Navigating the fixed-income market: The calm before the storm
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July 21, 2014 01:00 AM

Navigating the fixed-income market: The calm before the storm

Timothy Ng, Clearbrook Global Advisors
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    Robert Salmon via Wikicommons

    There are no safe harbors at present in fixed-income investing.

    As we know, the fixed-income sector has enjoyed a bull market rally over the past 30 years plus, with interest rates declining from the midteens in the late 1970s and reaching their nadir of low single digits in the spring of 2013. This inexorable decline in interest rates and increase in bond prices, with a few exceptions as seen in 1994, has protected investors against interest rate and duration risk. It is inevitable that this long-term trend of lower rates and higher bond prices will reverse, as we will see rates rise from their still historical lows. Staying with the status quo will not help to mitigate the potentially substantial losses investors can suffer in the impending rising interest rate environment.

    With a number of fixed-income asset classes at fair value or overvalued, there is little room for error in asset allocation. Investors — particularly institutions — are faced with a decreasing number of fixed-income investment options that are available to help solve the need for yield and return. For underfunded pension plans faced with liabilities that are continuing to rise unabatedly, the current pricing and yield environment poses a particularly vexing problem.

    The implication of rising rates for fixed-income investors could be devastating as they will be confronted with either diminishing returns with small losses or significant losses — depending on the magnitude and velocity of the rate rise. With these risks of loss in the back of our minds, there are two scenarios for the inevitable rise in rates — the process might be slow and protracted, or we might see a scenario where rates spike dramatically, as in 1994.

    To mitigate these potential risks, investors will need to consider investment solutions that employ both traditional and alternative investments in order to achieve higher yields, with lower correlation and downside risk associated with core fixed income.

    So what is a solution? Hedge interest rate and duration risk particularly in an investment cycle where the downside clearly outweighs the upside in the fixed-income sector.

    Investments with higher coupon levels, adjustable-rate coupons and above average current yields can insulate investors from principal loss as the higher yields will absorb the initial negative impact of a rate rise. For example, private debt structures such as bank debt, direct lending and real estate are protected against an interest rate spike as their coupon levels are typically readjusted with a rise in short-term rates such as the London interbank offered rate. In addition, private debt structures are not subject to mark to market risk such as bonds, but their values can be diminished because of a payment default or decline in the value of the underlying collateral.

    Investors over the next several years will need to seriously consider alternatives to traditional fixed income or a combination thereof, in order to increase their ability to achieve the returns they have historically enjoyed from traditional fixed-income investments.

    In order to protect fixed-income investment principal as well as try to achieve a positive return, there needs to be a series of trade-offs that sponsors and investors will need to make. These trade-offs include credit (high yield, bank debt and trust preferred securities) and/or liquidity risk (direct lending and/or sovereign risk in the case of global/emerging markets debt) vs. interest rate and duration risk.

    Money managers and their clients need to take an entire portfolio asset allocation approach, in order to determine the appropriate percentage allocation per asset class, strategy and investment manager. These decisions must be made in relationship to the risk/return/liquidity inherent to each investor's existing equity, traditional fixed-income and alternative investments.

    Allocators should advise their clients that it is necessary to be agnostic to vehicle type, whether separate account, commingled fund, private fund or publicly traded to get the specific exposures that provide the best risk/return. In the end, the combined approach of traditional and alternative fixed-income investments will better reduce the interest rate and duration risk that is prevalent today in investor portfolios.

    In conclusion, investors will need to consider alternatives as a necessary complement to traditional (“core”) fixed income, in order to achieve the returns from these investments they have historically enjoyed and planned for.

    In addition to considering the investments already mentioned, investors in recent years have increasingly looked to build customized portfolios of hedge funds, structured to generate rates of return similar to fixed-income investments, while mitigating downside/interest rate/duration risks. These fixed-income “surrogates” are particularly attractive in a rising rate environment, as they can be structured to provide downside protection as well as benefit from rising rates. For these investments, rising rates will be additive rather than detract from returns.

    In the end, a combination of traditional and alternative fixed-income investments will best serve investors to reduce the interest rate and duration risk that is prevalent today in their portfolios, and increase the probability of achieving a semblance of the fixed-income-like returns they have enjoyed over the past several decades.

    Timothy Ng is chief investment officer for Clearbrook Global Advisors, based in New York.

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