Why Not Alternative Fixed Income Investments?
Traditionally, advisors have used bonds as a primary building block of client investment portfolios. The process generally works like this: First, evaluate a client’s goals and risk tolerance; second, select a portfolio along the efficient frontier that is projected to deliver the required returns with the least amount of risk; third, select the actual investments that will act as proxies for the asset classes.
Advisors must construct portfolios that balance risk with returns. This is usually done by blending higher volatility, higher return assets like equities with lower return, lower volatility assets, such as bonds and cash. Historically, over long periods of time, cash maintains its purchasing power, but it offers little absolute return before taxes over inflation. Long term and intermediate government bonds have historically produced about a 1.5% positive return over inflation, but intermediates have done so with significantly less volatility. Under normal conditions, this would indicate that advisors should dampen portfolio volatility by reducing equity exposure and increasing intermediate bond exposure.
Times, however, are not always normal. In a period of rising interest rates, even supposedly “safe” intermediate bonds can generate negative returns and especially returns lower than inflation. In fact, if you wanted to look at a really long period of time, the 1937 to 1981 time period provides an excellent example of what can happen to intermediate government bonds’ (five year maturities) total return during a period of rising interest rates and inflation. During this time period of somewhat moderate inflation, intermediates returned 3.6%, while inflation was 4.3% - a loss to inflation of 0.7% for 45 years. Even in low inflationary periods such as the 1946 to 1965 period when inflation was 2.8%, yields on intermediate government bonds during that period rose from 1.03% to 4.90%, resulting in a total 2.2% compound return. As a result, these bonds lost 0.6% per year for 20 years to inflation. If that period is too long for you, from the beginning of 1955 through the end of 1959 (a period where intermediate governments produced negative total returns four out of five years), inflation was only 1.90%, while intermediate governments returned just 1.00%. Yields on intermediate governments rose from 2.80% to 4.98% during that time period. Today’s interest rates could increase that much in a similar period of time. Speaking of negative total returns, as recently as 1994, intermediate governments had a negative total return of 5.1%. In 1999 the loss was 1.8%.
Clearly, buying and holding intermediate term bonds is not an all-weather low risk strategy. Long-term bonds (20 year maturities) in a rising interest rate environment naturally produce even worse results than those of intermediate return bonds. During the 1937 to 1981 period, long-term governments produced total return losses in 15 of the 45 years. With the recent onset of interest rate increases and a probable period of at least a few years of extended rate increases (assuming we don’t sink back into a recession any time soon), the use of alternative fixed income investments will be necessary to derive higher fixed income total returns than what intermediate bonds will provide in future years and avoid many potential short-term losses even if interest rates should rapidly increase within a short timeframe.
We define a fixed income alternative investment as a fixed income investment that does not react inversely to interest rate movements as traditional intermediate and long-term bonds do. Alternative fixed income investments fall into two broad categories: investment vehicles that by their very nature are not highly correlated to “traditional” fixed income and take advantage of higher interest rates, and those that rely upon the manager’s skill to avoid the negative consequences of a rising interest rate environment.
Mutual funds that fall into the first camp include those that invest in bank loans and adjustable rate mortgages. Another type of mutual fund that has made a great deal of sense in a rising interest rate environment is a stable value fund. However, as this article is being written, the SEC is questioning the “stable part of these funds.” Funds that fall into the second camp include those that are geared toward absolute returns in any market environment, which are dependent upon managerial skill, such as fixed income arbitrage. TIPS, which might not fall into either category, are another possible option. TIPS, if interest rates rise steeply, can actually lose money, if they are not held to maturity. Also the government’s calculation of CPI understates inflation, which therefore curtails what should be their true return.
Bank loan funds (we like the quarterly redemption interval funds not the daily valuation types. On daily valuation types, yields are significantly less due to increased cash balances and/or the use of junk bonds to provide liquidity) hold short to medium term loans made by banks to non-investment grade borrowers. While the credit quality of the borrowers is lower, the debt is generally senior and secured against specific assets. This means that should a borrower run into financial difficulties, the loan holders would be the first lenders to be paid. The base rate is usually based upon LIBOR - London Interbank Offer Rate – or possibly even prime rate. Borrowers generally pay a few points above the base rate. The rates are reset at intervals, generally every 60 to 90 days, so there is very little interest rate risk to the lender. In essence, the lender is trading interest rate risk for credit risk. Columbia (XLFZX), now managed by Highland Capital Management, and Eaton Vance (EIFZX) (institutional versions) are the ones we prefer. Current yields are approximately 5.5%.
Historically, adjustable rate mortgage mutual funds have held up very well in a rising interest rate environment. These funds tend to react a little more slowly to interest rate moves, however. That is because interest rates reset at intervals. Some adjustable loans reset monthly, while others only reset annually. Funds however, often hold some hybrid loans which typically offer a fixed rate for a period of time, and float thereafter. In addition, some loans have a maximum interest rate cap. Historically, especially in recent years, these funds have provided much lower returns than Bank Loan funds. We have not researched this area in-depth as of late, but plan on doing so in coming months.
Stable value funds are really nothing more than higher quality intermediate bond funds that have sold off their appreciation and depreciation to banks and insurance companies. This is usually done in the form of a wrapper agreement. These banks and insurance companies accept the risk, primarily due to interest rate movements, for a premium leaving the stable value fund with a yield better than CDs. The yield will increase as interest rates increase but more gradually. Stable value funds do have a problem, though. That is finding banks and insurance companies that will accept interest rate risk in a market where interest rates are rising. The best-performing fund in this group, Scudder Preservation Plus Income – Institutional (DBPIX), has been closed off and on for the past few years because they could not find banks and insurance companies willing to take on this risk.
When examining funds that are reliant upon the skills of a manager, the decision to buy or not to buy is more heavily weighted to the qualitative as opposed to the quantitative. For example, a fund we think highly of is the Metropolitan Strategic Income Fund (MWSTX). Their fund seeks to deliver consistent positive returns that are non-correlated to negative market cycles. In effect, they are a bond arbitrage fund. As a side note, the portfolio management team are disciples of the PIMCO Fixed Income team and were directors of Hotchis & Wiley prior to starting Metropolitan West. In order to achieve this objective, the fund will invest independent of any benchmark or index constraints that would limit the diversity and freedom of the fund. This includes having a stable duration strategy, utilizing esoteric, complicated financial instruments, focusing on market inefficiencies and focusing on high coupon yields on a relative basis. We believe that interest rates are poised to rise. We also believe that allocating a portion of the fixed income portfolio to astute managers who possess the flexibility to hedge interest rate exposure and/or seek out overlooked opportunities is preferable to investing in traditional fixed income instruments.
The most common form of TIPS are US Government notes that periodically adjust principal and interest payments to reflect inflation (as measured by CPI). Inflation adjustments are reflected in interest payments, but the principal adjustments, while recorded semi-annually, are not paid to investors until maturity. Furthermore, since interest rates can move up more rapidly than inflation does, especially in the short term, there could be a drag on performance. TIPS can preserve purchasing power, but the real return they offer is over and above their inflation adjustment (assuming the government calculates inflation accurately) and is approximately 1.8% at this time for ten-year TIPS and 2.1% for 20-year TIPS which is good on a historical basis.
We are undoubtedly facing a challenging fixed income environment in the coming months and probably years ahead. Non-traditional fixed income vehicles offer some intriguing alternatives and opportunity that advisors should investigate.
For further information, contact Louis P. Stanasolovich, CFP ä at (412) 635-9210 or e-mail him at firstname.lastname@example.org