Sameer Jain, Chief Economist and Managing Director, American Realty Capital
Many investors are drawn to fixed income because it provides steady income, and has the ability to diversify portfolio risk. Fixed income investors contend with the challenges of very low expected returns, a paucity of skilled managers who have the potential to outperform the benchmark in what is a fairly efficient asset market as well as take on interest rate, credit spread and unexpected inflation risk.
Complementing traditional fixed income investing with Durable Income investing may be a better way forward. Returns in Durable Income are seen to be a combination of both passive exposure to general market factors and active investing decisions often resulting in market outperformance. Durable Income sources are agnostic to underlying instruments and to the markets in which they trade. It is the investing and trading methods to either arbitrage opportunities or in other ways create and unlock value that creates income and preserves capital.
By creatively using expressions to access real assets, too often overlooked liquid fixed income asset subtypes and investing with active managers focused on pursuing absolute returns (with aligned incentives), portfolios can be structured that maintain the attractive features of traditional fixed income while mitigating attendant risks. Financial innovation and new products now provide flexibility to repackage various fixed income return sources in a way that better meets long term capital preservation and income goals. Assets with shorter duration, safer and backed with real assets, an optimal holding period, moving defensibly, being alert to changing credit standards can be a good way to participate in markets. And that is what creates Durable Income and capital preservation.
Perils of Fixed Income Investing
Passive exposure to traditional sources of fixed income may no longer necessarily be an optimal investing strategy. Traditional fixed income investors may no longer be getting compensated for taking the risks that they do – risks from widening spreads, rising interest rates, as well as exposure to unexpected inflation.
Fixed income investing has 'not been working' for some time now. Our examination of the Barclays Capital U.S. Aggregate Bond Index, one of the most diversified fixed income indices over the last ten years reveals:
- Low absolute returns: The index offers investors very little excess return; a paltry 40 basis point premium relative to cash over the last 10 years.
- No capital appreciation: Nearly all the return in diversified fixed income has come from only interest income (i.e. driven by interest rate risk) and almost none from capital appreciation. Investors forego the benefits of value created from making good buy and sell market timing and security selection decisions.
- Low risk adjusted returns: The index has a Sharpe ratio of just 0.1. This is very low in both absolute and when compared to most investing strategies. Investors are decidedly not getting compensated for the risks that they take.
- No illiquidity premium: Since the underlying securities in fixed income investing are all very liquid, such a strategy offers zero opportunity for investors to appropriate valuable illiquidity premiums.
- Significant interest rate risk: For every 1% increase in short term interest rates, the index declines by almost 4.48%; the sensitivity to interest rates measured by the duration of the index. Any short-term increase in interest rates could therefore significantly impair returns.
Durable Income offers a better alternative.
Durable Income is Different from Fixed Income Investing
Durable Income investing is very different from fixed income investing for it has different asset characteristics as well as sources of risk and return drivers. Such differences can be a source of both resilient long term income and skills based excess returns, as well as a valuable investment diversification tool. Intuitively, Durable Income cash flow streams are relatively stable and predictable - say for example in the case of a long term infrastructure investing concession, often resulting from either a captive customer base, or from long-term contracts, or regulated pricing schedules, and limited competition or licensing. Stable, income producing, occupied, core real estate is yet another example. In these two instances the stable cash flows generated by mature infrastructure assets, such as electricity transmission cables, roads, and oil pipelines are analogous to the rental income streams in core real estate. These stable cash flows provide resilient long term income – in other words Durable Income.
Durable Income has stable resilient cash flows derived from multiple return drivers – not just interest rate bets. In other words it seeks to provide what fixed income often does not provide; (i) potentially higher absolute returns; (ii) both capital appreciation and income return; (iii) potential for higher risk adjusted return; (iv) unlocking an illiquidity premium when warranted; (iv) long term resilience; (v) and niche opportunities in credit investing.
Durable Income is a wide category but with shared features:
- Expected Returns: High single digits.
- Source of Returns: Periodic stable cash flows.
- Effect of Asset Value Growth: Modestly positive.
- Opportunity for Active Management: High.
- Investing horizon: Mid to long term.
- Liquidity: Varies.
- Effect of Inflation: Sometimes hedged with inflation linked cash flows.
- Effect of Interest Rate Increases: Modestly negative/ neutral; inflation correlation partially hedges nominal interest rates.
Durable Income is not a replacement, but rather, something complementary and a better way to get fixed income like asset characteristic exposure. Durable Income is a broad category and diversifies away from traditional fixed income investing.
Durable Income drivers include interest rate, credit spread, Illiquidity and alternative risk premiums.
As Exhibit 1 indicates, some asset subtypes, such as treasury bonds and credit default swaps, provide access to just one source of return- interest rates and credit spreads respectively. By contrast, other sectors generate return from multiple sources. For example, investing in private oil & gas partnerships, or in private infrastructure, or in private real estate provides multiple sources of return: interest rates, credit spreads, liquidity and alternative risk premium. The more the sources/drivers of return, the lesser the dependence on a particular market factor, and the more resilient the investing thesis. And this sets the basis for Durable Income and differentiates it from traditional fixed income investing.
Exhibit 2 below summarizes salient differences between traditional fixed income and Durable Income investing.
Traditional fixed income returns are very low and outperforming efficient markets is difficult. It is increasingly hard to ignore emerging fixed income investing risks from unexpected inflation, interest rate and credit spread widening. Investing passively in traditional fixed income exposes investors to low expected returns, has little scope for capital appreciation, comes with significant interest rate risk, forsakes opportunities in unlocking an illiquidity premium, as well as excludes niches in credit investing.
Durable Income is a complement to traditional fixed income investing in an inevitable (albeit difficult to time) rising rate environment. Durable Income, unlike traditional fixed income, has its foundation in multiple resilient drivers of return; interest rates, credit spreads, illiquidity and alternative risk premiums amongst others. The more the sources/drivers of return, the lesser the dependence on a particular market factor, and the more resilient the investing thesis.
Durable Income, unlike traditional fixed income is intended to be more resilient to economic downturns, to changes in credit and market risk and to macroeconomic conditions. Durable Income seeks to preserve the attractive features of traditional fixed income - stable, consistent, predictable returns - but potentially mitigates its risks as well as provides opportunities for capital gains. Durable Income characteristics include current income, low volatility and low correlation to other investments, and can provide portfolio diversification benefits. Durable Income investing, when implemented through active management, is a potential source of both market based (beta) and skills based returns (alpha).