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Against a backdrop of economic uncertainty, real estate – when structured correctly – can provide sustainable, risk adjusted returns that act as an inflationary hedge.

What opportunities exist in the living and wider property spaces? How can these strategies achieve place-based impact? And what are the challenges and ways for the LGPS to invest in this asset class?

This roundtable explored where participants are currently with real estate, and found that while there are plenty of opportunities, there are no one-size-fits-all solutions and instead a variety of different paths to success in this ‘massive’ asset class.

Abdul Bashir, senior investment manager, Greater Manchester Pension Fund

Iain Campbell, investment consultant,
Hymans Robertson

Andy Chaytor, desk strategist, global markets, Nomura

Laura Colliss, pensions investment manager, North East Scotland Pension Fund

Huw Davies, investment manager, fixed income, Jupiter Asset Management

Jason Fletcher, advisor, independent

Simon Freedman, managing director,
head of UK sales, global markets, Nomura

Aysha Gilmore, senior reporter, Room151

Sean Johns, pensions investment manager, Cornwall Pension Fund

Rachel Perini, head of UK institutional,
Jupiter Asset Management

Peter Wallach, director of pensions, Merseyside Pension Fund

Jason Fletcher, independent advisor and previously CIO at LGPS pension pool London CIV, kicked off the roundtable by stating that over the past three years, there has been a large demand and appetite for equities within the pension scheme.

Jason Fletcher: The valuation point of 31 March 2022 is critical because that’s the testing date for some pension funds and you will notice that fixed income, especially in government bonds, has fallen quite a long way. But, if they redid the valuation now, I think they would find that there needs to be an awful lot more [of fixed income] put in. In my experience, most of them are underweight and they certainly will be now.

The main risks associated with fixed-income investing are credit and liquidity risk. Now, there are lots of other risks and premiums, but I think keeping within those two is useful.

Following on from Fletcher’s opening remarks, Huw Davies, investment manager, fixed income at Jupiter Asset Management, introduced the manager’s alternative fixed income strategy from a sovereign-based environment. He explained that the idea around the strategy was created from having discussions with the sector.

Huw Davies: Over the last 12 months, the conversations we have been having with fixed-income investors centre around three main concerns: the lack of diversification, rising volatility and liquidity. 

In terms of diversification, I think the market post the global financial crisis got itself into a too-relaxed situation where a negative correlation between equities and fixed income had become seen as a permanent characteristic of financial markets. But if you go further back in time to the 1970s, 80s and 90s, the relationship between equities and fixed income was more random, possibly due to higher levels of inflation.

Now, it depends on your future view of where inflation will be, but if we've entered a much more uncertain period of inflation and interest rates then we must expect that the level of negative correlation is going to be more random. That has been a major concern for investors over the course of the last few years.

In regard to volatility, the big problem over 2022 was not only the breakdown of negative correlation between equities and fixed income but also the significant rise in the volatility of fixed income exposures. So, funds that had traditionally given controlled levels of volatility at 4 to 6%, were now delivering 8,9 or even 10 to 11% over that period and continue to deliver these high levels, which does create a problem.

“Term premium looks like it is reverting to pre-QE levels, so this gives a situation where people can revert to a more natural habitat.”

Andy Chaytor, desk strategist, global markets, Nomura

The other problem is liquidity. [Former prime minister Liz Truss’ mini-budget] last year was a big problem in terms of liquidity. This has caused an increased focus on the liquidity of investment and their ability to raise money in a timely manner.

Again, the post-global financial environment where we had very low interest rates was the perfect environment to take on illiquidity. This is due to it being a much more comfortable environment as it felt like the authorities and the central banks were on your side.

Therefore, all these three concerns are what we’ve been tackling and concentrating on in our own strategy.

Following on from Davies’ remarks, Andy Chaytor, desk strategist, global markets at Nomura, highlighted that an important debate around investment into fixed income is quantitative easing (QE).

Andy Chaytor: Now is a good time to look at fixed income, not because rates have gone from 1 to 5% but that QE has finally stopped.

I have always hated QE and thought that it was a terrible idea, with a few brief exceptions being in 2009 and 2020. Over the last 15 years, QE has distorted premium liquidity and credit premium, which wasn’t an unfortunate side effect, but was the main point.

QE was there for a portfolio balance effect, which Mark Carney [former governor of the Bank of England] was a leader on. The whole idea of QE was to force all the actual real asset owners to accept the same return as they were getting before but with a higher risk, with a panacea of ‘don't worry, we're printing money, so it's fine’.

“Within our fund, we've not increased our allocation to public market bonds, but we've had our asset manager have tactical
decision-making.”

Abdul Bashir, senior investment manager, Greater Manchester Pension Fund

As this process goes on, I think it makes sense that more people should be looking at fixed income, because that is a natural habitat for a lot of people who may have been forced out of it for some years.

Fletcher then diverted the conversation to the LGPS funds in the room, with Abdul Bashir, senior investment manager at the Greater Manchester Pension Fund (GMPF), outlining that the fund’s total bond holdings are 21% including 8.5% in UK and overseas government bonds and around 3% of this in index-linked gilts.

Abdul Bashir: From a GMPF perspective, we've always invested in bonds predominantly for risk mitigation purposes. When there's a downturn in the economy or when equities do poorly, we expect it to be the counterweight and provide some safety.

Two points from this perspective: One is diversification, we've had a period of positive correlation between equities and bonds, which obviously makes the argument that it's not providing much diversification.

Prior to this, we’ve had a downward trend, primarily through QE, which has driven down interest rates and government bond yields to where the lower bounds are. Fixed income can't act as a safe haven asset if there isn't much further for yields to drop.

For a number of years, we as multi-asset investors haven't really been getting the benefits we would have expected from bonds. But, as we get more stable inflation and economic growth, we may get back into a period where there is a negative correlation. We're now in an environment where yields are much higher, and therefore there's more room for them to fall.

But now it is gone and replaced by quantitative tightening (QT), which we should get about a trillion dollars over 2023 and 2024 and then in 2025 that should pick up. It’s still only chipping away at the edges of the astonishing amounts of QE that we have done, but it should start putting things into reverse.

For 15 years asset owners were pushed out of their natural habitat. But term premium looks like it is reverting to pre-QE levels, so this gives a situation where people can revert to a more natural habitat.

“I can see us increasing our allocation to fixed income certainly as a tactical move and it’s likely to be strategic too.”

Peter Wallach, director of pensions, Merseyside Pension Fund

From that safety argument, I think it does make more sense to have fixed-income on the balance sheet.

Aside from that we are getting a return now, so you're not being negatively impacted for holding those bonds. Therefore, it's a better environment and within our fund, we've not increased our allocation to public market bonds, but we've had our asset manager, UBS in this case, have tactical decision-making on that.

Historically, we've held zero weighting in index-linked gilts and very low short-duration gilts so significantly underweight. UBS has started to increase this now towards benchmark and GMPF is also increasing our allocation to private debt.

Jason Fletcher: Do you hedge?

Abdul Bashir: We don’t on the passive side. We do hedge currency within our bond portfolios, but on the active side most of ours are managed, so we leave that to the discretion of the managers.

Peter Wallach, director of pensions at Merseyside Pension Fund (MPF), then added that rather like GMPF, the fund has held liquid fixed-income assets principally for liquidity and diversification purposes. 

Peter Wallach: MPF is one of the most mature LGPS funds and we have a growing requirement for income. On the back of that and with the pick-up in yields, I can see us increasing our allocation to fixed income certainly as a tactical move and it’s likely to be strategic too.

“We've got a collateral pool in our risk management portfolio that we moved to cash a few years ago ahead of the Retail Price Index announcement and we are currently looking at moving this back to gilts.”

Jason Fletcher: On behalf of London CIV, although I no longer work there, we have seen very similar things as between 15 and 30% is very typical for fixed income. The pool has been moving more into private markets and buy and maintain. Typically, they are increasing their fixed income waiting.

Sean Johns, pensions investment manager, Cornwall Pension Fund

Sean Johns, pensions investment manager at Cornwall Pension Fund, outlined that eight years ago the fund got rid of its corporate bond allocation given where yields were to invest in private debt and multi-asset credit.

Sean Johns: After we did our investment strategy review this year, which revealed that we're getting close to being cashflow negative and given where yields are going, we've now made an allocation of about 8% to UK corporate bonds.

We've also got a collateral pool in our risk management portfolio that we moved to cash a few years ago ahead of the Retail Price Index announcement and we are currently looking at moving this back to gilts.

Our current thinking is to invest in liquid, shorter-duration but things are moving around all the time and we shall see where we end up. Equities will always have a place in an open pension fund as a core, low-cost, engine of growth.

Adding to Wallach’s points, Laura Colliss, pensions investment manager at North East Scotland Pension Fund (NESPF), outlined the fund’s allocation to fixed income.

Laura Colliss: We've been a very traditional LGPS fund over the years, with our strategic allocation being an 80/20 split [80% in stocks, with 20% in fixed income]. That has changed over the years, Currently, we have a strategic allocation to bonds of 20 to 22%, but we are currently under this at about 16%.

We have quite a small number of index-linked gilts. However, lately we have been leaning and heading towards buy and maintain credit and private debt. We have been looking to diversify our portfolio of what we weren’t getting from more traditional markets.

“I have seen a change in the conversation around index-linked gilts from funds questioning whether they should get rid of the asset and look for alternatives to funds being okay with holding them.”

Iain Campbell, investment consultant, Hymans Robertson

Huw Davies: I am interested to hear from funds about index-linked gilts; I never thought we would see yields like this again. They seem like a bit of a steal right now to me and a very attractive investment. Is this an active debate which is currently going on?

Abdul Bashir: From GMPF’s perspective, we've had index-linked gilts in the benchmarks, but this isn't a new change from a strategic point of view. But being in cash and then going into index-linked gilts at this stage has been a very good call from the managers.

Also, our liabilities are inflation-linked. There's an argument from a wider risk mitigation point of view for investing in something that's going to move in line with your liabilities. The other side is liquidity, which we have touched on before, if you are now getting 1% real around a 10-year maturity, relative to the recent past that is pretty good.

It’s hard to see if we are in a different regime but as a pension fund, we try and take a step back and think about a longer time horizon. From a strategic point of view now is the right time to at least hold some [bonds] even if you don’t want to explicitly hedge any liabilities.

Agreeing with Bashir’s point on relativity, Iain Campbell, investment consultant at Hymans Robertson, added that in the recent past bonds had a negative real return for a long time, which for an LGPS fund was difficult to accept. However, he highlighted that the recent positive yield has changed the conversation about whether to continue holding the asset.

Iain Campbell: What I have seen is a change in the conversation around index-linked gilts from funds questioning whether they should get rid of the asset and look for alternatives to funds being okay with holding them. However, I still haven’t seen the conversation going to loading up on index-linked gilts.

“That post-global financial crisis period will be looked at as an aberration historically, so we have probably just unwound that period and gone back to where we were in 2006.”

Huw Davies, investment manager, fixed income, Jupiter Asset Management

Huw Davies: Going back to your point about whether we are in a new regime, I personally believe we are, and I agree with Andy’s point. I don’t think QE is as much of a disaster as he thought it was, I think it was a necessary evil given the situation we were in, particularly after the global financial crisis.

But from my perspective, the bar for QE now is veryhigh, you'd have to have another financial crisis for it to be even considered. Therefore, increasingly that post-global financial crisis period will be looked at as an aberration historically, so we have probably just unwound that period and gone back to where we were in 2006.

Jason Fletcher: What is the right yield for a government-backed or index-linked gilt?

Huw Davies: The right yield should reflect the underlying real Gross Domestic Product growth for the economy, but you shouldn’t get any more than that. For instance, if the long-running trend rate of growth is 2%, I can't see how you can get a greater than 2% real yield guaranteed by the government, it should always be lowered.

Andy Chaytor: I think one of the interesting things is comparing that to equities, which is a potential problem for fixed income as equities can generate returns of well above growth in the economy of one country.

I think I would agree with you that a 1% or 2% real yield seems very attractive, but that is on its own. A lot of funds will say that they can get much more in equities, which seem to deliver year on year. Why wouldn’t they just invest in equities?

Abdul Bashir: Considering the bigger picture of the LGPS, funds are now in a much better funding position because yields have gone up so far and discount rates have gone down. This makes an argument for de-risking and locking in some of that gain, which will drive some of the investments into gilts. We’re in the territory of considerable surpluses and if you can lock that in, why wouldn't you do it?

Jason Fletcher: Coming back to the equity argument, from an old-school perspective, what you need is 2% over inflation because that is what wages go up by typically and that is what pension fund liabilities are. I would be over 2% real like a rash, but interestingly we're not quite there in the UK and we probably never will be because maybe too many people think like me.

Andy Chaytor: We're in the process of finding new habitats and that's a long-term process. I also do think there is a real risk to government bonds. The risk is that governments are trying to issue a lot. At some point, we will need to get to a place where the US, the UK and European governments issue a lot less bonds. Beyond that we are seeing some de-risking, there are a lot of people who at the end of the day want to end up with something that looks a lot like a bond.

The 60/40 portfolio is probably not very sensible. As when you're 22 [years old], you definitely don’t want 40% in fixed income, but when you're 80 you don’t want 60% in equity, and it's about that transference.

I think there are those buyers that will come out but that doesn't mean that you can keep up a relentless pace of supply forever. I think we will end up seeing a steeper yield curve and what drives this is your bread and butter of fixed-income investing.

It’s not meant to be inverted; it is inverted when you go from 0 to 5.5% bank rate in a heartbeat. This is fine, but I suspect it will come down to 3 or 4% and stabilise, which will provoke plenty more buyers as it will generate income.

Andy Chaytor, desk strategist, global markets, Nomura

“I think we will end up seeing a steeper yield curve and what drives this is your bread and butter of fixed-income investing.”

Abdul Bashir: That is probably where it is lying, but I think it is too early to tell. From history, people generally get regime shifts wrong and they time it wrong. But my job is not to time anything. It's to take a more pragmatic view and humble view, so we could be wrong, and we could be right.

This is where modelling such as stress testing and scenario analysis comes in as it can help with decision-making for the unknown. You must accept that you may be wrong, so what are the consequences of being wrong? This is what GMPF is trying to do when we think about strategy.

Andy Chaytor: One interesting point is the demand for data over the last six months. I've had dozens of questions from clients, colleagues and ex-colleagues about which bonds they should buy for themselves, and I've had zero in my career before that.

There is something about what people are prepared to do with their own money, which is quite a telling sign around bonds, I think.

Peter Wallach: Following up on Andy’s earlier point, two or three years ago all we heard was that bonds look expensive but there’s huge demand for them and there will always be buyers. However, it seems to me a lot of those buyers have potentially gone away.

As of September 2022, suddenly, a lot of the demand seemed to have disappeared and it hasn’t reappeared. There also seems to be a lot of de-risking going on and maybe that does involve buying bonds. Who are the natural buyers of UK government bonds?

Over the last year, we've seen a lot of reticence from the traditional LDI funds to get back into buying gilts and linkers. The main reasons for that are they’re still grappling with regulation and collateral buffers as some of these schemes were running 10 times leverage, which given the sharpness of the Truss budget is very difficult to deal with.

With the forced fire selling of gilts and linkers that took place, there are a lot of very weary private sector funds out there. But now we are seeing a drift back.

Jason Fletcher: When we've got UK gilts at 5% or 1% real, does anyone need to stretch for yield at that point and why do people go to private credit for an extra percent yield?

Abdul Bashir: Our position is for two reasons: one is mainly for more return, but you could argue that we don’t really need it as much now that we are in surplus territory and the second is diversification. If you're thinking about risk premiums, you want to get diverse sources of return.  Credit risk is just another way to get some return.

Going back to the earlier question of who the buyers are, there is an implication on liquidity. In the gilt market turmoil, if you've got all the same buyers and that segment needs to sell, you've got a problem and we saw this in the banking crisis. Another reason why you would want to hold cooperates as well is to diversify that liquidity risk a little bit.

Andy Chaytor: In regard to the government bond market, we're in the new regime where [moving] 10 basis points a day is normal. That is obviously some kind of impact of volatility, but liquidity is okay. But, even on those days of high movement, people are getting stuff done and there is also a government backstop to the government bond market.

“Over the last year, we've seen a lot of reticence from the traditional LDI funds to get back into buying gilts and linkers.”

Simon Freedman, managing director, head of UK sales, global markets at Nomura

Coming off Chaytor’s points, Simon Freedman, managing director, head of UK sales, global markets at Nomura, jumped into the conversation.

Simon Freedman: Over the last five to ten years, private sector defined benefit (DB) schemes were the big buyers. Liquidity driven investment (LDI) as a concept was sold by consultants and it made a lot of sense when you're a closed fund and you don't have access to central government and you're worried about sponsor or covenant risk. It was obvious for a long time, who that marginal buyer was.

Abdul Bashir, senior investment manager, Greater Manchester Pension Fund

“Corporate bond markets and global markets are linked together, and you do have the duration and the credit spread on top. There’s going to be a high correlation between the two.”

But it's a very small book for us as of our £30bn of assets under management, we have about £1bn in a bespoke strategy and of that less than £100m in LDI type of funds. Even during the crisis, it didn't bother us because we've got plenty of cash.

It had no impact on us from a day-to-day perspective, but we were constantly being asked to give more money over a very short time frame. For those who didn’t have the internal governance, I would hate to see how the corporate DB side handled that and this is why you see a lot of burnt feeling coming across and why people may be hesitant to re-enter the market.

Simon Freedman: On the LDI piece in some ways it's unfortunate because it's been turned into a dirty word. It's now got these connotations that can cause problems and it can force you to liquidate certain asset holdings that you have.

But, I agree with you, it was a combination of the pension funds that were either running too much leverage or those with operational issues to do with governance. For example, we have the UK’s largest pension fund as a key client of ours and they’re open. It’s interesting as over the last five years, they've increased their allocation to fixed income steadily and hired experienced LDI managers to manage and run those fixed income teams. They are not just buying and increasing their allocation to UK linkers they are also buying TIPS (US Treasury bonds).

Jason Fletcher: To put it into perspective, there are 86 different LGPS funds in the UK and Wales and only four of them have LDI, which is a very small part.

Abdul Bashir: I accept this, but it comes down to supply and demand. If everyone's selling something and there isn't the demand on the other side that's just going to drive down markets.

Also, going back to the rapid movement in the gilts market last year, we [GMPF] were okay because we didn't need to sell them, as we didn't really hold that many gilts. But, the private sector DB who did, were required to put up more and more collateral, which is what caused the crisis in that particular instance.

However, I do agree that corporate bond markets and global markets are linked together, and you do have the duration and the credit spread on top. There’s going to be a high correlation between the two.

Jason Fletcher: How much leverage do you have deployed in repo or otherwise?

Abdul Bashir: We have a small amount of LDI where we've got a few bespoke strategies for a few clients. Regarding leverage, we try and go unlevered. Unlevered in the sense that we don’t go multiple leverage.

Jason Fletcher, advisor, independent

“Bonds do look quite interesting at the moment and should make up part of someone’s portfolio.”

From an LGPS perspective, a year ago I was at a conference where quite a few funds stated that they were mis-sold LDI. I haven’t since seen any LGPS funds say that they wanted leveraged LDI.

Huw Davies: In terms of unlevered, given the funding ratio of the LGPS, is there appetite?

Iain Campbell: Ultimately, it comes down to what funding level in the LGPS means. You are expected to have enough money to pay one’s pensions as long as things happen in the future including that you earn a certain rate of return. I think a lot of investors still are of the view that we're investing essentially forever. So why would we be locking into lower yields?

Abdul Bashir: Peter, what are your thoughts on increasing allocation to LDI?

Peter Wallach: We are thinking about LDI very hard. We are one of the most mature LGPS funds, with a huge demand for income as we are paying a lot more out in pensions than we are getting in contributions and investment income. From this perspective, bonds are something that we are thinking about very seriously.

Simon Freedman: That is going back to the question of where the marginal buyer for bonds is. I think in an increasingly less DB and more defined contribution world and with an ageing demographic, bonds as a solution when they are at reasonable rates is part of where the marginal buyer for bonds comes from.

Jason Fletcher: From my perspective, bonds do look quite interesting at the moment and should make up part of someone’s portfolio. Thank you very much to everyone who attended today and thank you Jupiter and Nomura for sponsoring this roundtable.

It’s sad that we weren’t there when the private sector got into trouble and were desperate for liquidity as we have it. Sometimes you can’t get your governance turned around in a day.

Abdul Bashir: That is why we try and outsource our tactical capability as we know we can’t do things in a day. Has anyone seen more LGPS funds doing more LDI and what do you think of this going forward?

Iain Campbell: At Hymans, we've never recommended LGPS clients have a long-term strategic allocation to leveraged LDI.

Mark Nash, Jupiter Asset Management

“Nations are increasingly building capacities within their borders following the supply chain debacle caused due to reliance on China during the pandemic. This should result in more capex and more fiscal spending in the west.”

Higher for longer

The US Federal Reserve (Fed) has said that inflation will come down, though it might take longer, and that unemployment won’t rise that much. They see productivity gains helping to tame higher prices. Still, we think they will need to keep rates higher for longer given the strong growth – and the market needs to accept this.

I fail to see how you can get a recession. Given the stronger balance sheets since the Global Financial Crisis, we see it as harder for something to break and change the macro direction. However, the bond market breaking is a risk given the lack of demand for duration, quantitative tightening, massive fiscal spending, a strong US dollar and higher energy prices. Defaults will happen, zombie companies that overindulged on cheap credit will be taken out by higher rates, and some consumers on variable rate mortgages may suffer, but that will not change the global macro picture. The dollar will stay strong, and US risk assets look good.

In Europe and the UK the situation is more difficult. Demand is being hit from high interest rates and weakness in China, inflation is still far too high, and the employment picture is less robust. It’s something like stagflation. Europe and the UK will be impacted by higher oil prices and a strong dollar. If the Bank of England (BOE) and European Central Bank (ECB) stop hiking, their currencies will fall and make buying energy in dollars even more expensive.

The demand side of the US economy has been very robust. Fiscal spending by the Biden administration is massive and is supportive for growth at a time of low unemployment. This explains why the economy has held firm against higher interest rates.

Consumers have jobs and wage increases, and when inflation moderates, they will have real wage gains, which may provide strength into next year.

We are also seeing a supply side response to all this demand. The labour market is increasing, participation rates are going up, and productivity is coming back. That’s what you need to deal with the surging demand – which includes fiscal programmes like President Biden’s Inflation Reduction Act, higher defence spending and capital expenditure related to geopolitical changes.

Jupiter Asset Management’s Mark Nash discusses the difficult choices facing central banks as inflation lingers and what it might mean for absolute return bond strategies.

Race to the top

In a world where global goods are more expensive, it’s not a race to the bottom with interest rates and currencies – it’s a race to the top. This a new phenomenon. The central banks have a difficult choice now: they can protect their economies and accept higher inflation, or they can try to eradicate inflation and knock their economies down. The Fed is in a better position than the ECB or BOE.

Many investors today haven’t experienced these kinds of markets; they only know low inflation. Investing strategy has to be different now. Managing fixed income assets in an unpredictable macro environment calls for a lot of flexibility. The 60-40 portfolio model (60% equities, 40% fixed income) with long-only equities and bonds, used to be effective. Now it’s about relative value, bottom-up selection for stocks, credit and sovereigns and finding relative value. We see it as a new world and an excellent opportunity for absolute return strategies.

Mark Nash, Jupiter Asset Management

“The central banks have a difficult choice now: they can protect their economies and accept higher inflation, or they can try to eradicate inflation and knock their economies down.”

Geopolitical change

China’s economy hasn’t managed much of a recovery since the Covid lockdowns and there are structural issues at play. China isn’t doing stimulus anymore; it is worried about debt levels and wants better quality growth. China investment supported the world for the previous 20 years but now the geopolitics are changing, and the impact is starting to be seen.

It’s time for everyone to do more for themselves. No more Russian energy for Europe or cheap goods from China. Nations are increasingly building capacities within their borders following the supply chain debacle caused due to reliance on China during the pandemic.

This should result in more capex and more fiscal spending in the west. Europe hasn’t done this very well so far. Eventually, we can get to a place where growth should be better, demand will improve and as long as countries can cope with that higher demand – with more workers and better productivity – all will be well. Inflation will never completely go away, however.

Mark Carney, 2013

“To some extent that is natural when you think about the main channel, in our view, of quantitative easing is through a portfolio balance effect; a shifting of investors from the risk-free asset into assets that start to have a risk.”

Why is now a good time to buy fixed income products? You might think the answer is obvious; because yields are ‘high’. However, I would argue that is the outcome not the reason why now is a good time to buy bonds. The real reason is that quantitative easing (QE) from central banks has finally stopped and indeed has begun to reverse. This is what makes fixed income a more investible product again for those who have the choice.

To recap; in the 12 years between 2009 and 2021, the Bank of England purchased £895bn of bonds. An extraordinarily large sum. And this was just part of the trillions of dollars’ worth that were bought globally by central banks. Initially, QE was meant to be a short, sharp economic shock, designed to push inflation (and thus bond yields) higher. However, as time went on, and with rates at the effective lower bound (ELB), it became the only tool left at central banks’ disposal.

Inflation a bit low? Buy bonds. Growth a bit weak? Buy bonds. Brexit referendum result you don’t like? Buy bonds.

While we can debate QE’s impact on the real economy, there is no denying its efficacy on markets. You see the special thing about bonds is they are two things at the same time:

1) A financial measure of expected short-term yields over time
2) A commodity with set parameters for supply and demand

QE acted on the second facet of bonds to force yields lower, overriding the first facet. What is important to remember here is that this was not an unfortunate side effect of QE but was absolutely baked in as part of the plan.

Nomura’s Andy Chaytor reflects on more than a decade of quantitative easing, the journey it set investors on towards riskier assets, and why now may be the right time to reconsider bonds.

Of course, this forces the yield on IG credit down – perhaps to ‘x’. So those investors who require at least ‘x+1’, who had been the previous owners of IG, are forced further out the spectrum, perhaps to high yield paper. And so the chain goes on and on, with the result that you force every investor in the system to take a higher than previous risk just to get the same return.

Out of this, some sort of growth or inflation benefit is allegedly meant to accrue but that isn’t what we are interested in right now. We are interested in the investors.

Every investment has some term premium (the price of time), some credit premium, and some liquidity premium. Depending on your required returns and risk-tolerance for each of these premia you will pick the asset-class (and part of the asset class) that suits you best. Perhaps very short-dated liquid paper with some credit risk. Perhaps longer-dated paper with minimal credit risk. Whatever it is, you will have a ‘natural habitat’ as an investor.

QE deliberately shifted people out of their natural investing habitats.

Now, QE is over. Rates are rising not just because central banks are hiking rates but also because term premium (and possibly harder to measure liquidity premium and credit premium) are reverting gradually back to pre-QE levels.

Fifteen years is a long time to be moved out of your natural habitat. It may not even feel that natural any more. But now is an excellent time to do a proper assessment of which risks – time, liquidity and credit – you wish to take, and how much you want to be paid for taking them. You might find that there is a new home waiting for you.

The interesting thing about the portfolio balance effect is that it was rarely mentioned in the initial period of QE. It reared its head some years later when QE appeared – at the time – to be morphing from a short, sharp shock to part of the framework of the system, and so some tricky questions are arising about how QE actually works. One of the answers that proponents of QE come up with is the portfolio balance effect.

So, putting aside questions as to whether it is a good idea to manipulate the risk-free rate of an economy for years and years at a time, we do at least know that it was the plan – if not from the start then for a good period. The idea is that investors need a certain return. If you force risk-free yields below that given level of ‘x’ you force those investors to buy riskier instruments. Perhaps investment grade (IG) credit at ‘x+1’.