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Fixed Income Products in a Zero-Rate Market

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What You Need to Know

  • Rates are... what they are.
  • The author acknowledges that diversification works for stocks.
  • The author thinks there's a need for a more active approach for a client's fixed income assets.

It’s a relatively new thing in America that a large contingent of people publicly distrust those who create wealth. Yet, what started with Occupy Wall Street has culminated in a pitched battle where Wall Street, represented by hedge funds shorting GameStop, was roundly defeated by Main Street, represented by day traders taking the long position. These two watershed moments illustrate everything that is wrong in the investment world today: that two groups sharing the same interest, namely increasing their wealth, are doing battle with each other.

In an ideal world, Wall Street should win when the everyday investor wins. But too frequently, the everyday investor is a pawn in a much bigger game that only kingpins get to win. Therein lies the source of growing resentment, a belief that when Wall Street wins, Main Street loses. The little guy — often the middle-class worker — gets shorted. So, it’s unsurprising that regular people have lost their faith in the American wealth creation machine.

Where Are We?

For those who do participate in the market, the old idea of “slow and steady wins the race” has clearly flown out the window. Instead, in the age of the internet and especially social media, investors have been conditioned to expect unicorns — those magicked-up, largely tech-based companies that turn into billion-dollar babies overnight. Or, as in the case of GameStop, the sense that we can create them. This is largely where the stock market has resided in the public imagination: possibly a bit less risky than betting on horses, but the stakes are much higher.

How are workers supposed to plan — or save — for retirement, with that slow and steady maxim being ripped out from under their retirement funds, too? Only 55% of Americans own stock, and of those, 52% are in retirement funds; just 14% are individual stockholders. This also speaks to the growing distrust in the system, especially when contrasted with historical figures. In 2002, 67% of Americans owned stocks; already by 2007 this had dropped to 65%; then the 2008 crash brought savers, especially those near retirement, to their knees.

That middle class — with lifetime jobs, reliable pensions, and happy retirements — has been gutted. Now they’re on a downhill path, completely out of faith and quickly running out of options.

Of course, there are options to transfer risk, such as insurance. Vehicles like annuities likely have an appropriate time and place for inclusion in certain client portfolios. Clients typically count on a trusted advisor to choose which solutions in their toolbox are appropriate based on the client’s customized needs. In today’s zero interest rate environment, where traditional fixed income funds are struggling to keep up with real inflation and income needs, advisors are increasingly looking at insured solutions like fixed indexed annuities as a fixed income alternative.

However, there are drawbacks to transfer of risk arrangements. One potential drawback that’s consistent across insured alternatives to pure market solutions is that they are not daily liquid.

Here I want to make the case that fixed income investments may once again merit attention as a way to rebuild the American dreams.

How Did We Get Here?

Rate policy has caused all investors, especially conservative ones, to consider riskier assets in a search for high returns. In practice, money managers and investors have largely deleted the 30/70 stock-to-bond portfolio in favor of the 50/50 or 60/40 portfolio acting as the “New Conservative” approach. Our belief in the markets long-term has pushed us to solve for longevity risk in lieu of sequence-of-return risk. Look no further than the most utilized target date funds in American’s 401(k)’s to see that those that are near-dated (2020, 2025) are mostly 50/50 or 60/40 stock-to-bond portfolios. And what they make up in bonds often comprises holdings that are subject to fixed income risks, which we will address shortly.

In the absence of a better tool to address today’s and tomorrow’s markets, who can blame these managers for this drift toward risk? Given the choice between a mix of stocks and bonds only, those allocations seem prudent. But remember, we’re dealing with regular people and their hard-earned money. To accept risk is to accept volatility — and volatility challenges the emotions of even the most sophisticated investors.

To illustrate, let’s take what happened in March with the onset of COVID-19. We witnessed one of the sharpest declines the market has seen recently, with the S&P going down 33% in one week. Now that things appear to be getting better in the market, we can talk about it with apparent confidence, but if you take yourself back to that time, the world looked bleak.

Even investors who thought they were being conservative by holding to the classically designed model of a 60-40 stock-to-bond portfolio didn’t necessarily respond well to a medium degree of risk; their accounts took a sharp downturn.

And while there were many predictions about what might happen to the market after the COVID crisis — a W-shaped recovery curve, a banana-shaped curve, does it happen in 6 months or years? All over the board — it ended up being a V-shaped, short-term recovery, with new highs. And that outcome naturally played into American investors’ recency bias, which goes something like: ‘We don’t have to worry about things like the COVID downturn anymore, because look how the market came back.’ However, that’s not what the average American saver, especially one nearing retirement, was thinking last March.

Where are We Going?

Common wisdom among financial managers is that the market rewards people who stay in — but with the volatility and, let’s be honest, crashes we’ve experienced in 2008 and again at the beginning of the coronavirus pandemic, it may be time for a rewiring of our expectations. The persistent low interest rate environment has made traditional saving a no-win proposition, factoring in inflation and changing needs over a lifetime.

In the 1950s, when efficient frontiers were conceived, a high-yield savings account yielded on the order of 5% to 10%; this type of investment made sense over the long term. Over the last 30 years, aggregate bonds performed relatively well. However, post 2008, interest rates declined sharply due to quantitative easing measures. As rates declined, bond investors enjoyed a general price appreciation, potentially not fully understanding the inverse relationship between fixed income yield and price.

Assessing where global interest rates are today, one begins to understand why we have concerns about some fixed income solutions ahead. Consider the most obvious potential scenarios in fixed income:

1. Rates could remain near zero. There are many factors incentivizing the Fed and other sovereign banks to keep interest rates where they are. Conservative savers continue to get pushed into riskier asset classes — namely equities — and are subject to volatility and sequence of return risk.

2. Rates could go even lower. This scenario presents other problems that would require a separate article to address, but our view is, we don’t want negative interest rates. Other themes remain consistent – savers are forced into riskier assets and risk of disappointment along the way remains high.

3. Rates could increase. The question of by how much, and how quickly, becomes an important factor in predicting consequences of a rate increase. However, if we examine the basic relationship between interest rates and fixed income again, we believe it is prudent to predict that a rate increase would lead to a decrease in bond prices/values (the opposite effect of the prior 30 years in fixed income).

So where do these scenarios leave conservative investors who have traditionally sought fixed income to anchor their portfolios? In every scenario above, the traditional fixed income investor is forced to contemplate one of two options for their hard-earned money. They can commit to zero risk investing, escaping volatility but risking portfolio longevity (the chance of outliving their money) and relinquishing the chance for growth. Or they can increase their risk to make up for rate changes — with those same riskier investments that left many in dire straits in 2008.

Is There a Way Forward With a Longer View?

What if there were a better way? That question fueled us to dive deeper to find answers better suited to our times.

During the same COVID downturn of 2020, just three weeks after launching our new strategy, our flagship fund was down only 6.24%. Compare that to other conservative funds that were down 14% to 15% and the S&P 500, which was down 33%. Our strategy then participated in some of the equity market gains that followed, finishing our one-year anniversary up 10.3% (as of January 28, 2020).

Simply put, we threw out some of the old rules that seemed to us not to be working anymore. Chief among them was seeking to improve on classic stocks-and-bonds portfolio construction. We dared to think that it’s possible to develop an investor experience superior to the “diversify and pray” approach that is largely taken today, in order to improve not only investors’ experience, but their results.

The payback would be in seeking better risk-adjusted performance, allowing for more confidence along the way — a smoother ride that would address sequence of return risk and longevity risk in this new zero interest rate regime.

We took an approach that embraced active fixed income management, passive equity exposure and a new risk management model that would be guided by a quantitative framework. The goals: equip financial professionals and investors with a better tool, designed to meet the new challenges introduced by today’s zero interest rate policy world. This new tool should provide meaningful downside protection when equity markets crash and a reasonable capture of upside participation in equity markets when times are good. In so doing, we sought to solve for sequence-of-return risk for those nearing and entering retirement while providing the opportunity for upside potential that many traditional conservative investments are challenged to provide in today’s low-rate environment, thereby attempting to simultaneously solve for longevity risk as well.

At root, investing in the market is like playing musical chairs. You want to have a chair when the music stops. History seems to point to the market going higher over time, so we favor a passive approach to equity market exposure provided by an options overlay. On the other side of the equation, we favor a strong base of active fixed income management. Not knowing what makes the market go higher or lower, we need to be hyper-focused on protecting these less risky assets. We find fixed income vehicles more transparent, their rules clearer — after all, a bond is a contractual instrument. And we’ve just experienced a lot of reasons why not to own an index or a basket of debt.

The current approach to portfolio management is ripe for an update. Not only do we need to flip traditional models on their head, we must also challenge the old language of “hang in there, it always comes back.” We can’t ask people to regain their trust in the market without striving to equip them with a better approach. After all, what is our job as professional asset managers if not to make saver’s goals more attainable? The zero interest policy world makes the job of the saver harder and the finish-line a moving target. A new balance of fixed income and the risk mitigation side of the portfolio is clearly needed, especially to achieve a truly conservative tilt in glidepaths to and through retirement.

After a year like 2020, we are all humbly reminded that change is a consistent theme of life. A line was crossed when the world doubled down on zero-interest rate policies. As a result, now is the time for a change to the conservative side of portfolio construction. Fixed income is ripe for a rethink. Let’s venture to give the American saver its conservative portfolio back.


Pen (Image: iStock)John Ruth is co-founder and chief executive officer of Build Asset Management, a registered investment adviser in Jefferson City, Missouri.

 

 

 

(Image: Shutterstock)

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