Gilts were once perceived as the exemplar of the risk-free asset. But this is no longer the case. These days, is there a risk free asset anywhere in the world?
If we look back, gilts were only ever risk free in a precise sense. They were free
of credit risk. Free of the risk posed by corporate loans and certainly of equities and real estate, that the business cycle would impair the credit quality of the counterparty. Gilts continued to pay coupons and be redeemed at par regardless of what was happening in the economy. So they were a perfect complement to equity and real estate risk in a balanced portfolio designed to accumulate steadily throughout the business cycle. When business was thriving so would equities and real estate but, when business conditions turned and these asset classes faltered, gilts would prosper.
But those were the good old days when business cycle risk was the principal
risk that investors faced. Now, on top of the traditional business cycle has
been superimposed a mega credit cycle, the peak of which we passed in 2008
and which is now slowly, unevenly and painfully unwinding. Gilt investors now need to consider credit risk.
The fact is that UK credit worthiness is now a topic of discussion – as is the credit worthiness of almost every OECD country. So every gilt holder is exposed
to credit risk. This is, in part, because of current absolute levels of public debt but also because, in the event of a renewed downturn in the business cycle, debt levels will increase as borrowing again rises to fund automatic stabilisers (such as welfare payments) and credit worthiness will deteriorate. Gilts no longer act as the perfect hedge to the business cycle.
To make matters worse, gilt holders are not only exposed to credit risk. More perniciously, we have seen the appearance of debasement risk via currency risk or inflation, or both. This is the risk that substantial money printing will undermine the real value of the currency and, in the case of gilts, the real value of coupons and principal. If this happens, either domestic inflation will undermine the value of paper money in relation to real goods and services, or there will be a dramatic fall in the external value of the currency. In either case, debtors will end up paying back less to creditors than they borrowed.
When financial instruments and currency are debased, investors have often turned to real, tangible assets to act as a good store of value. Real assets include prime core real estate, commodities, precious metals and art – and indeed these assets have seen an increase in prices. These assets are, to an extent, hedges against inflation in the way that gilts used to be hedges against a business downturn.
But real assets are not the perfect hedge against all outcomes either. One possible scenario over the coming years is that, in the light of the UK’s fiscal debt problem, we all work harder, for longer, pay more tax and clear our debts on time in a currency that has not been debased. In this world, real assets will shiver in deflationary chill while gilts thrive.
Clearly, there is no longer a single risk free asset for the new world because there is no longer a single risk about which to worry. This brings us to the importance of careful portfolio construction. Portfolios require a mix of different assets to cope with different risks. You need to own a bit of everything at all times. Now is the time for wealth preservation.
We became accustomed, during the great moderation, to long trending cycles and we continue to look for them. Investors try to design portfolios by spotting what the future will be: deflation or inflation, growth or stagnation. But, now more than ever, the future is unknown and unknowable. One of the many consequences of the unwinding of the credit mega cycle is that business cycles are shorter and more volatile than before.
In 2011, we had worries about both inflation and deflation, moments of great optimism and moments of great pessimism. This was true of 2009 and 2010. In this choppy environment, portfolios must reflect the range of risks to which we are all exposed. There is no one risk free asset – but a truly diversified portfolio can go some way to protecting your wealth from the worst of the squalls.
