What can investors do when the traditional allocation to fixed income doesn’t work anymore?
That question was discussed by an expert panel presented by the Canadian Association of Alternative Strategies & Assets (CAASA) in Toronto on Wednesday. Panellists included James Price, director of investments and advice at Richardson GMP; Brian D’Costa, founding partner and president at Algonquin Capital; and Kerry Stirton, managing partner at Alignvest Investment Management. Price is also the author of a paper analyzing fixed income alternatives.
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The paper describes the challenge so familiar to advisors: when bonds mature, assets must be re-invested at prevailing low market yields. “Since the purchase yield so closely resembles the ultimate return, this spells trouble,” the paper says.
Further, the classic ways to boost fixed income returns—by increasing duration, taking on more credit risk or decreasing liquidity—can no longer be counted on. For example, the flat yield curve offers no term premium and credit spreads are compressed, Price said.
As a result, many investors are reducing their traditional fixed income allocations as a way to boost returns. Some advisors even question whether investors should use fixed income at all, Price said, and, with yields declining steadily over three decades, that perspective is getting harder to refute.
But advisors who advocate portfolios of 100% equities likely are selective about serving only clients with a similar view, he said, or they manage multi-generational money with a lengthy time horizon.
Moreover, sticking with a traditional 60-40 portfolio makes sense in some instances, panellists agreed, as when liabilities, such as a down payment for a home, must be funded. And in addition to providing returns, the traditional allocation to fixed income helps ensure diversification and non-correlation. After a long equity bull run, investors might have forgotten those benefits, Price said.
Advisors who turn to alternatives must ensure they deliver on those benefits. Price’s paper examines the pros and cons of various options, including preferred shares, hedge funds, private debt funds, mortgage investment corporations and structured notes. Panellists also offered tips when assessing alternatives, as well as how their firms have responded to the fixed income challenge.
D’Costa described how his firm’s debt strategies fund is based on the idea of “robbing banks.” The fund transforms interest rate risk by shorting government bonds in a portfolio of investment grade bonds.
Interest rate changes are responsible for 75% to 85% of the volatility in a fixed income portfolio, D’Costa said. By isolating credit exposure, the fund is subject to default and liquidity risk, instead of interest rate risk. As a result of the strategy, “You’re left with a really low-volatility portfolio that’s paying you really well,” he said.
Stirton described his firm’s fund that consists of 50% alternative strategies with low correlation to other assets. “We are looking for strategies where there’s alpha and/or a premium that works differently than an equity market premium does, if not against it,” he said.
His firm plans to offer a version of the fund with 100% alternatives, because “there will be a big market for fixed income replacement strategies,” Stirton forecasted. The fund will have no equity, little interest rate risk and be “uncorrelated to what most individuals hold,” he said, with potential returns of 5% to 7%.
Panellists also discussed the fast-growing alternative of private debt, whereby investor pools fund loans to businesses or individuals. Understand why the opportunity to lend exists, and look for structural reasons why banks, for example, can’t get in the space, D’Costa said.
Also key is knowing who you’re lending to, what the backing security is, and what the redemption terms are, he said, as well as speaking with the investment team face to face, finding out how they’ll get your money back if the loan is defaulted.
When asked for their interest rate outlooks, D’Costa noted that bond markets are pricing in central bank rate cuts in Canada and the U.S., but he expects monetary policy tightening to continue despite the threat of a trade war, based on central bank commentary and research.
Kerry said that, as asset prices continue to climb, “using long-short strategies that are truly absolute-return-seeking and are taking market risk out of your portfolio is a way not to worry nearly so much about that question.”
Given ongoing low returns in traditional fixed income, the Richardson GMP paper concludes with this tip: honest conversations about the risks being taken in duration, credit and liquidity, as well as how a portfolio will perform in times of stress, are a necessity in this market.
For more details on the benefits and risks of alternative fixed income strategies, read the full Richardson GMP report.