Thus far, 2022 hasn't been kind to investors in the share market. Although it's well established that temperament and patience are equally as important — if not more important — than skill and knowledge to succeed as an investor, no doubt the magnitude of this bear environment has tested the resolve of even some of the more experienced investors.
The question is, should investors sell their shares, what could they do with the proceeds? Where in this environment can they hide?
High Yield Corporate Bonds
Well, there's always corporate bonds. Rather than buying a company's shares (i.e. equity), bonds are a form of debt sold by a business to raise capital. Investors will typically receive fixed interest payments (coupons) in return for effectively providing a loan to a business, but they won't receive any extra income if the company performs well.
Depending on the business, bonds tend to be less risky (but also less rewarding) than shares because, in the event of liquidation, all creditors are repaid before shareholders may see a cent.
But bonds still carry risk. High-yield (HY) bonds, typically offered by companies with lower credit scores, naturally carry greater credit risk than investment-grade (IG) bonds (those offered by businesses with sound credit scores, like the big-four banks). If we were to have a recession, or if economic conditions continue to become more challenging generally, you'd tend to see more corporate defaults.
So whilst high yield corporate bonds sound good in theory, they do carry a higher risk because the underlying companies have poorer credit scores.
Because of that heightened risk, the returns required by investors in high yield bonds increases; that leads to a higher yield and, consequently, a lower bond price — a bad thing for bondholders (bond yields and prices move in opposite directions).
Investment-grade Corporate Bonds
Okay, so maybe you could look at IG bonds instead. The risk is lower (because the underlying businesses have a stronger credit rating) and therefore expected returns (the interest payments for investors) aren't as high. You absolutely could do this, and bonds are a staple in many well-diversified portfolios. Would you want to put all your capital in them, though?
I'm not so sure.
Let's assume for a minute that you focus on the short-dated bonds (say, 12 months or less). If you hold the bond to maturity, you might pocket a couple of coupon payments and get your principal repaid at maturity.
But the yield (your overall return) isn't likely to be very significant; although some would justifiably make the case for capital preservation, particularly in the current environment. The return also might not be enough to exceed inflation. For instance, annual inflation in Australia reached 6.1% in the June quarter, and the Reserve Bank of Australia (RBA) expects inflation could end up at 7.75% this year. Inflation is even higher in countries like the US and UK, so investors are currently finding it difficult to generate real returns (returns above the rate of inflation) from defensive assets.
Investors could instead opt for longer-dated bonds (say, 5-10 years, or more!). These offer the potential for greater returns over time, partly through (typically) higher yields as well as due to shifts in the yield curve (which rises and falls based on expectations of future interest rate movements, amongst other factors). But if rates continue to rise, so too should the yield curve, which could negatively impact the value of your bonds – recalling that bond prices fall when yields rise.
Government Debt
The same goes for government bonds, which carry even less risk than IG bonds. As we know, the lower the risk, the lower return we can expect from our investments.
At the moment, 10-year Australian government bonds can be bought with a yield of 4.0%, meaning a negative real yield today (given that inflation is running hot) and minimal real return potential, assuming inflation returns to the RBA's target range of 2%-3% over time.
Cash
So, rather than bonds, maybe investors should just carry cash. But as the least risky investment class (Australian deposit guarantees exist), we can expect the lowest returns from this asset class.
One positive for cash is that as interest rates rise, the variable rate (or yield) on savings accounts increases. This is in contrast to bond coupons which are typically 'fixed' payments.
Still, yields on cash are unlikely to generate a positive real (i.e. after inflation) rate of return.
Cash, however, does provide some optionality during volatile times, but it loses its usefulness over very long periods of time.
Real Assets
Real Assets (such as commercial property and infrastructure assets) can offer some protection against inflation, as they typically generate strong cash flows with contracted or regulated price increases over time. For instance, a shopping centre landlord may set annual rent increases linked to the consumer price index (CPI), or a regulated toll road operator may have CPI-linked toll escalations.
Listed real assets can also be bought and sold like other companies on the share market, and the market's inherent volatility means these assets can be bought below fair value from time to time.
Like any asset class, though, real asset investments are subject to a range of risks, including economic, liquidity and operational risk. They can also be pet expensive to maintain. Because real assets are typically funded with significant debt, there's also the potential for higher borrowing costs as interest rates rise, as well as declining valuations as asset prices and yields rebase across the economy.
The challenge with investing in real assets at the moment is that they are susceptible to rising interest rates which not only reduce their theoretical valuation but also reduce overall demand as less people can afford the mortgages and loans required to finance the purchase.
The Case For Shares
Overall, when inflation is running high, often the best place for investors (with long-term horizons) to hide is in strong cash flow generating assets with growth potential. As you may have guessed, high-quality operating businesses can exhibit both these characteristics, making listed equities one place for investors to find opportunities to 'hide'.
Of course, shares aren't without risk, either. We've witnessed plenty of businesses suffer from the impacts of inflation and supply chain pressures recently. And again, investors can absolutely make a strong case of 'capital preservation' for some of the above asset classes.
But bear in mind, the share market has already endured heavy falls. To cash out now (if you haven't already) could be to do so at precisely the wrong time. Indeed, just as one investor could argue the case for capital preservation from government debt or holding cash, another investor could argue that those safer asset classes won't be enough to help offset increases in inflation. They could also argue that there are plenty of attractive opportunities presenting themselves on the ASX for those willing to put up with temporary uncertainty.
Compared to other asset classes, the long-term income and capital growth potential of certain equities remains very attractive. With some equity indices materially lower than they were just at the start of the year, there are inflation-beating opportunities that are being thrown out with the rest of the market.
Vanguard's study of asset class returns over 30 years shows that whilst shares are very volatile, they generally provide higher returns over the long-term.
Foolish Bottom Line
It should be noted that we fully endorse investors having a well diversified portfolio.
Not only does that mean investing across different businesses within different industries, and with different risk exposures; it also means maintaining some cash and balancing your exposure across different asset classes (e.g. real estate, fixed income, etc.).
However, the point is that each asset class has its own risks and potential benefits. To withdraw everything from the share market in the face of volatility to put it in bonds, for instance, is still likely to leave you exposed to credit or other risks while potentially limiting your upside. Likewise, to move all your capital into real estate could yield you some real assets, although those real assets may come under pressure from rising interest rates and a cooling economy.
The reality is that, in such an uncertain environment, there is no 'perfect' place to hide. With shares down considerably from their highs, however, we firmly believe there are attractive opportunities presenting themselves. That is, investors have sold out — possibly out of either necessity or panic — of businesses that are worth more than they are currently trading for. It may take some time to get back to what we consider to be more reasonable values, but we firmly believe that will happen.
In that sense, we strongly encourage investors to sit tight. In fact, we'd go a step further and encourage them to buy while prices are down, and potentially put themselves in a position to outpace the rate of inflation over the coming years.
