European Perspectives

The Pharaoh’s Dream

​With the prospect of central banks keeping interest rates lows and purchasing yet more assets, clipping the coupons on higher yielding, riskier assets might pay off for a few more years yet. Equally, the risk to investors who are ill-prepared for a futur

Thanks to central banks’ ultra-loose monetary policies, financial markets have delivered five consecutive years of handsome capital market returns since 2008. Meanwhile, liquidity is likely to remain a feature for at least a couple more years, giving rise to the possibility of seven years of abundant capital market returns.

As central banks around the world slashed policy rates and embarked upon a policy of quantitative easing – purchasing financial assets in response to the crisis – they helped push down long-term interest rates, thereby raising the present value of future cash flows and bestowing capital gains upon their owners. But seven years of plenty may soon be followed by seven years of famine. The story of the Pharaoh’s dream premonition, where he predicted and prepared for seven years of famine, is one that resonates in today’s modern markets. Prudent investors are preparing for the famine now.

Capital gains are a by-product of central banks’ quantitative easing policies. In theory, the extra wealth created via such measures should cushion the deflationary impact of private sector deleveraging, and combined with low interest rates, encourage investment and consumption. Even if you choose to dispute this theory, partly because there is no other counterfactual reference other than the recession of the 1930s, the returns delivered by the bond market remain indisputable. The past five years’ average annual total returns – including capital gains and coupons – on Barclays’ Euro Aggregate index weighed in at 6% per annum, while credit “risk free” assets, as measured by JP Morgan’s German government bond index, returned 7% per annum on average (as at 31 December 2012).

But while multiple years of loose monetary policy may have given rise to abundant capital market returns, they have equally increased the risk to investors who are ill-prepared for a future without quantitative easing and leaner investment returns and continue to venture into riskier, potentially higher yielding assets.

When we discuss capital allocation at PIMCO, we often use the concept of concentric circles. The center is typically reserved for the lowest risk and most liquid asset possible, such as overnight repos using Bunds or Treasuries as collateral with the commensurate lowest yield. The outer circles contain potentially higher yielding, riskier and more illiquid assets;
like junk bonds, distressed loans, growth stocks and, depending on your investment universe, commercial real estate and farmland. The concentric circles framework provides a simple tool for thinking about how to invest in a low yielding world. As yields on assets decline, central banks’ ultra-loose monetary policies are effectively forcing investors further out the concentric circles into lower quality, more illiquid sectors in search of positive yielding assets after deducting inflation. That government bond yields are ultra-low is common knowledge, less well known is the fact that yields on high yield bond indices or emerging market external debt are beginning to enter uncharted waters (Figure 1). This is a wakeup call for some. Today’s low interest rate environment therefore poses a dilemma to investors: In order to achieve 6% to 7% returns in the future, they may be required to take on more risk. While cash equivalents, typically the safest alternative, yield literally nothing.

With the prospect of central banks keeping interest rates low and purchasing yet more assets, clipping the coupons on higher yielding, riskier assets might pay off for a few more years yet. If that comes to pass, investors might then be looking at seven abundant years of capital market returns. Similarly, prudent investors should start thinking about how to prepare for some lean investment years ahead, for ultra-loose monetary policy comes not without risks.

The risk of ultra-loose monetary policy
Lower interest rates are a double-edged sword. While they generate capital gains as yields decline, they also generate capital losses as yields rise. For pension and insurance funds, lower yields raise the present value of future liabilities.

If those liabilities can no longer be met using today’s capital market yields, pension plan beneficiaries could be looking at higher premiums or lower benefits in the future.

Another risk posed by “easy money” is the potential wedge it creates between asset valuations and their fundamental values, setting the stage for a misallocation of capital. When asset valuations are no longer determined by economic growth, employment and company profits, a herd mentality can take over among investors seeking to squeeze out every last drop of yield. This will likely lead to boom and bust cycles. But when central banks eventually remove the liquidity, or when the cost of acquiring productive capacity via mergers and acquisitions exceeds the cost of building investments from scratch, asset valuations can come crashing back down to earth.

In Europe, a third risk – moral hazard – is increasingly prevalent although its emergence owes more to the European Central Bank’s (ECB) concerns about a run on deposits rather than its low interest rate policy. Led by the ECB, Europe’s policy makers have proven reluctant to bail-in investors when recapitalising insolvent banks, although recent events in Cyprus mark a significant break with the past. In case after case they have invariably bailed-in the equity and subordinated debt holders but left senior unsecured creditors whole. Except in the case of Laiki Bank and Bank of Cyprus, today’s de facto policy practice ranks senior debt holders and unguaranteed depositors pari passu with guaranteed depositors. That sends a message to the debt markets: buy senior tranches of solvent institutions experiencing a liquidity shortage because governments, i.e. taxpayers, will bail them out and make good on the obligations. But while today’s bailout practice encourages moral hazard, the European Union’s framework for bank recovery and resolution, developed by Commissioner Michel Barnier and planned for implementation in 2018, envisages bailing-in senior creditors and uninsured depositors after common equity and subordinated bondholders have absorbed losses. Importantly, the events in Cyprus raise the bar for these so-called moral hazard trades. Therefore, post-2018 or sooner as events in Cyprus portend, the risk to returns across the different levels of the capital structure is likely to be better reflected than is the case today.

Prepare for leaner investment returns
With these risks and opportunities in mind, let’s revisit the concentric circles and look at three hypothetical portfolios. Assume there exists portfolio A that is invested predominantly in middle circle asset classes. Let’s assume it is 60% invested in the Barclays Euro Aggregate index, 20% invested in the BofA Merrill Lynch Euro Corporate Investment Grade index and 20% invested in the EuroStoxx 50 index. Based on the return estimates shown in Figure 2, portfolio A would return 3.4%. And using the weighted historical volatilities of the underlying indexes it would have generated 4.4% volatility and a 0.77 Sharpe Ratio. Can we construct another portfolio with the same estimated return while also preparing for a potential famine of returns in the future? For example, if mark-to-market valuations turn negative in the future because central banks withdraw liquidity or if asset prices detach themselves too far from fundamentals before sharply correcting themselves, it would be good to have some liquidity in reserve while still earning yield during the interim.

Portfolio B is one alternative allocation that addresses this issue. It also generates a 3.4% estimated return, but it shifts out of the middle circles, placing part of the allocation into potentially higher yielding, riskier assets while placing another part into cash equivalents for liquidity purposes that can be redeployed to invest in the future should today’s elevated asset prices decline. Portfolio B’s asset class allocation is not as efficient as A’s because it generates more volatility and has a lower Sharpe Ratio. To find the asset allocation that minimises volatility while still generating a 3.4% estimated return, we can use a so-called mean-variance optimiser. A mean-variance optimisation is a statistical exercise based on estimated returns, volatilities and correlations among asset classes. It can be used to solve for the asset allocation that minimises volatility subject to achieving a specific target return. While it assumes a normal distribution, and financial asset returns are rarely distributed normally, it nonetheless provides useful input to the asset allocation discussion. Portfolio C shows the allocation resulting from an unconstrained mean-variance optimisation. Interestingly, it also allocates away from the middle circles into assets with higher return potential as well as into cash equivalents for liquidity. The mean variance optimisation suggests and allocation with a lower volatility and higher Sharpe Ratio relative to portfolios A and B. Based on these two metrics alone, Portfolio C is more efficient than A and B, although this hypothetical example represents a concentrated bet on the eurozone’s recovery.

The point here is not to emphasize Spanish or Italian government bonds. It is about a choice between being fully invested in low yielding asset classes or investing some of a portfolio in higher yielding assets as well as in lower yielding assets that offer greater liquidity. What concerns us about portfolios like A is that they are fully exposed to sectors with low nominal yields and increasingly compressed spreads and they hold little to no liquidity in reserve that could be deployed if better market entry levels arise in the future. Middle circle asset classes contain non-negligible duration and spread risk that will likely deliver negative mark-to-market returns in a rising yield or less benign macroeconomic environment. Allocating part of a portfolio away from middle circle asset classes into assets with higher return potential as well as into assets offering liquidity is the right strategy in our opinion. Yield levels on middle circle assets may no longer protect investors’ purchasing power against inflation. Middle circle asset classes performed well in past years. Harvesting some of those gains is a prudent strategy in our mind. Few investors can afford to go entirely into cash, so if one is going to take on more risk in “outer circle” asset classes, where are the opportunities?

Where to look for opportunities
One place to look is in Southern Europe. While far from being out of the woods, economies in the region are adjusting to the reform efforts of previous years. Italy has returned to a primary surplus on its budget balance. The 5 Star Movement is a new and uncertain force in Italian politics, but it is serious about ridding Italy’s politics of graft. Ireland’s and Spain’s current account balances have moved to surplus and deregulation has increased the flexibility of Spain’s labour market, where dismissal costs are now significantly below those in Germany. Taking the region as a whole, we can observe that the overall level of indebtedness as measured by net financial assets is stabilising (see Figure 3). Net financial assets, the result of subtracting financial assets from liabilities, have stabilised as corporations in the region de-lever while households draw down on their savings, and governments take on more debt owing to automatic fiscal stabilisers and the cost of bank recapitalisations. While investments in the region are a form of moral hazard – because governments have promised to do their fiscal homework and the ECB has promised to buy government bonds of countries that apply to the European Stability Mechanism for help – they are also backed up by fundamental adjustment.

Another area to consider is equities that pay out bond-like dividends and bonds that offer equity-like upside potential. For example, some senior bank debt yielded between 6% and 8% just a few years ago while dividends were slashed close to zero. The tables have now turned with senior bank debt from core eurozone countries yielding about 2% while some banks’ dividends are two to three times higher. Higher capital buffers demanded of banks under Basel III regulation will likely transform this sector into something more akin to utility companies. So long as banks can maintain comfortable net interest margins, their dividends look set to become more bond-like. Similarly, yields on some subordinated bank debt of well-managed institutions offer equity-like, albeit limited, potential returns in a low yielding environment.

Finally, when considering opportunities within the “outer circles”, we think the institutions mentioned previously look attractive. While countries like Germany are eager to implement the Barnier Plan earlier and bail-in senior unsecured debt holders, these institutions might still benefit from a few more years of public sector assistance as they continue to delever. Doing so may require investors to relax guidelines on credit quality for bonds because companies in receipt of state support will often see their credit ratings reduced.

When the Pharaoh, in the book of Genesis, dreamt of “lean cows” and “scorched grain”, financial markets barely existed. Modern day investors might nonetheless draw lessons from the Pharaoh’s tale. His decision to build-up reserves for the famine saved Egypt from hunger. Today, getting out of the middle circle asset classes and reallocating capital into potentially higher yielding sectors and some into cash is one way to be prepared for leaner investment returns ahead.


A “risk free” asset refers to an asset which in theory has a certain future return. U.S. Treasuries are typically perceived to be the “risk free” asset because they are backed by the U.S. government. All investments contain risk and may lose value.

Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks, including market, interest rate, issuer, credit and inflation risk. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.

Hypothetical and simulated examples have many inherent limitations and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated results and the actual results. There are numerous factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. No guarantee is being made that the stated results will be achieved.

Barclays Euro-Aggregate Index in an unmanaged index that tracks fixed-rate, investment-grade Euro-denominated securities. Inclusion is based on the currency of the issue, and not the domicile of the issuer. The principal sectors in the index are Treasury, Corporate, Government-Related and Securitized. Securities in the index are part of the Pan-European Aggregate and the Global Aggregate Indices. The Euro-Aggregate Index was launched on July 1, 1998. | BofA Merrill Lynch Euro Corporate Index tracks the performance of EUR denominated investment grade corporate debt publicly issued in the Eurobond or Euro member domestic markets. The index is made up of securities with investment grade ratings (BBB-, Baa3 or better) that have at least one year remaining term to final maturity, coupon schedule and a minimum outstanding debt of EUR 250 million. | JPMorgan Emerging Markets Bond Index Global is an unmanaged index which tracks the total return of U.S.-dollar-denominated debt instruments issued by emerging market sovereign and quasi-sovereign entities: Brady Bonds, loans, Eurobonds, and local market instruments. | JPM Italian and Spanish government bonds indexes are subcomponents of the JPMorgan Government Bond Index which is an unmanaged market index that currently comprises the local currency, fixed rate coupon issues of 13 markets greater than 1-year in maturity. | BofA Merrill Lynch High Yield Index is an unmanaged index consisting of bonds that are issued in U.S. Domestic markets with at least one year remaining until maturity. All bonds must have a credit rating below investment grade but not in default. | Dow Jones EURO STOXX 50 Index is a capitalization-weighted index of 50 European blue-chip stocks from those countries participating in the EMU. Objective is to provide a blue-chip representation of supersector leaders in the Eurozone. | It is not possible to invest directly in an unmanaged index.

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