Escaping the Income Problem in a Low-Yield World
Eight tactics that may enhance income, returns and portfolio diversification
Ten years ago, when interest rates were much higher and government bonds actually produced yield, index bond funds were solid products because they delivered income with much less sensitivity to the movement of interest rates. Today, a traditional fixed income fund typically yields less than 2.0%, and that’s before fees.
Most bond mutual funds and ETF strategies are passive and constrained, meaning they must mirror a benchmark like the ICE Canada Broad Market Index. Typically, about 75% of the securities contained in these bond funds are low yielding government or quasi-government bonds (source: Bloomberg). As a result, these indexed bond funds yield less than a GIC, but with significant duration risk of around 8 years. If interest rates move up by only 0.25% an investor starts to lose money because bond prices go down when interest rates rise.
Government bonds are safe, but they aren’t risk-free. Locking in an interest rate for 10 years or more, that you wouldn’t normally accept for a year, isn’t a productive way to invest in bonds. Taking that much interest rate risk to earn a GIC equivalent yield shouldn’t be acceptable to investors who are concerned about risk and capital preservation.
And, in the pursuit of income, adding an over-concentration of high-yield bonds and/or additional preferred shares and dividend-paying equities just increases unwanted portfolio risk that may lie dormant until it doesn’t.
What’s an investor to do?
Liquid Alt bond funds can provide investors with an alternative that offers several benefits: more opportunities for income, greater flexibility to generate returns, and excellent portfolio diversification.
In this paper we’ll explore eight tactics that an unconstrained bond strategy can use to help investors escape the troublesome portfolio income trap that index funds can create.
An unconstrained fund strategy does not require a fund or portfolio manager to adhere to a specific benchmark. Unconstrained investing allows managers to pursue returns across many asset classes and sectors.
Tactic 1: Asset Allocation
Unconstrained strategies are not constrained by a narrow benchmark.
That means that managers of these funds can be highly tactical in their asset allocation. They can have weightings across many fixed income asset classes, including cash, without as many restrictions. This table shows you the relative performance of seven fixed income asset classes over an almost nine-year period.
You will note that more than one of these asset classes has been both the best-performing and worst-performing over the period. An unconstrained strategy has the freedom to move in and out of these asset classes at will, changing the characteristics of the portfolio to be defensive or opportunistic.
Tactic 2: Duration Management
Unconstrained strategies can increase or shorten the duration of their portfolio in response to the interest rate outlook.
In a falling-rate environment, an unconstrained strategy enables a manager to increase duration to capture more upside. In a rising-rate environment, they may shorten duration to reduce the risk of loss. This chart gives you a quick rule of thumb for estimating the impact of duration:
Conventional bond fund managers most often have to construct their portfolios’ duration to mirror that of their index. The Bloomberg Barclays Canada Aggregate Index is one of the benchmarks commonly used by Canadian bond managers. The duration of this index has steadily increased as interest rates have fallen over the years and is currently at approximately 8 years*. This means that these funds, traditionally viewed as safe, have in fact a high degree of interest rate sensitivity and can become more volatile.
*Source: Bloomberg as of November 1, 2021.
Tactic 3: Credit Selection
Unconstrained strategies recognize that the global fixed income market is not perfectly efficient.
This means that it is sometimes possible to invest in illiquid bonds or lower quality credit that can add return without adding equal risk. When these opportunities emerge, unconstrained strategies can take advantage of them to improve risk-adjusted returns. Credit quality is one of many factors prescribed by an index. This can prevent conventional bond fund managers from taking advantage of certain opportunities, and it can also force them to sell or remain in areas of the market that are likely to underperform. Flexibility around credit quality is another important lever that the manager of an unconstrained strategy can pull.
Tactic 4: Geographical Orientation
Unconstrained strategies can invest anywhere in the world.
Although Canada is generally a desirable market, it makes up a thin slice of the global pie. The face value of all Canadian bonds outstanding was about USD$2.2 trillion at November 25, 2020, or just 3% of the $66 trillion global total, as the graph to the right illustrates. Being able to cross borders gives unconstrained strategies better diversity and the ability to pursue value wherever it may be found. This is in contrast to conventional managers who may be tied to an index with undesirable traits.
Tactic 5: Currency Exposure
Unlike index funds, unconstrained strategies can buy bonds denominated in almost any currency.
Interest rate differentials can sometimes result in higher-yielding securities when converted back to Canadian dollars.
Tactic 6: Short Selling
Unlike index funds, unconstrained strategies have the freedom to utilize short selling.
In essence, short selling means “selling high and buying low.” You borrow a bond from a broker, sell that bond in the market, re-buy it for a lower price at a later date, give it back to the lending broker, and keep the difference (minus interest) as a profit. Here are two scenarios where the manager of an unconstrained strategy may use short selling.
Unconstrained strategies can use short selling to seek profits and to manage credit and interest rate risk. These strategies can be used to capture returns from securities that are expected to decline in value, or as a pre-emptive move against market declines.
Tactic 7: Options Strategies
Unlike index funds, unconstrained strategies can use options to reduce losses and enhance returns.
The two basic types of options are puts and calls. When you buy a put option, you are buying the right to sell an asset at a fixed price – such as a bond index ETF – at a specified “strike” price until a certain expiry date. Call options are the opposite – they give you the right to purchase an asset at a certain strike price until the expiry date. A manager under an unconstrained strategy can use combinations of calls and puts on fixed income ETFs to alter duration and credit risk, either to be defensive or opportunistic.
Sometimes, the manager of an unconstrained strategy will simultaneously buy or sell a number of put and call options at the same time with the goal of improving the overall risk/reward profile of the portfolio. Strategies using multiple options are often aimed at reducing the portfolio’s downside potential in exchange for a small reduction in its upside potential.
Tactic 8: Leverage Enhancement
Within the Liquid Alternative fund format, unconstrained strategies can use leverage to enhance returns.
Corporate bond returns are made up of two components:
- government bond yield (the interest rate risk), and;
- the credit risk or spread (compensation for probability of default).
By buying a corporate bond and then selling short the corresponding government bond, the manager of an unconstrained strategy gains exposure to a security that generates yield with no interest rate risk.
Escaping the Fixed Income Trap
Today’s fixed income investing environment has become even more challenging due to the persistence of ultra-low interest rates. Government bond yields are so low, a traditional fixed income fund now yields around 1.0% and that’s before fees. If interest rates rise, it’s conceivable that these index bond funds will never produce a positive return. This is the conundrum globally: low bond yields are rendering traditional bond funds ill-suited to do their job – to generate income and preserve capital with low volatility.
Unconstrained bond strategies, and especially Liquid Alternatives bond strategies, are a game-changer for fixed income. Investors have access to differentiated bond funds that can deliver higher returns with much less correlation to the bond market, resulting in less volatility.
For bond managers this provides more tools to do a better job – a bigger opportunity set of assets and strategies to generate returns, with improved diversification, less correlation to the index, and a higher level of risk management. And for investors, this approach provides an escape from the unrelenting Income Trap.
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