Why anybody thought it was a good idea to repackage subprime securities into AAA bonds is akin to the assumptions regulators and investors make about the “risk-free” status of Western sovereign debt.
Despite Basel III’s insistence that government debt is risk-free, it is not. Events over the past five years should have surely dispelled this notion. This notwithstanding, it is still the most central concept within investment theory – credit risk is priced off this basic premise.
The essential role of a risk-free asset is to provide liquidity, and as the level of credit risk associated with sovereign bonds increases, the negative impact on market liquidity grows. Arguably, it has been central bank policy to collapse the risk-free rate in order to force investors up the risk curve. However, apart from defusing any notion of sovereign debt providing a risk-free rate, it has also had the effect of reducing liquidity across the bond markets.
Indeed, a recent report by the Bank for International Settlements (the central banker’s bank) warned that “market liquidity may increasingly come to depend on the portfolio allocation decisions of only a few large institutions”.
Effectively, there is now simply too much political interference in the sovereign bond markets for them to be the benchmark against which all other risks are measured.
We are living in a strange world in which negative-yielding bonds have been the fastest growing “asset class” in Europe over the past 12 months.
To the best of my knowledge, the world has not suddenly developed a chocolate addiction, yet Nestlé bonds are now yielding less than UK government bonds. It is inconceivable to believe that Nestlé (or any other corporate) is less at risk of default than the UK government, but herein lies the irony of the spread differential – a -phenomenon exacerbated when analysing the UK commercial real estate market.
Investors are being excessively compensated for taking on liquidity risk. To illustrate: for those market participants who own a bond, collect the coupon and hold it to maturity, market volatility is irrelevant; principal and interest are received according to a predetermined schedule. Those who are not investing for the long-term are effectively “speculators” who are betting on the price movement as opposed to the inherent value.
Equally, long-term holders of institutional-quality leases are not affected by market volatility, yet they are compensated by the additional returns generated from the “illiquidity premium”.
Undoubtedly there is merit to the illiquidity or risk premium. However, when rates are so low, UK commercial real estate investors are being very well rewarded for holding that risk.
Currently UK prime property yields a premium of 350bps over 10-year government bonds; in other words, the compensation for an investor purchasing prime UK property as opposed to the gilt is an additional 3.5% annual return. Simply put, this is too high and we expect the prime market to see a continued tightening of yields.
This does not, however, relate to the non-core or secondary market, where the lack of institutional-quality and grade-A covenant leases allows for the comparison with fixed-income investments. Although it is plausible that secondary yields do tighten – as investors continue the search for yield – the risk premium between prime and secondary should theoretically widen. The key challenge for the savvy investor is to create the value-add yield compression by purchasing non-core assets and managing them well to allow a regrading of these assets to a core institutional fixed-income category. This is inherently more risky and investors should be compensated for warehousing that risk.
At its simplest, the risk premium between secondary and prime property should be significantly wider than prime versus government bonds. The risk associated between the two asset classes is more closely aligned at a prime level, and as such the liquidity premium is overcompensating property investors. Conversely, buyers in the secondary category are more than likely being short-changed.
When I was a youngster my dad would repeatedly tell me: “The only way to change the temperature in the room permanently is to reset the thermostat.” The actions of the central banks over the past five years have reset the thermostat. Investors can take note and acclimatise to the new heat, or sweat it out as a young stubborn me would have done.
Michel Heller is a fund manager at Strawberry Star
