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Interest Rates, Expected Returns and Portfolio Construction Conundrums

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By the time you read this, another calendar year will have passed, and with it, most likely another year of unmet expectations for rising interest rates. The yield on the five-year Treasury was 1.58% on Dec. 31, 2013, and had moved upward a mere 10 basis points at the time of this writing (Dec. 4, 2014). Further, over the same time period, the yield on 10-year Treasuries actually fell from 2.90% to 2.32%. Many investors believe rates simply can’t keep falling, but a look at Germany, France and Japan would suggest otherwise, as their 10-year bonds are offering yields of 0.75%, 1.01% and 0.41%, respectively, at present. This environment poses a major problem for investors of all types—namely, what to do with fixed income allocations?

To oversimplify (and state the obvious), there are three potential paths from here: flat rates, rising rates or falling rates. In the absence of a high-conviction perspective on which path rates will take, asset allocation and portfolio construction are daunting problems.

What if rates remain relatively flat for the next few years? Over the medium term, say five years or so, the best predictor of bond market returns, as measured by the Barclays Aggregate Bond Index (the “Aggregate”), is the yield at the time of investment, which isn’t surprising given that the duration of the index is about five and a half years. Currently, the yield on the Aggregate is about 2.2%. Further, our estimate of future inflation, which is based on a simple model that combines the inflation forecast from the Philadelphia Fed’s Survey of Professional Forecasters and the implied breakeven rate of inflation between nominal Treasuries and TIPS (adjusted for the liquidity premium), suggests that inflation will run around 2.1% over the next five years. Therefore, even without a much-feared rise in interest rates, the best investors can reasonably hope for their U.S. investment-grade bond holdings over the next five years is a return of very close to zero on a real basis.

Of course, the math will likely be worse if rates rise, although reality might not be as bad as many investors believe. In a rising rate environment, investors can recycle coupons into higher yielding assets, which can offset some of the price declines suffered by existing holdings. Bond managers who we’ve spoken with over the years largely prefer such a scenario to one where their expected return continues to decline with each new bond purchase. Having said that, in a prolonged environment of increasing rates, things do get ugly. Long-term corporate and government bonds experienced four consecutive decades of negative real rates of return beginning in the 1940s. Forty years is an entire investment horizon for the typical investor, who begins saving at age 25 and retires at age 65. While it would seem highly unlikely that history would repeat in such a way, investors at least need to be cognizant of the fact that it isn’t outside the realm of possibility.

And what if rates continue to fall? If that is the case, we will undoubtedly be knee deep in a worsening economic quagmire, and investors could still do well in investment-grade debt for a while longer, as their equities falter.

We suspect that many investors will choose to lose money “comfortably”—that is, accept the dead money proposition of investment-grade debt over the next five years or so. Most retail investors don’t have the luxury of waiting to earn the “average” returns offered by the long term, though. With only a few decades to save for retirement, a prolonged period of low real returns can be detrimental. Investors need to improve upon the return potential of an investment-grade debt portfolio without taking on too much equity risk. The only way to do that is to diversify more broadly, by including truly alternative return streams within their otherwise traditional portfolios.

With the proliferation of liquid alternatives, investors have more tools at their disposal to solve the complex problem of a low-return environment. While throwing money at all things “alternative” is clearly not the answer, and selecting the right strategies and managers is admittedly not an easy task, investors who would prefer not to lose money “comfortably” need to make an effort to understand and incorporate liquid alternatives into their portfolios.