#TheZero: How to escape it
#TheZero: How to escape it
In some ways, and for many, #TheZero is inescapable. We’ve started seeing zero everywhere. It’s in interest rate policy; it’s in returns on bonds. Zero is the gateway to negative.
We are at the beginning of a prolonged period of policy-led financial repression, where we will all have to focus on #TheZero, its impact on investment decision-making and its impact on asset allocation.
Of course, #TheZero is not new; we have seen near-zero interest rates in Japan as well as in Europe. However, when those local rates declined, the US became a haven of sorts - it was the higher yielding developed economy. This is no longer the case; zero interest rate policy is here to stay, at least for the foreseeable future.
But #TheZero also has implications for how we live our lives, not just our investments.
Change of plan?
I’ve always liked simple concepts. The simple life plan was always: work hard, get a scholarship, educate yourself, get a job, care for your loved ones, save money, invest, retire and live off of the income your invested savings generate.
Invested retirement savings, as a simple rule, meant bonds. Using bonds was the plan because you could earn income and maintain your lump sum (the principal). Simple plan. Iron-clad even ... or so I thought.
But what happens when the coupon income generated by bonds is close to zero?
With zero income, the maths no longer works for retirees, not to mention for those that manage pension plans for the benefit of retirees. What’s more, in an aging society, this problem is compounded.
If savings do not generate adequate income, you have three options: you must be willing to spend down your savings, you must be willing to reduce your expenses, or you must continue working for a longer period prior to retiring.
This is the impact of “#TheZero”, and it will get a lot of attention, it certainly has mine.
Macabre? Yes. But is it escapable? Definitely
Past performance disclaimer
For bond investors there have been four significant sources of return over the past four decades: duration, roll-down, coupon and spread.
They are all going to be far less significant in the years to come. #TheZero has seen to that.
It’s reminiscent of the widely-used disclaimer: “past results are not indicative of future performance.”
Look to the road less travelled
So, with traditional sources of yield and returns declining, where can attractive returns be found?
Presently, we see more attractive yields coming from more esoteric areas such as Asset Backed Securities (ABS), Collateralized Loan Obligations (CLOs) and Commercial Mortgage Backed Securities, than from the more common traditional benchmarked credits.
For example, today the European ABS index offers more attractive metrics relative to US IG credit than at any point in the last three years, implying that the premium for the complexity is more attractively priced today.
This is the benefit, in the words of the poet Robert Frost, “the road less travelled”.
When looking at yield alone, you can see that it’s in traditional assets that risk premiums have been reduced the most in the now decade long voracious search for yield.
Set your priorities
In evaluating solutions for #TheZero, there are certain critical factors that need to be emphasised. These are stronger fundamentals, better tolerance to volatility, and lower sensitivity to interest rates. At the same time, there are various factors that should be de-emphasised.
Within a portfolio, each asset should serve a purpose, based on the factors that it emphasises. The building blocks of a successful strategy will likely require new thinking about sources for return, such as:
- Fast liquidity: For most, some component of a portfolio needs to be used for liquidity. Liquidity is one area that requires a re-examination in light of the changing size of various markets, and the securities within them.
- Opportunity: Based on their exposure to certain themes or trends, some products benefit from opportunity, either right now, or down the road. Opportunities today are more likely to include those that are housing related, but future opportunities will include real estate-, consumer- and corporate-related.
- Recovery: Other types of opportunity can be driven by mispricing. Recovery opportunities are often the “babies thrown out with the bathwater” in dislocated or uncertain markets.
- Carry: Assessing the carry of a bond in consideration of its duration and potential volatility should be a key driver. If this is desirable, our view is that a sector like ABS affords these characteristics more so than many other sectors.
- Evolution: Lastly, liquidity takes us into another dimension of risk premium. The terms of liquidity can range in terms of return and in terms of lock-up. This is another tool that could be used to improve or reduce risk within a portfolio in #TheZero.
Break with tradition
In looking across the investment landscape, there is a need to solve the problem of #TheZero. Participants in all markets alike will need to consider diversifying sources of return beyond traditional markets, or traditional thinking.
It has been said that “underneath every revolution lay a zero”, and from an asset allocation perspective, this time is no different. We believe that we are just now at the beginning of changes to fixed income asset allocations in order to more aptly navigate #TheZero.
With very low structural yields and returns we must consider more risks, rather than just more risk as the backbone of portfolio construction. Consider a more diverse basket of less correlated assets to embed resilience. We believe this is the order of the day.
A re-assessment is essential given the new challenges of the zero paradigm. The sustainability of this recovery may be challenged and even a mere delay in the expected US fiscal package has altered expectations. Unemployment perceived as temporary will begin to shift to unemployment perceived as permanent. Policies that helped companies and consumers bide time through non-payment will expire, and we may see another wave of layoffs and increases in bankruptcy filings.
We believe these challenges will begin to mark the second phase of this economic crisis and recovery, as we begin to see new data, we may initially see the death of optimism.
There will likely be renewed opportunities to benefit from structural changes taking place in the economy, be they social, political or economic.
Generating successful investment outcomes with an uncertain economic backdrop is hard. With high asset prices, and with very little income offered in traditional markets, it is very hard.
But as Tom Hanks said in 'A League of Their Own', a movie about women taking over the US Professional Baseball League during WWII, “It’s supposed to be hard. If it wasn’t hard, everyone would do it. The hard… is what makes it great.” – and there is NO crying in baseball.
Please find our full paper #TheZero as a PDF below.
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