Retirees in Australia need to prepare for rising interest rates. This may be bad news for some, while others will be unaffected.
Warren Buffett once said only when the tide goes out do you discover who’s been swimming naked. In this case I believe we can work out who needs to put on some bathers, so to speak, before that point in time.
Let’s start with rates. The US Federal Reserve lifted its official cash rate by 0.25% in March, an adjustment expected to be repeated each quarter this year.
Other major central banks are likely to follow suit. And while cash rates in Australia appear on hold through 2018, they are likely to increase next year.
It usually follows that bond yields rise, which could impact asset prices and strategies designed to support the achievement of retirement goals.
The impact of rising bond yields on assets
Rising bond yields can impact asset prices in several ways.
First, because companies and real asset vehicles are partly financed by long-term debt, an increase in the cost of debt can reduce the cash flows these investments produce.
Second, the discount rate investors use to value future cash flows tend to rise side-by-side with bond yields. For example, the price of a high-quality bond falls when yields rise, even though all cash flows are fixed. And it explains why the prices of assets with stable and predictable cash flows are sensitive to bond yields.
To be sure, bond yields are only part of the story.
The economic developments that drive interest rates also directly impact corporate cash flows and investor confidence, and hence asset pricing. For instance, robust economic activity may boost share prices as the favourable influence of improved earnings visibility more than offsets the impact of higher yields. It is important to know why bond yields are rising.
What this means for retirees when the tide goes out
While asset prices may come under pressure from rising bond yields, in some circumstances the prospects of achieving retirement goals will be unaffected. It depends on a retiree’s circumstances, their goals, and the design of their investment strategy.
Some retirees have sufficient assets to fund their essential living goals solely from income generated by a tailored investment strategy.
While higher bond yields may be a modest negative for cash flow generated by their portfolio, these retirees have the flexibility to “tighten their belts” and continue to fund their essentials from income without touching their capital.
Critically, their sustainable spending power isn’t negatively impacted by rising discount rates that may depress asset prices. From a “goals” perspective, lower asset prices merely represent an opportunity cost. These retirees are largely insulated from rising discount rates unless that foreshadows a major decline in corporate cash flow.
Who needs to reset
By contrast, retirees whose cash flow goals require the drawdown of capital to supplement investment earnings are vulnerable to falling asset prices. Unless they can materially adjust their lifestyle in the short term, their assets will fall faster than planned, and they risk running out of money early.
An unexpected increase in inflation presents the greatest threat to goal achievement for this group of retirees because it would hurt asset values while simultaneously raising the level of cash flow needed to fund essential spending.
This cohort may benefit from a new pair of bathers. For them, a revised investment approach would incorporate inflation-sensitive assets plus strategies to protect against large declines in asset prices.
The outlook for bond yields
So, what is the likelihood of a sustained rise in bond yields and what might push them up?
The following chart depicts the 10-year bond yield in Australia and the US over the past 150 years. It evidences the challenge of forecasting bond yields.
I think about the problem by treating bond yields as the sum of three parts – inflation expectations, the expectation for the average real (inflation-adjusted) cash rate over the period and a third component known as the “term premium”.
Here are my estimates for these three components for the sustainable yield of 10-year US government bond, the benchmark global risk-free asset. While Australian 10-year yields are lower than those in the US today, they usually trade in step with US rates at modestly high yields.
Inflation expectations for the US over the next ten years are well-anchored around 2.0% - 2.25%. Investors remain confident that the Federal Reserve will hit its inflation target. It would require a major change in mandate for the Fed to disturb these expectations.
Real cash rates expectations for the US over the forthcoming decade aren’t directly observable and are based on models estimating sustainable economic growth. Expectations of 0.25% -1.0% appear reasonable. That is consistent with the Fed’s long-run expectations portrayed in its so-called “dot plots”.
The Term Premium compensates for uncertainty around these first two components and reflects investor appetite for liquidity and safety. This premium has been negative of late due to a shortage of safe assets and fear that inflation would undershoot its target. Looking forward, it is reasonable to expect a term premium of 0.25% - 0.75% as inflation pressures rise, and bond supply grows with larger budget deficits and a wind-down of QE.
So, in aggregate, the sustainable level for the yield on 10-year US bonds appears to be in the range 2.25% - 4.0%. Of course, it is entirely possible for rates to trade outside that range. And if yields trade near the top end of that range it is reasonable to expect the price of many assets to come under pressure. Strategies designed to support achievement of essential spending goals in retirement need to be resilient in this scenario.
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While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.