. The only option to reduce the risk is to sell positions. Usually at exactly the wrong time.

Value at Risk is a problem, among other things, because it looks with a one-year horizon, while every serious investor has a much longer investment horizon.

Risk profiles increase the risk

Later, Mifid added fuel to the fire by requiring that a warning message be generated for the investor for every 10% decline, without advising what the investor should do with such a message. What is also less attractive is that Value at Risk was used as a starting point for the widely introduced risk profiles.

The only solution to avoid the sometimes bizarre regulations was to simply no longer offer certain risk profiles. The Very Defensive risk profile thus disappeared from the scene. In retrospect, that was a good thing, because this basically very cautious profile turned out to be the way to cut into purchasing power. After all, not only have interest rates risen, but inflation has also risen sharply. Inflation is still the biggest enemy of every bond investor.

The risk with pension funds

While pension funds have communicated as much as possible about sustainable investing in recent years and as little as possible about non-indexation, pensions had to change course due to the extremely low interest rates. The result is that in the coming years we will be entering a new pension system where it is still unclear in essential aspects how the pot will be distributed.

Unfortunately, my attempt to limit the damage was not successful. It is possible that the system change I proposed is far too major, but an important reason for not reaching the finish line was that I had not assigned a role to the trade unions. The unions no longer have any significant power anywhere, except with the pension funds.

My proposal, in short, meant that pension benefits would no longer be taxed from now on. As a result, a deferred tax liability equal to the national debt would disappear from the pension pot. Without national debt, it would then be possible to 'give' every Dutch person a pension pot of 100,000 euros at birth, with which the government would invest in a much freer and debt-free population, which would also solve many imbalances in the current tax system. It wasn't meant to be.

Risk of bonds greater than shares

As it stands now, this year will be the third year in a row that losses have been incurred on investing in bonds. And I'm still talking about nominal losses, not even about real losses.

All Value at Risk limits have now been exceeded, but there is now a deafening silence regarding warnings from the government or regulators. By emphasizing the high risk of shares, many private investors are investing an above-average amount of money in bonds. While the risk of bonds is even greater than the risk of shares. This is simply evident from the price drops from the top.

This century there have been two major price corrections of 50% each in the stock market, after the dotcom bubble and after the Great Financial Crisis. Long-term bonds are now more than 50% below the top. For the record, that's nominal.

Anyone who looks at American and European bonds over the past ten years will see that these investors have significantly reduced their purchasing power. This period is therefore comparable to other reflation periods. In 1900-1920, American bond investors lost half their purchasing power. After the Second World War until the early 1980s, American and European bond investors lost two-thirds of their purchasing power.

These corrections in the past ensured that debts reached a sustainable level. After all, debt is always expressed as a percentage of income (GDP). The problem this time is that we are not there yet in that regard. Debt levels are high and the nominal growth of the economy must be higher than the nominal interest rate for a long time to achieve this.

So much more financial repression is needed. For bond investors, this means even more risk before there is any return. The big question is whether in the short term the economic cycle prevails over the eventual structural decline of bonds. Due to the increased interest rates, it is quite possible that in a recession next year, a better return can be achieved with bonds than with shares.

More columns by Han Dieperink