Looking beyond 'Bondification'

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25 June 2015
Anshuman Jaswal
There has been an interesting article in the Financial Times by John Authers on the 'bondification" of the equity markets, namely the tendency for fund managers to invest in good dividends, low debt and high return on equity. Some of the causes of this phenomenon include the low interest rate regime in many of the mature markets such as the US and the tendency for high risk aversion after the financial crisis. Authers also quotes a move away from traditional finance theory as comparing returns with the risk-free rate does not always work given the issues in defining what a risk-free rate is in the current fixed income market landscape. He also mentions issues fund managers have with risk diversification since it did not seem to work in the financial crisis for commodities or emerging market equities. The author concludes by saying that the bondification of risk might not necessarily be desirable in the long run. I agree broadly with the conclusions of the author but would also like to point out some relevant issues in this context. The first is that the low interest rate environment will not stay forever, hence the market is going to move away from the tendency for bondification and this would benefit both fixed income and equity markets. The fixed income markets would see more activity and the equity markets would be able to get out of the constraints that bondification places on it, including investment into mainly blue chip stocks which would be popular anyway and away from less established or riskier stocks of smaller firms. The second issue is regarding the falling relevance of the investment models, namely the use of the risk-free rate and falling tendency for risk diversification. Just because there was a financial crisis does not mean that financial theory or models become less relevant. The issue was less with the models and more with the practice and issues in the economic, business and political environment. The use of a risk-free rate might still be of relevance, it might just have to be calculated more carefully and using a set of return indicators instead of certain benchmark bonds. Similarly, risk diversification is still as relevant as it was before the crisis. With the lessons from the crisis, our approach can become more sophisticated and complex, but we cannot stop using diversification just because it might have failed in the financial crisis, which was (hopefully) a once in a lifetime phenomenon. It should work as long as there is no crisis of similar proportions.

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