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Investing textbooks and journals all promote the doctrine that bonds are safe and equities are risky, but 2022 has reminded everyone that bonds can be very risky too. It’s becoming increasingly clear that we are living in a tail-risk world where serial once-in-a-lifetime events have and will continue to challenge investors like never before. Whether they like it or not, a very challenging macro environment has pushed all investors out on the risk spectrum.
In January 2021, we published a white paper called “What is the Future of Income?” We did so because we saw that investors were facing an “income famine” due to historically low interest rates caused by policymakers’ aggressive response to the Covid crisis. We predicted that the 40-year trend of declining rates was about to end and that the typically boring 40% in a traditional 60/40 balanced portfolio was going to be challenged. The significant tailwind of declining rates that caused many investors to manage their fixed income allocation passively was going to require they revive long atrophied skills. We hate to say that we told you so, but….
Fast forward to the present, and 2022 was the worst showing for both equities and fixed income in years; so much for bonds being a reliable hedge against equity risk. Numerous unanswered questions remain, making this the perfect time to revisit the questions we posed two years ago.
Although nominal interest rates are now much higher than they were then, most real rates remain in negative territory because inflation has spiked to levels not seen in decades. No doubt, inflation will moderate, in part due to extremely hawkish central bank policy, but it will take time to settle back to the target level of 2%.
In our original paper we spoke of the challenge of generating income in a low-rate environment while investors were becoming progressively more risk-averse. Even though interest rates and yields have improved, the trend toward conservatism has also likely accelerated because of the war in Ukraine and the prospect of a looming recession. Whatever relief asset managers gained on the yield side has been more than offset by the uncertainties of a challenging macro environment.
We postulated that conventional approaches to generating income would not be sufficient going forward. Let’s see how that prediction panned out with respect to what we said, what happened and what we now think.
In January 2021 we said: Locking investors into GICs at “historically low rates seems like an abdication of duty.”
At first glance, the rise in interest rates has made GICs more attractive to consumers with one-year contracts paying over 4% for the first time in years. Looking beyond the obvious, it’s clear that, even at these more attractive nominal rates, buyers are still locking in negative real returns. As we mentioned, GICs are still unfavourably taxed at marginal rates, and they also eliminate optionality for participating in equity markets when they recover.
No doubt there are situations where it is prudent to recommend GICs. Nevertheless, endorsing savings products remains patently off brand for investment advisors.
In January 2021 we said: There was an “extraordinary level of risk” investing in Treasuries with yields of less than 1% all the way out to 10 years.
Although the risk of a capital loss is much lower now, volatility is much higher because the market is still trying to find an equilibrium. Many questions remain unanswered. Are we getting a recession? If so, how deep or shallow will it be? What happens to inflation and growth and the tradeoffs that policymakers will have to make? There is a very delicate dance going on in bond land right now, since good news on the economic front would likely mean bad news coming from policymakers in the form of higher rates.
Although Treasuries are more attractive now than they were in early-2021, the long end of the curve is still not compensating investors for the incremental level of risk.
In January 2021 we said: Dividend paying equities had “become a very crowded trade.”
Most companies have thus far been able to maintain their dividends while rising rates have caused a decline in equity multiples. This is a fertile environment for investors because prices have dropped for the same level of dividends, meaning sharply higher dividend yields. Dividend-paying stocks also tend to align with the value factor, which should be more resilient than growth stocks in an inflationary environment.
Going forward, the big question is can companies maintain their dividend in the face of a looming recession.
In January 2021 we said: Demand had driven down yields, “making it more difficult to realize value.”
Corporate bonds had their worst first half ever due to inflation and recession fears. Despite strong corporate fundamentals, historically low default rates are likely going to tick higher because of tighter financial conditions and decelerating economic growth. There remain areas of the market that offer an attractive spread above Treasuries; especially amongst U.S. sub-investment grade issuers who opportunistically refinanced and extended maturities while interest rates were still at extreme lows.
Selectivity is key to ensure that investors get adequately compensated for the heightened default risk.
In our original paper, we proposed three ways investors could complement traditional approaches to generate higher, more predictable fixed income returns.
Let’s revisit those strategies but with a slightly different lens. Generating income and making income payments to investors are two different things. Fixed income securities produce income, but income payments can be made from any source of returns, or even a return of capital. Income investors want a reliable source of income; however, they are largely ambivalent as to the source of that income, provided it does not take them outside of their risk profile.
In January 2021 we said: Emerging markets (EM) debt “offers very attractive yields with very positive risk characteristics.”
EM debt, especially local currency debt, has been a good investment and an extremely important source of real yields for fixed income investors. EM remains the growth driver for the world with younger, growing populations and middle-classes. Although there are fewer easily accessible investment options than in other asset categories, one must still have a deep understanding of this segment of the market.
EM debt continues to offer attractive yields and remains a very important risk management tool.
In our earlier report we signaled that the U.S. dollar had begun a long-term secular downtrend. That was true until the war in Ukraine validated the dollar’s safe haven status as an asset people want to hold in times of crisis. In part due to widening interest rate differentials, the British pound, Japanese yen, and euro have all made extreme moves to the downside versus the dollar. Investors must be cognizant of the implications of these moves while also recognizing the long-term fundamental overvaluation of the dollar.
Although currencies can diverge from fundamentals for extended periods of time, actively modulating those exposures has become an important tool for managing risk and delivering alpha.
In January 2021 we said: “The set-it-and-forget-it era of income generation is most definitely over.”
Rates have finally begun to normalize, and bonds are once again starting to offer attractive yields, but this has come with a higher degree of volatility. Modulating cash exposure has historically been the ultimate risk management tool in a rising rate environment and getting the right call between growth and inflation is going to be key.
In future, income investors may not have to go as far out on the risk spectrum to generate yield, but a difficult macro environment will mandate their full attention.
Asset managers reeling from a difficult market in 2022 will have to pick themselves up, dust themselves off, and start over again with a much more active and involved approach to fixed income than in the past. This will mean active cash management, active country and regional exposures, active duration management, active credit management, and active currency management.
Two years on from our original report, we maintain that investors should not give up on income; rather, they should explore new methods of sourcing income to complement the traditional approaches. Portfolio construction and tactical positioning are even more important in the face of serial economic, geopolitical, and environmental tail risks. The “set-it-and-forget-it” approach to fixed income management developed over the course of a 40-year trend of declining rates is even more dangerous than when we wrote our original report.
Francis D’Andrade is Head of Sales and Marketing at Forstrong Global Asset Management Inc. He oversees Forstrong’s marketing and communications, building on their global macro thought leadership brand positioning and media strategy. He also helps set the firm’s distribution and overall strategy. This article first appeared in Forstrong’s Global Thinking blog. Used with permission.
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Content © 2023 by Forstrong Global. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. Used with permission.
The foregoing is for general information purposes only and is the opinion of the writer. The author and clients of Forstrong Global Asset Management may have positions in securities mentioned. Performance statistics are calculated from documented actual investment strategies as set by Forstrong’s Investment Committee and applied to its portfolios mandates, and are intended to provide an approximation of composite results for separately managed accounts. Actual performance of individual separate accounts may vary with average gross “composite” performance statistics presented here due to client-specific portfolio differences with respect to size, inflow/outflow history, and inception dates, as well as intra-day market volatilities versus daily closing prices. Performance numbers are net of total ETF expense ratios and custody fees, but before withholding taxes, transaction costs and other investment management and advisor fees. Commissions and management fees may be associated with exchange-traded funds. Please read the prospectus before investing. Securities mentioned carry risk of loss, and no guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.
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