C&B Notes

“Safe Assets” Are Not What Many Think

I would highlight that equity-market valuations at this point generally are quite high.  Now, they’re not so high when you compare the returns on equities to the returns on safe assets like bonds, which are also very low, but there are potential dangers there.

— Dr. Janet Yellen, Federal Reserve Chairman, May 2015

The quote above is just one example, but many market commentators and strategists will use the shorthand terms “safe assets” and “risk assets” to describe entire groups of financial assets.  This concept is a natural complement to the “risk on/risk off” framework that financial market participants often use when making allocation decisions between greed and fear.  These broad ideas obscure the underlying truth that asset classes are not inherently safe or risky.  Instead, the riskiness of a financial asset should only be defined by the likelihood that an investor (or speculator) can incur a permanent capital loss after inflation by investing in that particular asset.  And this likelihood of permanent loss can only be determined by a sober and well-reasoned assessment of the difference between the price of this asset and its conservatively-calculated intrinsic value.

While Yellen may just be speaking off the cuff, this line of thinking can be dangerous for your wallet.  With a very broad brush, she initially describes bonds as “safe assets” but then goes on to say that potential dangers lurk based on the historically low rates that the Fed has perpetuated.  In other words, bonds cannot really be considered safe because they are priced so dear, as indicated by the near-zero yields that have prevailed since 2008.  At a high enough price-to-value, in fact, no asset can be considered a safe investment.  Chairman Yellen’s comments are perhaps innocuous in this particular case, but the underlying sentiment embodies pernicious finance dogma that risk management is principally a top-down exercise.  When the present unsustainable interest rate environment ends, this approach will place many of the currently labeled “safe assets” at great risk and, by extension, the broader portfolios of which they are a part.