Liquid Debt: Active or Passive?

This research note is produced by Elkstone in conjunction with our hedge fund and cta manager database partner, Nilsson Hedge.

EXECUTIVE SUMMARY
  • Liquid Fixed-Income has traditionally had a positive return expectancy and we would tend to use an ETF vehicle to capture the positive systematic risk.
  • When looking to replace Fixed-Income in an investment portfolio, we must replace all characteristics of the asset class and not just the real yield that used to be provided.
  • Given the structural changes and interest rate tailwind getting exhausted, we have a negative outlook on using liquid Fixed-Income as part of our holistic investment portfolio and instead prefer to utilise direct lending opportunities.
INTRODUCTION

Investment Committees are wondering how to replace the yield that used to be earned within their fixed-income portfolio. Despite the low yield, traditional fixed-income deserves a place within a portfolio due to its portfolio protection characteristic – a portfolio manager and investor’s best portfolio tool. Fixed-Income portfolios are at the forefront of many investment committee discussions and many investors are struggling to find alternatives.

At Elkstone, our investment philosophy has us

  1. Requiring a positive return expectancy,
  2. Looking to achieve exposure to the desired markets and risks in the cheapest way possible,
  3. Looking for diversification when diversification is needed,
  4. Looking past the name of the market, strategy, investment process and investment vehicle type to analyse what risks and exposures are actually driving the return stream.

Oftentimes, a return stream can sound different and therefore diversifying, but is driven by the same underlying drivers and is therefore not additive to a portfolio. With this investment philosophy as governance, this short research note looks at whether we want to build our internal fixed-income investment exposure through passive or active management and through ETFs or alternative investment vehicles or structures.

ETF VEHICLE CHARACTERISTICS

As we always look at what we are getting from both a market/strategy and investment vehicle, we understand that with an ETF vehicle, we will get the following:

Trade Setup: Long/buy-only exposure

Cost: Cheap exposure relative to other investment vehicles

Liquidity: Daily liquidity and high volume

Management: Passive

Portfolio: Diversified across multiple bonds

FIXED INCOME  MARKET AND INVESTMENT CHARACTERISTICS

As with all debt instruments, an investment is made based on the creditworthiness [ability to payback] of the counterparty. Counterparties tend to have different abilities to pay back and there is a credit rating to represent the credit risk you take on. Some entities have a high chance of paying us back and therefore known as ‘Investment Grade’ debt/bonds. Examples include governments as they can print money when needed, States [municipal bonds] as they can raise taxes when needed and large corporations that have sizable cash balance sheets. Others have a lower probability of paying us back; this group is called ‘Junk’ or ‘High Yield’ bonds and for us to lend to them instead of Investment Grade bonds, we require a higher interest rate payment than what Investment Grade will pay us. Most times, when we loan to a corporation, we are making the bet that the loan can be paid back due to an increase in revenue by the company or that the project we are lending towards will increase productivity and therefore earnings and cash reserves to be able to pay us back. This is regardless of what underlying sector or product the company is involved with.

It is important to not mistake the collateral put up as what you are investing in. Collateral is a secondary protective measure to help provide comfort that the loan we provide can be recovered in some proportion if the counterparty cannot pay us back. Uncollateralised loans are ones that do not provide any collateral while other loans will have collateral. Examples of collateral can include the company’s inventory, accounts receivables and/or real assets like land or a building. When considering giving a loan, the first question to consider is ‘can the counterparty repay the loan’ and then secondly, ‘if they can’t repay, do they provide collateral and how much is likely to be recovered based on that collateral’.

Why is Fixed-Income such an important player within an investor’s portfolio? Much of the talk within investment media is currently on replacing the Fixed-Income yield that a portfolio received, however we think about replacing Fixed-Income in a different way. When we look at what Fixed-Income traditionally provides a portfolio it is three things: i) a liquid investment with an income-type stream from coupon payments which is needed for asset-liability management, ii) a reasonable real rate of return for the credit risk taken on and importantly iii) equity portfolio protection due to its high negative correlation. The latter is achieved through the liquid repricing or the bonds value with a change in demand and/or interest rates. When we consider replacing our Fixed-Income portfolio, we must replicate all three characteristics described above. A future piece will provide insight into how we replace our Fixed-Income portfolio.

Given that we traditionally receive a reasonable, positive real rate of return for lending to companies and countries in addition to liquid bond holdings benefiting from drops in interest rates, we believe that there is a positive return expectancy within the overall market. Chart 1 below shows the increasing nature of this marketplace over the medium-long term. An ‘X’ was placed just before the previous two equity market crashes.

Chart 1: IEF’ ETF [7-10-year US Government Bonds] Price Since 2002


Source: Elkstone Private, Bloomberg

FIXED-INCOME MARKET’S STRUCTURAL CHANGE

A primary reason why bonds exhibited an equity protection characteristic is due to its traditional risk-on, risk-off relationship. During times of higher risk, market participants would take money out of their equity portfolio and put it into the safer bond portfolio. During times of lower risk, market participants would withdraw funds from their bond portfolio and put them into their higher risk equity portfolio. This direct relationship caused a high negative correlation which gives bonds its equity protection characteristic. There has been a structural change from this relationship since the Global Financial Crisis [GFC] where a new market participant, the Central Bank, stepped in and had three important affects: i) they provided liquidity into the market which got invested in the equity markets, ii) as they provided liquidity which went into the equity markets, they also enacted their Quantitative Easing [QE] program where they directly bought bonds and iii) they dropped interest rates down to near 0%. These Central Bank actions affected the traditional reasons to have your fixed-income portfolio as real rates of return and the equity protection characteristics were significantly affected.

Central Bank intervention has had another affect on the bond markets which is worth noting. We believe that investors are not getting fair rate of return for the actual credit risk being taken on. In the Covid-19 drop, the US Central Bank increased its bond purchases by directly buying corporate bonds and ETFs. Chart 2 below shows the US High Yield Corporate rate minus the US Government 10-year Bond rate. The noticeable difference between the level that High Yield rates got to versus the GFC is evident from central bank actions. As we stand today, the High Yield spread is at all-time lows despite ongoing covid concerns. Given the high inflation figure we are witnessing from all this money supply increase, even High Yield bonds are producing negative real returns for the first time ever. It’s difficult to argue against the statement that investors are currently not getting a fair rate of return given the credit risk they are taking on.

Chart 2: US High Yield Corporate Spread Since 1997


Source: Elkstone Private, Bloomberg

FIXED-INCOME MARKET OUTLOOK

As noted earlier in the piece, we believe there is positive return expectancy due to a traditional positive real rate of return and the tailwind of interest rate drops. The structural changes mentioned above have significantly affected the real rate of return. The other element is the interest rate level. A drop in interest rates positively affects liquid bond holdings and a rise in rates negatively affects bond holdings. Chart 3 below, shows the fed funds rate and the US Government 10-year bond yield over the past 30 years. We have witnessed a persistent decrease in interest rates over this period and sit near an all-time low in Government 10-year yield while we are at 0% in fed funds rate. The tailwind that supported liquid fixed-income portfolio price increases over the past 30 years looks to be dying off. The probability is low that rates will be persistently low or negative over the medium-long term. Once the FED decides to ease expansionary monetary policy there really is only one way for rates to move (up) and that will have a negative effect on fixed-income pricing. Once again, an ‘x’ was marked just before the previous three major equity drops.

Chart 3: Fed Funds Rate & US 10-year Bond Rate Since 1992


Source: Elkstone Private, Bloomberg

CONCLUSION & FURTHER THOUGHTS

We are guided by our investment philosophy, and it is based on that philosophy that market, strategy and investment vehicle decisions are made.

Explainable Positive Expectancy

Does liquid fixed-income market’s systematic risk have positive return expectancy?
In our opinion, traditionally, yes but currently no due to negative real yields and interest rates down near the floor. Due to this opinion, we prefer to not utilise ETFs for exposure to systematic risk within the traditional liquid fixed-income markets.

We do however carry out research into accessing liquid, Fixed-Income’s systematic risk of other countries. Here, we search for markets that have had significantly less central bank intervention.

We are a fan of using direct lending to bring us in a fair positive real yield given the credit risk we are taking on and we utilise different strategies and markets to replace the other characteristics a traditional, liquid fixed-income portfolio provided which we will discuss further in a later research note.

RELATED RESEARCH

Liquid Equity Market Investing: Passive or Active?

Liquid Alternatives: Traditional Commodities

Zero Lower Bound Monetary Policy’s Effect on Financial Asset Correlations

An ‘Alternative’ Safe-Haven

ABOUT THE AUTHOR

Karl Rogers is the Chief Investment Officer of Elkstone Private. Elkstone is a family office managing the wealth of its principals, with a focus on real estate, venture and alternatives, and a Multi-Family Office, regulated by the Central Bank of Ireland, which provides both access to co-investing in our principals’ investment portfolios and traditional family office services to many of Ireland’s entrepreneurs and HNWIs. Previously to Elkstone, Karl was a Managing Partner with Athlon Family Office, Head of US Power Trading with RISQ, Managing Director of ACE Capital Investments, a hedge fund manager and a proprietary commodity trader.

Karl currently sits in the adjunct faculty for Trinity College Dublin’s M.Sc. in Finance program where he is both a guest lecturer in their alternative investment module and supervises the student’s theses and he is a Special Advisor to the ESG Foundation.

Karl has been referenced in major industry publications including the Wall Street Journal, Bloomberg and the Financial Times and has spoken at numerous family office and alternative investment conferences across multiple continents.

Connect with Karl on LinkedIn.