Monthly Archives: October 2012

Path dependency and expected return

If one was asked, in the mid 2000s, what the nominal risk-free rate should normally be, he probably had a figure somewhere between 2-4%. That was barely enough to beat inflation. And if one is willing to take a bit of risk by for instance investing in some investment-grade corporate debt, the credit spread will reward him with positive real return. And equity investors would assume they should be rewarded more – say 8-12% – as they are taking even more risks.

However, if you ask investors now what their required returns on asset classes are, it is not surprising that the figures are lower. And we all know what contribute to that: central banks’ zero interest rate policies, high debt and low growth, etc….

Let’s take the time machine and go back further. Say we were standing around Wall Street or the City of London in early 1980s, and did a simple survey by asking the pedestrians the same question: what the risk-free rate should normally be. It shouldn’t have been surprising if the answer came out to be around 10%. Why? Because it was the reality (see the graph below):

Ten percent. That is ten times (or more) the current interest rate and is the level that should require the current investors to take on equity-like risks in order to achieve it. But back in 1980s, people took it for granted to get 10% annual return. And I bet no one at that time would have imagined that the interest rate would drop to less than one tenth of what it was 30 years later.

I am not here to admire the power of central banks, but to illustrate an example of intended/unintended consequences of monetary policy. That should partly root in the fact that people’s expectation about asset returns are not only tied to underlying risks, but also historic paths of realized returns. Path dependency plays an important role.

Again, let’s take 1980s as an example. A few years of above 10% interest rate made people think 10% nominal return was normal for risk-free bonds. As inflation gradually came down, so did the (nominal) interest rate. Lower interest rate (down from 10%+ to a high single digit) means two things: on the one hand, realized return looked really attractive as declining interest rate resulted in capital appreciation on top of the return from the starting yield; on the other hand, the expected return going forward (for the same risk) is lower than the expected return a few years ago and more importantly, is very likely to be lower than the realized return. Such discrepancy between the past and the rationally-expected return has important implications on investor behavior: they yearn for the same level of nominal return so much that they are willing to take on extra risks. Then the history saw the booming of junk bonds in 1980s, a result of investors’ chase of yield as they wanted to be equally compensated as they did before. And of course, some risks later proved to be excessive and overly under-estimated.

Note that such implication is different from what the rational expectation theory implies. The latter would state that, as inflation comes down, people should feel comfortable with the lowered nominal interest rate, as the real return remains constant, and they don’t necessarily go for extra return for the same amount of the extra risks.

The same story took place again in the first few years of early 2000s. Lower nominal interest rate makes bond returned handsomely but expected return going forward was inevitably lower. That pushed people to take on extra risks and – more often than not – excessive risks in assets of alphabets: CDO, ABS, CDO square….

Currently, with zero interest rate policy in place for a few years already, investors feel increasingly lack of risk assets that could generate positive real return. What do they do? Some of them open the map and try to find places that generate higher yield, however “exotic” the places are. Examples? Look at the recently issued dollar sovereign debt by Zambia, Angola and Paraguay. Investors are pleased to be compensated at 6-7% by taking risks in countries some of which are still struggling with weak institutions and unstable political situations. While it is generally beneficial for less-developed countries to raise financing at lower cost, investors may have under-appreciated the risks they have taken. Such phenomenon could be explained by the path-dependency problem of expected return.

I hope the next time when investors open a map and look for “the new world” of investment, it is still the map of Earth, not Mars.

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