Risk-Free Ride To Retirement

Risky assets like equity and real estate usually outperform fixed income returns. However, that equation may have changed for now

Unlike in most years, giving retirement investment advice in 2016 is easier. In Echelon’s 2015 Retire Rich issue, I said “The opportunity is to stay in cash and not invest, but wait because assets become very cheap, both fixed income and equity, and then when the dust settles, you have an opportunity. It’s not too far away, it’s within the next year or so.” That opportunity is here.

Risk-free, long-dated Treasury bond yields have been rising in recent months. Four and five year bonds have each risen around 190 basis points (1.9%) in the five months to end-May. There are a number of macroeconomic concerns, which led to the yield spike. The main reasons are the high frequency of medium- to long-term local debt issues by the government, outflows in foreign holdings of government securities, the Central Bank’s monetary tightening and overall negative sentiment in the market.

Rates were last raised in 2011/12, when growing consumption fuelled a surge in private sector credit, which also added exchange rate pressure. The Central Bank’s two policy rate hikes in response during the first half of 2012 led to a rise in yields. Yields rose about 4.3% on both the four and five year bonds peaking in September 2012.

Interest rates will – while continuing on short-term up-down cycles – come under pressure for a trend rise in the coming months. This pressure could arise due to high external financing needs and higher inflation, which could see the Central Bank staying on a path of tightening bias. Rather than trying to time the absolute peak of rates, which can be difficult, we feel it’s advisable to invest in long-term fixed income now. Many mid- to long-term government bonds now offer over 12% returns.

Inflation is expected to be higher in 2016 following recent tax hikes and adverse weather. But we don’t expect long-term inflation to rise to worrying levels. Over the next five years, we expect inflation to average 4-5%; this means real returns on fixed income investment would be high. Even if you believe inflation here is underestimated and long-term inflation to be 2% higher than estimates, the real return is still acceptable.

Despite the rupee’s weakness since 2015, over the long term, depreciation against the US dollar is likely to continue at historic averages and is, therefore, quite predictable. The rupee has depreciated 4.2%, 5.4%, 3.5% and 5% on an annually compounded basis (CAGR) over three, five, 10 and 20 year periods, respectively, up to end-2015.

Thus, even for an investor looking in terms of US dollar returns, investing in longterm rupee bonds looks attractive. It is often true that risk-free assets give lower returns than risky ones. However, we now think risk-free assets have a much higher probability of outperforming risky assets such as equity and real estate. Stocks recovered somewhat with news of the IMF facility and signs of foreign inflows in April 2015. However, stock prices (ASI) have been on a declining trend from their August 2015 peak of 7,489 points on the ASI. The equities outlook is dull compared to fixed income, especially because the IMF’s Standby Agreement terms demand a narrower budget deficit. With the deficit expected to be lowered from 6.9% of GDP in 2015 to 5.4% in 2016, and thereafter to 3.5% by 2020, there would have to be greater focus on austerity and taxation, which in turn will negatively impact corporate profits.

While we feel this has already been factored into listed equity markets this year, given that further tax revisions could be made over the next two to three years, the effects on equity would be prolonged. Real estate is an asset class that has continued to capture attention. More condos are being constructed, so there is plenty of future supply. However, given that it is a very opaque market, it is difficult to see if current prices are sustainable. Picking the right real estate asset also makes this a more complicated investment, in addition to being a more illiquid asset. Of course, an investor that is able to pick the right stocks or real estate assets would inevitably be able beat fixed income returns. This, however, requires a high degree of skill and/or choosing the right advisors. Therefore, given current economic conditions and interest rates, we believe the greater opportunity lies in midto long-term government securities.

 

Frontier Research Founder and Chief Executive Amal Sanderatne’s views were captured in this piece written by Frontier Research Product Lead Trisha Peries.