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The Fixed Income Conundrum
Genesis Wealth Advisors0 comments Fixed Income, News
Generating Sustainable Income in a Highly Challenging Environment
By David Feldman, President and Co-CIO of Palladiem, LLC and a member of Genesis Wealth Advisors’ investment committee.
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There was a time when fixed income was the sleepy asset class where portfolio managers were put out to pasture. Bond portfolio management was predictable, safe, and boring, while the idea of a ‘rock star’ PM like Bill Gross or Jeff Gundlach would have been viewed as laughable. Times have changed.
Bonds have traditionally been used in portfolios in three (related) ways:
- To hedge equity risk in a total portfolio context,
- To act as the safe-haven capital preserver and liability match, and
- To generate income, often to be withdrawn for expenses of the portfolio owner.
Bonds, and bond funds, have fulfilled these roles admirably over the past 30 years. But now bonds, and bond funds, face significant challenges across all three fronts. Advisors and their clients are squarely facing the biggest challenge since the Great Recession and the deep market correction of 2008 – 2009: generating sufficient, sustainable income in a repressed rate environment.
Most investors have historically relied upon the fixed income portion of their portfolios to provide a smooth ride, but this may well change in the future. The results from the classic approach to using fixed income – buying a ‘core’ fund of intermediate duration comprised of investment grade issuers – will likely be anything but smooth, with higher rates (i.e., price declines) potentially more than offsetting coupon income, heightened duration risk, and higher risks of default, even among high quality issuers such as sovereigns that were once thought essentially ‘risk-free’.
We believe three key factors are significantly influencing credit markets:
- The low absolute level of interest rates at the tail end of a 30 year bull market in bonds,
- Artificial suppression of rates globally due to central bank activity, and
- Massive dollar flows from individual investors out of stocks and into bonds since the ’08 decline.
Each of these elements contributes to the challenges facing advisors and investors. We are likely toward the latter stages of a 30-year bull market in bonds, and may already have seen secular lows in interest rates. The yield on the bellwether 10-year U.S. Treasury, for example, peaked at nearly 14% in 1982, and (potentially) reached its nadir in July of 2012 at 1.39%. (Source: Bloomberg. The rate currently stands at about 2.60%.)
Central bank activity in the U.S., U.K., Euro zone and Japan – setting short-term rates near zero and purchasing enormous amounts of government and agency issued bonds – has had the effect of artificially suppressing intermediate and longer-term Treasury rates and, indirectly, most other rates as well. Any return to a more normal interest rate environment, whatever the cause – tapering of central bank security purchases, stronger growth, or higher inflation – will necessarily involve higher rates and lower bond prices.
In the near term, with rates so low, savers and conservative investors have effectively been penalized, and in some cases compelled to seek higher ‘yields’ by moving into riskier asset classes such as real estate, Master Limited Partnerships (MLPs) and dividend paying equities. The potential for capital losses from rising rates and low coupons, and the addition of new, and perhaps less well understood risks, combine to make income generation and principal growth in real terms, i.e. after inflation, a steep hill to climb.
What’s next for fixed income?
Not for the first time do I regret my missing crystal ball, but with a high degree of confidence we can say that:
- interest rates, broadly speaking, are artificially low, particularly at the shorter end of the curve;
- credit spreads are compressed, suggesting potential overvaluation of spread securities; and,
- developed market governments are generally facing significant long-term fiscal and entitlement funding issues, compounded by demographic and slow economic growth challenges.
These three aspects combine to suggest that rates will rise and/or spreads will widen at some point: a clear negative for bondholders. The options for sovereign bond issuers, such as the United States, are not appealing to either borrowers or lenders. The typical response to massive debt overhang from sovereign issuers like the U.S. Treasury is some combination of default (bad for credit rating and borrowing costs), create or allow high inflation (think of the 1970s in the U.S. – hard on taxpayers, savers and the economy), renege on entitlement commitments (see item 1, plus aggravated seniors who vote in large numbers) and raise taxes (diminished growth).
There are no magic bullets or easy solutions. To earn a positive real return, investors are compelled to take some combination of rate, credit or currency risk. Compounding matters, new and different risks have emerged. Because of the typical index construction methodology predicated on the amount of debt issued, most commonly used bond market benchmarks have significantly increased concentration risks. For example, the Barclays Capital Aggregate Index is currently comprised of 77% US Treasury and Agency issues. Further, because of the prolonged drop in interest rates, benchmark tracking portfolios, such as indexed bond funds and many ETFs, have lengthened durations, i.e., heightened sensitivity to rising rates. Prior rising rate environments have had coupon levels sufficient to offset fairly moderate interim price declines. Current levels make that much more difficult.
What can be done for client portfolios?
Despite the challenging circumstances, advisors and portfolio managers still have a number of options:
- Diversify, but be selective in doing so. Expand the opportunity set from domestic high quality bonds. Widen the geographic horizons surveyed, and the currency and interest rate cycle exposure beyond the U.S.
- Broaden thinking about implementation beyond bond funds and ETFs to consider holding individual issues to maturity if portfolio size permits sufficient diversification, or consider the new generation of ‘bullet’ ETFs, which diversify across issuers but also have the return of principal benefits of a known maturity date.
- Revisit the benefits of a laddered bond portfolio: hold individual issues and bullet ETFs to maturity, and counsel investors to ignore interim price volatility.
- Look to modest allocations to dividend paying equities, especially those with sustained track records of increasing dividends, sound balance sheets, capable management and strong industry positions.
- Keep a close eye on expenses, striving for low cost implementation; in a low yield environment, basis points matter.
- Mitigate taxes by using tax advantaged issuers, and smartly employ the benefits of asset location.
- Consider covered call option writing on those dividend paying equities.
It’s our view that a well-diversified portfolio can be constructed for clients to deal with current market risks and generate reasonable levels of income. The correlation table below (Chart 1) shows the relationships among various less traditional asset classes that we believe can be utilized in today’s environment to construct an attractive, well-diversified income generation portfolio. The tradeoff, of course, is that until we return to a more ordinary interest rate environment, that portfolio will necessarily involve exposure to riskier asset classes including high yield, emerging market corporate and sovereign debt, bank and floating rate loans, and dividend paying equities.
In addition, it’s our belief that the shifting nature of the market landscape requires more than a naïve or static allocation to a variety of strategies. The risk, as shown in Chart 2 is clear: incorporating higher yielding asset classes increases portfolio exposure to greater drawdown. We believe this challenging environment requires ongoing, dynamic risk assessment, recognition of market and risk changes, and timely response via active allocation among those strategies.
Balancing Risk of Capital with Need for Income
We believe an actively managed, multi-strategy, flexible approach to managing fixed income can help improve the durability, sustainability and overall success for investors in a much changed, highly challenging environment.
More specifically, we believe this approach can offer investors:
- Increased income,
- Increased diversification across issuers, currencies and interest rates,
- Access to a broader set of return sources, and a
- Better potential ‘shield’ against rising rates, inflation and benchmark concentration risks.
If all this seems overwhelming, Genesis would be glad to help. Our Sustainable Income strategy has been developed with these challenges in mind, and managed since inception utilizing the principles and approach outlined in this paper.
Please contact Paul Duval (firstname.lastname@example.org, (781) 344-1023, ext. 117) or Ron Aines (email@example.com, (781) 344-1023, ext. 115) to learn more about Genesis, our solutions, and services.
And please visit our website at www.genesisadvisors.com.
Past performance is not a guarantee of future results. All investments are subject to risk, including the loss of principal. This communication does not constitute investment advice and is for informational purposes only, is not intended to meet the objectives or suitability requirements of any specific individual or account, and does not provide a guarantee that the investment objective of any model will be met. The statements contained herein are based upon the opinions of the author and the data available at the time of publication and are subject to change without notice. Neither the information nor any opinions expressed herein should be construed as a solicitation or a recommendation by Palladiem, LLC, Genesis Wealth Advisors, LLC, or any of their affiliates to buy or sell any securities or investments or hire any specific manager.
Palladiem, LLC and Genesis Wealth Advisors, LLC are unaffiliated firms. Both are registered investment advisers under the Investment Advisers Act of 1940