Chris Barlow: Right now, there are three tectonic shifts going on for financial advisors and their clients. First, we have a tidal wave of retirees coming. Some estimates have over 10,800 people reaching the retirement age of 65 every day, or that’s close to one person every eight seconds is reaching the retirement age. At the same time, we are experiencing a substantial change in fixed income markets, where rates, on average, are significantly lower than people have experienced or perhaps even expected while they were saving for retirement. For example, anyone who started working at the end of January 1975, less than $10,000 invested in the 10-year treasury, would have generated a thousand dollars of income. As of December 31st, 2020, with 10-year treasury yields at about 93 basis points, to generate that same $1,000 of income, one would need approximately $108,000. And then lastly, the effects of income and portfolios are changing as we see significant divergences in risk and volatility around different income-producing asset classes and securities.
Emily Larsen: Those trends, in case you missed them, were one, in 2021, someone will turn 65 every eight seconds. That means in the time it takes you to listen to this episode, about 225 people will turn 65.
Ben Jones: Wow. The second trend that was mentioned is that when these retirees started working, it took only $10,000 to generate $1,000 of annual interest income. And today, that figure is 10 times that amount, around $108,000.
Emily Larsen: And three, income producing asset classes are becoming a bit messier. These trends are converging to make creating income for clients extremely difficult at a time when more people require income to fund their retirements.
Chris Barlow: So, let’s just kind of start there, Derek. Can you share your thoughts on the roles that fixed income plays in a portfolio?
Derek Sasveld: Yeah. Sure, I can. Thanks, Chris. My opening thoughts are simply that investors set their framework for how to use stocks and bonds together in portfolios over a time period, a long time period really, that’s not very representative of the current circumstance and maybe probably not representative of the near future. Since 1926, a mid-risk portfolio of 60% stocks and 40% bonds would have generated about 9% return performance at reasonable or mid-level of risk and would also have generated 4% income or yield out of treasuries and dividends. In the current circumstance, that 4% yield is really more like 1%. And over the last 20 years, it’s been more like 2%. So, I think my main concern is that people who are investing currently, for retirement, using a framework that although 95 years old and has been time-tested contains some embedded assumptions about what’s available in income and what may be available in terms of returns, that may not be entirely realistic.
Chris Barlow: Walk me through then, how did we come up with that 60/40 portfolio mix? And you mentioned the 4% or expectations there. Also, to me, for retirement, oftentimes we talk about a rule of thumb of 4%. And so, I’m curious how those have worked together historically and if you would expand on your thoughts a little bit about why that’s not working now.
Derek Sasveld: Sure. Most people, and I think most financial advisors, would be familiar with the work on portfolio selection by Harry Markowitz, back in the 1950s. Shortly after that took place, there were a number of people, especially in the pension community who wanted to use that framework of mean, variance, optimization to better invest pension funds. And so, they looked at historical data that they could find on the US stock market and the US bond market that went back to 1926. And in the mid 1960s, the first Markowitz optimizations of 40 years of stock and bond data were executed using mainframe computers. That identified essentially, a middle risk portfolio that was 60% S&P 500 and 40% long-term treasuries. Middle risk, meaning standard deviation as we would know it today, of roughly about 14%, halfway in between the risk of bonds and the risk of stocks. So that’s where the 60/40 portfolio came from. If you update that information for the S&P 500 and long-term treasuries through 2020, the middle risk portfolio looks more like about a 70/30 portfolio, which is why I think there’s been some commentary that perhaps 70/30 is the new 60/40. But that’s based on a period of time in which stocks did extremely well and treasury yields were much higher. As it happens, those total return portfolios that investors identified as efficient or providing strong growth at a middle level of risk, also provided coincidentally, a 4% level of income. That’s significant because people already were generating income that framed their expectations for what they thought they might get in the future. And that I think is the source of the 4% income profile for investors that people have used in rules of thumb. The problem with that is that in the world of the future, it’s unlikely that we’ll be able to generate 4% income from stock and bond portfolios like we’ve seen for the last 70, 80, or 90 years. In the current environment, we’re looking at essentially the last 20 years, that income being 2%, and at current yields, roughly 1%. So, investors might have expectations that have been framed accurately during a period in which they had, fortunately, a higher yield from their stock bond portfolios than what they’re likely going to get in the near future.
Ben Jones: The 4% rule referred to by Chris and Derek is a rule of thumb that’s often cited in determining how much a retiree should withdrawal from their account each year. The rule seeks to provide steady income streams for the retiree while maintaining the account balance. However, as Derek stated, the expected income from a portfolio is approximately 25% of what it was when the rule was created. So, what are your options to help your clients solve for the current environment?
Chris Barlow: So, we find ourselves then in this new landscape. The 4% rule, which may have been, I don’t necessarily want to call it accidental, but it definitely feels dated there. So, we find ourselves in that new landscape. What should we consider? How do we approach things going forward?
Derek Sasveld: I think you can look at a retirement challenge for income in a variety of different ways. One is simply to seek out more income where we can find it, and there are more dangerous ways to do that and less dangerous ways to do that, and more comfortable ways to do that. I think a more effective way to do that is to use credit. And we’ll talk about some of the credit instruments. And I think specifically, Scott will talk about approaches in credit that can get investors to a happier income situation. But there are also investments that are potentially higher yielding like real estate equities, infrastructure equities, option overlay programs, closed end funds that are leveraged that I think are just a little too risky for a lot of investors. So, I think part of it is just to consider income when making investment decisions, which a lot of investors generally don’t do. And when considering that income, maybe think about levels of income that are available in credit markets that are much better known to investors and more liquid than some of the other alternatives that they can pursue.
Chris Barlow: Got it. And you kind of touched on this a little bit, but would you qualify as all yield being an equal or should some advisers be reaching more to the esoteric to, for lack of a better phrase, juice up their yield?
Derek Sasveld:I just think that investors can take on a lot more risk in a portfolio than they need to, in exchange for the potential to generate very high rates of income. So, for instance, master limited partnerships currently yield in the single digits. But given the volatility of oil prices, is that really something that a fiduciary should be suggesting to a client? Or say for instance, a closed end fund solution that might offer a relatively high level of yield because it’s extremely leveraged at low interest rates. Well, if those interest rates rise, will that leverage be stable, and will it be applicable in the near future? So, I think you can reach too far for certain types of income that could juice the level of income in a portfolio but might do so with a little bit too much price volatility or structuring risk or financial engineering risk.
Chris Barlow: Great. And with the wide range of risk spectrum and with the lower interest rates, why should investors consider a more yield centric approach in a portion of their allocation?
Derek Sasveld: I think the biggest reason, Chris, is that if they pursue other types of strategies to generate dollars in retirement, i.e. counting on the stock market to provide enough growth in the body of a portfolio so that dividend yields, in the longer run, can compensate them and provide for their retirement and their dollar needs in retirement. Equities have a good deal of uncertainty and over a reasonable timeframe, five to 10 years, especially perhaps starting from today, a period in which the equity market is richly valued, that can lead to five to 10 year or intermediate time periods in which there is a good deal of uncertainty regarding whether that investment strategy will be successful. Like if we have, for instance, a 30 or 40% drawdown in the equity market in the next couple of years, people who retire today and have an equity heavy investment, especially if they harvest distributions out of that equity portfolio, they might not get to the point 20 or 30 years hence where that equity portfolio could generate potentially significant dividend income. Because if you think about what happens in market drawdowns, equity prices tend to fall pretty considerably. If you’re spending out of that equity, you’re really damaging the ability of the portfolio to grow in the future. At the same time, higher yielding investments may offer a lot of flexibility. Perhaps you’re getting similar levels of dollar coupons that you would in other environments. Your yields actually have the potential go up in drawdowns, because if some of the prices of credit instruments fall, the yield, the coupon divided by the price, rises. The dollar coupon becomes more valuable in a period in which liquidity is an issue. This is because you have potential coupon income to use to rebalance a portfolio, you can use coupon income to live off of, and you can use coupon income to reinvest in a total portfolio, that may be more balanced, and thus experience less volatility in the longer term, than one that’s tilted more towards risky assets.
Chris Barlow: That’s an interesting thought because at least for me, historically, when I’ve thought of income, it just helps me feel safer, right? If you get that regular check where it’s just coming in, that just feels safer. But from what I’m hearing you describe, you would say from a portfolio management standpoint, particularly in volatile spaces, it not only feels potentially safer, but may create better outcomes. Am I understanding that correctly?
Derek Sasveld: Yeah, you are. I’ve heard from individual investors and financial advisors alike that income has historically helped mitigate overall portfolio volatility. We believe adding income-producing assets is important, especially for a five or 10-year timeframe in which there can be volatile markets. Even over that timeframe, negative returns are possible, that can help to really harm an all equity portfolio. Or a portfolio that may reach for yield in some investments that have historically displayed significant price volatility. It doesn’t just feel smarter, Chris, we believe it is smarter.
Chris Barlow: One last line of thought that I wanted to go through with you here is you had talked about the credit allocations and how that seems to be the sweet spot for fixed income investing. And we’ll come to Scott in just a moment to talk about how to manage a credit portfolio, but I’m curious if you could just expand a little bit more on what you’re talking about relative to the risk and return of credit, relative to traditional portfolio allocations.
Derek Sasveld: I think, Chris, it’s a bit of a frustration, at least for me. I managed target date strategies for a number of years at a significant provider of target date portfolios. And it’s just interesting when you look at retirement target date portfolios. Your average at retirement target date portfolio from one of the top 10 providers of target date strategies is roughly about 55% equity and 45% bonds. And of that 45 percentage points in bonds, only seven percentage points is in credit, on average. Those types of portfolios are built on sort of the older time-tested model that we were talking about earlier but isn’t really necessarily updated for a world in which income is not as significant for treasuries or even core bonds. So, my concern would be that those target date portfolios won’t necessarily be as successful in meeting the income needs, especially in the near future for a lot of investors that credit might. And when we talk about credit, something that would be, say for instance, equally weighted, or have participation in a variety of higher yielding environments, like say corporate investment grade in the US, corporate high yield in the US, securitized investments like mortgage backed securities and commercial mortgage backed securities, and even emerging market debt, can provide a compelling alternative for investors with regard to yield that I think is much more compelling for longer term success and especially shorter to intermediate term success from an income standpoint, than either target date funds or sort of traditional portfolios.
Emily Larsen: Income in a portfolio can help financially. You’ll have different opportunity outcomes with regular coupons and reinvestment, whether you’re in volatile times or have a short to intermediate time horizon.
Ben Jones: Now that we have a better grasp on how income could fit into a well-diversified portfolio, we thought it would be an interesting idea to explore Derek’s topic of credit exposure a bit further with Scott Kimball. Now he runs funds across the spectrum of credit exposures. But given the current environment, we thought we would discuss the multi-sector credit category with him in more detail.
Scott Kimball: Well, I think that the first thing to establish about this fixed income environment is that it’s ever evolving, in that really over the last decade and a half, going back to a lot of the unusual tools that the Federal Reserve undertook coming out of the financial crisis, through where we are today, engaging in even more robust and unusual or atypical set of tools, there’s been a persistent theme of interest rates declining throughout that period. And it really is anywhere you look in fixed income. So, for example, treasuries most prominently, steady decline in rates there. You could argue that’s been going on for about three decades. Corporate bonds across the spectrum. Investment grade through high yield, all in yields are declining. And then if we start looking in areas like securitized restructured areas, so for example, mortgage loans or commercial mortgage loans, as well, rates are declining. And there’s a few reasons for that. One is what you started off this conversation with, which is that there’s a tidal wave of people who are looking for income. So, when you have the demand for income outstripping its supply, we see downward pressure on yields, simple economic outcome. And if you exacerbate that by a federal reserve or a central bank anywhere around the world, global central banks really, continuing to take away fixed income securities from the marketplace, whether their treasuries, mortgages or now corporate bonds that further enhances or augments the demand for at the same time, it’s reducing the supply from the addressable market to, the open market for our individual investors. So, what we have to do as fixed income investors and fixed income asset allocators is take in and observe the yields available in the marketplace, and then compare it to the level of risk for the given securities or sectors or portions of quality. For example, it could be an individual security issued by a particular issuer from the energy sector or the retail sector or any sector that’s showing some signs of stress, or it could be a technology name that’s emerging in an area of the economy that’s improving. But we look at those yields, and we have to compare it to the level of risk. And that is what is been persistent throughout this market is even though market dynamics are changing, what matters to a fixed income portfolio manager, such as myself, is taking a objective look at the level of risk for an individual investment and deciding are we getting paid an appropriate amount of yield, are we getting paid too much yield or excess yield, or are we not getting paid enough? And we look to eliminate those where we’re not getting paid enough for a level of risk. And we look to make investments on those that are either paying us appropriately or preferably those that are paying us a little bit extra. And that little bit extra is where the alpha comes from. And then the combination of the two is where the income comes from. So, there’s a few aspects to that. First and foremost is as the market evolves, and we talk about the increased participation of investors and now central banks, in many cases, the size of the opportunities have diminished, meaning that we’ve had a lot of people looking for these opportunities. So, in some cases, you might have some managers that are large, and their funds have gotten very large, which is great for the manager. But what does that mean for the investor? In reality, it means any decision the manager makes is being shared very broadly across a growing pool of assets or a gigantic portfolio. So, the incremental benefit to the investor diminishes. So, there’s a pretty big constraint there. I think we’ve seen that in some other types of investments, whether on the equity side, people looking at frontier or small cap equity, you hear of these size constraint issues. The other is looking at just the process that’s in place. There’s a lot of different philosophies on how to manage fixed income. Some folks will look at things quantitatively, meaning that they look at mathematical equations of how a company financial health purist, and look to use that sort of scientific way of comparing, making an apples to apples comparison. Others look at things fundamentally and say that they’re going to use good old-fashioned elbow grease to dig through financial statements and come up with the current health of a company and the forward-looking health of the company. We believe in doing both. We use quantitative tools to address the broad market and what is a large number of investments, but it helps us filter things down to let us know what areas we should be focusing. Where is there a break? Where can we spot in a market where there are securities or groups of securities relative to their historical levels of risk and their current levels of risk, and what our analysts on the fundamental side think are the forward-looking risks, where is there a divergence? And that, we believe, is a skillset that a lot of individuals overlook. They get too focused on one type of investment. And this is a market where any particular style, particularly in fixed income, the nimbleness and the ability to go between a couple of different techniques to unearth value in yield is extremely important. And some are too married or too focused on just one type of solution.
Ben Jones: Wait, did you catch that? Some bond funds in the credit space are actually too large to capitalize on attractive opportunities because the issues, relative to their fund size, might be too small. In other words, building a position may end up sacrificing liquidity, or may not be large enough to matter for their investors.
Scott Kimball: We have to understand that there’s a level of risk involved with every decision we make in investments. And as we are looking for higher yields in, I will call it a challenging yield environment, anything that’s offering you yield in excess of what’s available in the market is going to carry with it a perceived level of higher risk. So when we’re talking about what we do, which is idiosyncratic risk or buying individual securities, we would tell you that while we are buying securities, that might be lower rated than investment grade, or might be in the commercial mortgage backed security market, and there’s lots of negative headline, surrounding it, we are actually encouraging and accepting of the fact that we are buying out of consensus or buying parts of the market or bonds within the marketplace that are being priced indiscriminately by investors, meaning that people aren’t doing the homework on the security. If you’re talking about using synthetics or derivatives, there’s no real homework to be done. It’s basically looking at broad market directionality and saying yes or no, right or wrong. It’s a bit like going to the roulette table and choosing the black or the red. Effectively, we look throughout financial market history, 50/50 is about as best as you’re going to get if you’re going to guess on directions of the market. And there’s times where you have it dialed in, and you’re onto the idea that markets are focused on and you might be able to produce some returns. But over time, it’s a lot more difficult to guess on the broad directions of market and do it consistently over a number of cycles. To get back to what we’re doing on bond selection, what doesn’t change is that where you were doing homework on individual securities, on a bottom up level, and while there is certainly an element of yes, we can be right or wrong, there is plenty of evidence that suggests if you fine managers that are doing their homework and making their decisions based on bottom up security selection, there’s a lot more evidence in performance attribution that that can be a persistent theme. There are managers that can consistently produce alpha throughout market cycles and over longer periods of time and trying to out guess the direction of the market. That’s a big difference is when you’re talking about bottom up security selection, we’re not trying to time the market. We’re looking for things where risk is priced inappropriately for the way the market looks today on known information. As things evolve and go forward, a portfolio of securities that we believe are trading at a discount and offering a yield premium, there’s a better chance of realizing your yield premium and positive returns over a market cycle more consistently than if we try to guess again, on those broad factors. So, what doesn’t change is that we’re doing our homework in all market environments, and we’re looking at things bottom up and the decisions we have to make are much more micro and focused. We don’t have to look at every balance sheet for corporate America to decide whether or not we like credit. We’re looking at a balance sheet from corporate America and making a decision about, do we like this balance sheet today, and how much can we beat it up before it has any problems tomorrow? And that is a much, in our view, a much more even-tempered proposition. It’s one where the decisions we have to make are smaller. You’ve heard aim small, miss small. This is assembling a portfolio with high conviction, let’s say a hundred names across our analyst team of over 20 people. And we’re asking them to know from the very intricate levels of the investment through what’s available in financial statements, and what’s available in the company’s history to understand the current risk position of the company. That’s a much more narrow decision, and it’s a much more focused decision. We don’t need the market to go a certain direction for the security to perform well. We just need to have identified that the company had the right levers to pull that the market was overlooking. And that’s why we think that you’re actually taking a lot less risk by focusing on bottom up security selection, as opposed to trying to guess the directionality of markets.
Chris Barlow: If you’re finding lots of value in a space or a sector in specific, how do you not end up in a, what I would just call an unconstrained bond fund to where you end up just loading up in a specific sector or area of the market, and just being almost overwhelmed by the opportunities in one area?
Scott Kimball: The way we approach the market and the way we approach multi-sector or strategic income investing is we do so from the perspective of giving ourselves enough leeway to emphasize parts of the market where the value exists. So, for example, high yield, investment grade, structured products, emerging market debt, sovereign debt, in some cases, even maybe even municipal debt if that’s the place to be. But we put enough constraints around that while we can express any view we want, we can’t take so much risk in one sector that we’re shifting away from the focus of what we’re doing, because what’s important, in this style, is those first five letters, multi. Multi-sector needs to be multi-sector. It has to be broad bond market exposure that is not reliant upon just backing up the truck in something like emerging market debt. We can take on enough EMD where it’s meaningful, but not so much that we skew the risk profile. That’s the first thing, is the broad constraints. I will say this on unconstrained, and this has been one of the challenges that unconstrained has realized, whether it is unconstrained is really introducing a alternative investment style or a hedge fund like trading vehicle into the 40 act mutual fund market. It can work well as a diversifier against broad baskets, as we’ve seen on the historical analysis. But the problem was most of them were trying to find areas where their fund outperformed these rising rate environments. As we know, as we look at markets today, yeah, is the 10-year treasury had at 1.10? Sure. Was it at 50 at one point? Absolutely. But have we really seen a rising rate environment? I don’t think so. To me, and to us, a rising rate environment is one where we’ve seen that the historical average for the 10-year treasury continues to move lower. We’re seeing those long-term averages just shift lower and lower and lower and lower as each five- or 10-year measurement period sees persistently lower rates than the prior decade or decade and a half. We haven’t seen a reversal of that where those long-term averages are now moving back up and retesting or moving closer to the previous historical averages. So, we haven’t really seen what we would define as a true shift in interest rate regime. And that’s what the unconstrained vehicles were showing you, their performance against a change in interest rate regime. Interest rate regime is just a very fancy way of saying “Thank God rates finally went back up.” We haven’t seen that. In fact, we saw a few glimpses where the market tried, or the fed tried, and they got beaten back pretty heavily. So unconstrained is really very focused on duration. In many cases, negative duration. They can run negative durations and really bet against rates. So, I just want to make sure that we set that perspective. Now they can invest in a number of different vehicles. They can use all the tools and all the different sectors that we’ve talked about. But the big thing is what are they really doing on duration? You can have the greatest security selection in the world, and you can have great sector rotation and quality decisions and all the stuff that you need to have alpha, but duration is an impactful thing in fixed income. And if you bet against rates or carry a negative duration and you’re wrong, I can tell you, you’re not going to have any chance of the other things you did right to shine through. It will trump everything else you did in the portfolio and effectively render what could have been some very good security selection, basically inconsequential.
Chris Barlow: So Scott, if I can kind of summarize this conversation and the things that we’ve been talking about, it seems to me, particularly if we’re going to adapt to the current fixed income environment, as well as adapt as things continue to change, and it’s felt like this my whole career, the fixed income market has just been one evolution of change. It seems that portfolios that have a nimble approach, that have high conviction, but are not unconstrained, and that are a pure portfolio looking at security, they can have the potential to allow investors to adapt with better outcomes for the current fixed income environment.
Emily Larsen: Income can have psychological and financial benefits in a portfolio. As you and your income seeking clients and prospects adapt to the changing landscape of income, it will require you to think differently about appropriate allocations and traditional frameworks. We thought we’d leave you with a warning label and parting thought from Scott.
Scott Kimball: There’s been a lot of people that are trying to predict a cataclysmic event in treasury rates. The same time, you’ve had people trying to predict cataclysmic events in the credit markets. And while certainly credit markets have given you a lot more frequency, they’ve been very short-lived. So I guess my strongest view that I would share when it relates to fixed income is no part of the fixed income market is broken. Both these markets are doing what they are meant to do. Treasuries are being very effective at defending portfolios against tail risks, particularly drawdowns in riskier asset classes. And riskier asset classes have been giving you more income, but some more volatility. So stop looking for areas where the fixed income market is broken. That seems to be the challenge that most are trying to solve. In the meanwhile, while people are trying to solve where in fixed income is broken, they’ve been letting other risks on their portfolio sit dormant. My message is, my parting shot is, stop trying to out guess fixed income. The market is functioning as it’s supposed to. You’re getting defensiveness from your core and your core plus mandates, and you’re getting return and yield from your more yield seeking, high yield and multi-sector strategies. They’re working, they can work in tandem and they are a, both, very relevant parts of your asset allocation today. There should not be a need to try to erase or eradicate one or the other. It’s a question of having them in the right balance for what you’re trying to accomplish for your portfolio or your clients.
Ben Jones: Thank you for listening to Better Conversations, Better Outcomes. This podcast is presented by BMO Global Asset Management. To access the resources discussed in today’s show, please visit us at www.BMOGAM.com/betterconversations.
Emily Larsen: We love feedback and would love to hear what you thought about today’s episode. You can send an email to [email protected]
Ben Jones: And we really respond.
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