January 4, 2011

Unconventional Substitutes for Fixed-Income Allocations

Paltry yields may call for tactics that look beyond plain vanilla. Here’s how.

Over the last several years the bond market has provided investors with a steady flow of generous returns; however, the spigot is drying up and thirsty investors are being forced to rethink their fixed-income allocations.

From January 2007 through September 2010, the Barclays U.S. Corporate High Yield, U.S. Corporate Investment Grade and U.S. Treasury indexes have experienced annualized returns of 7.8%, 7.4%, and 7.3% respectively, compared to the S&P 500’s annualized return of -3.6% over the same period. 

With GDP growth expected to be negligible for the foreseeable future, and investors clamoring for “safe” investments that provide meaningful yield, advisors need to look past conventional fixed-income products to meet investor needs. As a consultant that meets regularly with wealth managers, this has been a popular topic of discussion.

The bear market of 2008 along with low inflation, weak economic growth, and an aging population hungry for “stable” fixed-income investments has led to massive asset inflows into the fixed-income space.  In fact, according to Morningstar, an estimated $214 billion flowed into U.S.-taxable bond mutual funds between Jan. 1 and Oct. 31, 2010, with an additional $33 billion flowing into U.S. municipal bonds over the same period.  Applying simple supply and demand principles, this increase in demand is certainly a contributing factor to the steady appreciation of bond prices.  The consensus opinion amongst fixed-income managers is that prices are at, or near, a ceiling and that the outsized returns of the past are exactly that, a thing of the past.  Certainly, PIMCO’s launch of an actively-managed equity fund this past April is testament to this shift in sentiment.

Risk Choice: Lower Quality or Longer Duration

The typical high-net-worth bond investor is concerned with some combination of two things: the income “thrown off” from their investments and the stabilization they provide to a portfolio.  In the current low-yield environment, the problem facing investors who rely on income from the bond portion of their portfolio to fund future liabilities becomes the search for additional yield. Many investors have chosen to tackle this problem either by taking on the additional credit risk of lower rated issuances or by stepping out further onto the yield curve.

Bank Loans

If the main concern with longer maturity issues is staying out of the way of a yield curve shift when interests rise—as most analysts predict they will in the intermediate-term future—then a convincing case can be made for the addition of bank loans to a portfolio. Bank loans have floating rates that typically reset every 60 to 90 days and are tied to a major index, such as LIBOR. This floating feature makes bank loans less subject to interest-rate risk.  What’s more is that the S&P 500/Loan Syndications & Trading Association Index has averaged a 465 basis spread over LIBOR since 1999. Of course, the downside to bank loans is the higher credit risk associated with the borrowing companies; however, this is partially offset by their higher position in the capital structure.

Emerging Markets Debt

An allocation to emerging-markets debt is also a compelling option for investors more concerned with the income component of fixed-income investing.  In addition to the J.P. Morgan EMBI Global Index’s average spread of approximately 300 basis points over U.S. treasuries as of the end of September, emerging markets countries/companies are experiencing improved fundamentals and higher forecasted growth rates than their developed counter parts, according to Fidelity Investments’  “What’s Driving Emerging Market Debt,” Nov. 2010. When combined, these factors should help to offset the increased volatility that investors can expect when investing in emerging markets debt; however, there is still the issue of interest-rate risk.

Equity-Like Securities

Another possible alternative for investors seeking income are income-producing equity-like securities, such as convertibles, preferred stocks, MLPs, and REITs. As a whole, these securities currently provide competitive, if not higher, yields to bonds while simultaneously reducing or even eliminating interest-rate risk.  The drawback of such investments is of course the higher, more equity-like volatility that they experience.

Many fixed income investors are more concerned with the stabilization feature that bonds provide for a portfolio. For them, the preservation of capital is the overarching goal and many of them still have the bitter taste of 2008 in their mouths. With a likely interest rate hike looming, these investors are again facing the risk of principal devaluation and are looking for ways to protect their nest egg.

Properly screened and selected hedging strategies can offer these investors fixed-income-like volatility coupled with reduced interest-rate risk. Hedging strategies, once a tool for only institutions and ultra-high-net-worth individuals, are becoming more accessible to retail investors as a number of managers are offering their services through open-end funds. Skilled managers have the ability to pull either the long or short levers in order to hedge out specific risks, provide low correlated returns to bonds and equities, and reduce volatility at both the strategy and total portfolio level. However, this decreased volatility comes with a price as these strategies tend to be more focused on total return rather than income production.

Much like hedging strategies, unconstrained bond funds have more tools (i.e. the ability to short) at their fingertips and have become extremely popular during their very short existence.  These funds hold the promise of fixed income-like volatility while having lower correlations to traditional fixed-income products.  However, there is very little track record available to confirm this assumption.

It is important to note that before choosing one of these more “non-traditional” strategies, advisors should have a clear understanding of the nuances and risks associated with each.  Only by performing thorough due diligence on a strategy can an advisor make an informed decision as to whether the varied risk/reward profile these options offer fit with a client’s investment objectives. Of equal importance is the continual monitoring of these managers to verify that there has been no drift from the manager’s stated objective, process, and philosophy. The time and resources that need to be dedicated to properly reviewing these new strategies is not an insignificant investment for most advisors.

Although we do not advocate a total abandonment of conventional fixed income products, we do believe that the above mentioned options have their advantages and should be implemented in portfolios in accordance with each investor’s unique goals.  By tactfully eliminating certain fixed-income positions and reallocating assets to one or more “non-traditional” strategies, investors can maintain the core function(s) of bonds while enjoying some added benefits.

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