Investment Tips on a Subzero Yield Environment
Worried about what the growing amount of global debt with sub-zero yields means for your portfolios? Virtus investment professionals tackle the investment and economic implications.
Grappling with the possibility of negative interest rates and lower-for-longer scenarios, advisors must decide how they build a portfolio that balances client needs for inflation-protected income and growth over time without requiring they take on more risk than they can handle.
Talk about a tough juggling act! If government debt yields continue to shrink and equities have too much volatility, how should advisors and clients view the prospects of negative yields? Here’s a roundup of Virtus viewpoints.
That being said, I continue to believe that investors looking to protect their investments from inflation will fare better in spread product compared to investing primarily in US Treasuries and agency debt.
Concerning the Fed’s monetary policy response to the global credit crisis over the past decade (lower rates and balance sheet expansion) pushed financial asset prices higher, but growth in the real economy, while positive, lagged.
In the down phase of a credit cycle, economic growth collapses and defaults increase. Then the economy recovers. During the 2008 credit crisis, there was no debt purge. When the government took over Fannie Mae and Freddie Mac, two things happened:
1. Consumer debt declined, but...
2. Government debt increased.
The government also intervened in the financial sector. Both caused a huge build-up of government, and thus total, debt. As a result, financial markets rallied, but the ever growing debt burden hindered economic growth. Now that we are in the latter phase of the cycle again, but with a lot more total debt, the economy is very sensitive to interest rates. This plus waning demand for capital is suppressing the level of interest rates.
We expect this to persist and it will support our strategy.
In tandem with the recent decline in government bond yields, credit spreads widened with weaker equities. We were prepared. As credit spread investors, we dialed back our overall spread exposure by about one-third versus our historical averages. We now have ample capacity to increase our exposure to select spread sectors with high (and certainly not negative) yields.
The current environment doesn’t change the philosophy or process we have honed after 27 years of managing the same strategy with many of the same people in place. We continue to stay diversified, and will continue looking to uncover undervalued opportunities across the fixed income markets using our relative value, sector rotation approach to generate excess returns relative to U.S. Treasuries. Most importantly, we’ll do so with an eye on controlling and managing risks as evidenced by the strong Sharpe Ratios and Sortino Ratios across our multi-sector suite.
Global supply of bonds with negative yields hits $16 trillion
Data as of August 14, 2019
Chief Investment Officer, Chairman
Seix Investment Advisors
During the global financial crisis, I formulated our lower-for-longer thesis; i.e., rates would go to levels not seen in modern history and stay at those low levels for a very, very long time, as U.S. policymakers waited too long to deal with the debt bubble and opted for Japan-like stagnation. I said that the 10-year U.S. Treasury would go below 1% and the 30-year would be below 2% and everyone thought that I was crazy. Now people are talking about negative long-term rates as global central banks ease monetary policies. The repercussions could be very painful.
I also expect the Fed will take rates to zero and do more quantitative easing, but it will not help the economy—it could be deflationary. It is becoming more and more obvious that monetary policy is impotent and just creates asset inflation and inequality, which leads to populism politically. I remain of the view that the best place to be until this repricing of risk assets occurs is in U.S. Treasuries and precious metals. Once this major repricing occurs and stocks and credit are much cheaper, money will move from Treasuries (and interest rates will rise) into risky assets again. If there is not a major repricing of risk assets, inequality will likely worsen, and the populist pendulum could swing to the left, but not likely for the 2020 election (2024?). President Trump should win re-election unless a full-fledged recession incites voter backlash.
The bottom line: monetary policy cannot solve the structural problem upon us; it only buys time, and unfortunately Federal Reserve policymakers who followed the Greenspan/Bernanke playbook have exacerbated the situation as America’s aging population weighs more heavily on the economy.
Treasuries rally amid surging global demand
Data as of August 13, 2019
The 10-year yield fell below the two-year first time since 2007
Data as of August 14, 2019
Chief Investment Officer, Portfolio Manager
Kayne Anderson Rudnick
Instead of warning about higher yields and the impact on bonds, the real question should have been how on earth can a retiree or someone who needs income sustain this in a deflationary global environment. We started our global dividend strategy eight years ago for exactly this reason, with only a little more volatility, especially given the potential to pick up attractive yields with some growth over time in companies where we believe the dividend is extremely sustainable.
Fed model says buy stocks while yield curve warns of recession
Data as of August 7, 2019
Sustainable Growth Advisors
For a variety of reasons including: aging populations in large economies; populist-driven limitations on immigration; and most notably, high levels of debt, global growth has been and likely continues to be scarce for the foreseeable future, which in turn secularly pressures interest rates.
Thus, an appropriate balance of equity exposure in the form of growth companies that are “cash flow compounders” is necessary to achieve the appreciation required to cover future liabilities and create future wealth. The challenge in assuming equity exposure is of course to identify companies that can sustainably deliver growth; durably generate and return cash to shareholders (rather than through merely levering up the company’s balance sheet); and do so in a resilient manner with muted sensitivity to macroeconomic, political and trade-related volatility. As all three of these recent volatility drivers seem poised to persist for the next couple of years, we would question whether passive strategies that involve indiscriminate buying can achieve these objectives.
We employ a team-based process that selectively identifies highly-differentiated, secular growth companies that can reliably deliver cash flow growth. We then invest only in those which are attractively valued on the basis of cash flow. The result has been a long track record of strong upside capture and superior downside protection.
Debt as share of GDP at end of Q1 2019
Source: Institute of International Finance
Chief Investment Officer, Senior Portfolio Manager
Ceredex Value Advisors
Relative to the Fed model and/or nominal or relative yields, equities are a bargain! I would much rather own a business that generates free cash flow and has some modicum of growth than a bond at current yield levels. Against that backdrop, Ceredex does massive amounts of fundamental work to identify undervalued companies with upside potential in these strange times in the market.
Managing Director, Head Of Leveraged Finance
Seix Investment Advisors
We’ve been investing successfully in a declining rate environment for the majority of the last decade in the leveraged loan market. Returns are always driven by credit fundamentals first and foremost, not LIBOR levels. As rates have declined, we have already seen the return of LIBOR floors and I would expect that to continue.
With projected 2019 GDP of 2.3%, very similar to the average over the last ten years, companies can continue to grow into their balance sheets and delever. Naturally, there will be exceptions, which is why active management is needed to weed out the low quality, over-levered companies from our portfolio and that has been a hallmark of our investment process at Seix Investment Advisors.
Leveraged Loans Offer Compelling Yields in Current Market Environment
Source: Bloomberg Barclays, JPMorgan, Credit Suisse. As of 6/30/19. Yields above represented by the Bloomberg Barclays U.S. Treasury Bills 1-3 Months Index. Bloomberg Barclays U.S. Treasury Bellwethers 5 Year Index, Bloomberg Barclays Asset-Backed Securities Index, Bloomberg Barclays CMBS Investment Grade Aaa Index, Bloomberg Barclays U.S. Mortgage Backed Securities Index, Bloomberg Barclays U.S. Corporate Investment Grade Index, Bloomberg Barclays Municipal Bond Index (assuming 37% tax rate), Bloomberg Barclays U.S. High Yield Index, J.P. Morgan Emerging Markets Bond Index Plus, and Credit Suisse Leverage Loan Index.
While the rate environment may be worrisome, high quality high yield does have a place in portfolios next to dividend stocks and bank loans for an investor looking to minimize volatility relative to the broader market.
What attracts investors to high quality high yield is being paid while they wait, but there is also a built-in catalyst in that the bond matures (obviously more of a factor for shorter-date bonds). The key is putting together a diversified portfolio of high quality high yield bonds of issuers that have levers to pull to meet debt maturities, even if the high yield market is not available for a refinancing. We refer to the levers a company can pull to generate liquidity as our margin of safety, and that is something we spend a considerable amount of time trying to understand in our analysis. We believe this level of analysis should keep defaults at a minimum while providing the potential for solid risk-adjusted income.
One thing to know about broader high yield is that valuations suggest you want a barbelled portfolio of BBB’s and CCC’s (i.e., anything credit intensive, including pretty much the entire energy sector). BB’s are trading at historical tightness compared to BBB’s (not duration adjusted – BB’s are shorter and BBB’s are longer relative to other times we have been at this level). We have been looking to trade from BB’s that have poor convexity and buy BBB’s that have a better structure where it makes sense being very careful to avoid BBB’s that could be coming our way via downgrade.
As the head of distribution of a multi-manager firm with a wide range of offerings and portfolio managers with different views—no house view—I feel most comfortable following this course:
- Help FAs build broadly diversified portfolios and tilt toward caution.
- Look for the big vulnerabilities; e.g., bloated risk budgets (too much in equities or credit), excessive reliance on passive and indiscriminate investing vehicles (index funds/ETFs for equities and fixed income), home bias.
- Given richly priced markets and weakening global growth, look for most risk-averse options within each asset class you are diversifying to. Seek out managers with full market cycle experience and records of superior risk-adjusted returns who respect stewardship and respect loss avoidance. In this regard, we have more than 25 funds with these attributes.
Performance data quoted represents past results. Past performance is no guarantee of future results
The commentary is the opinion of the subadvisers. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Opinions represented are subject to change and should not be considered investment advice or an offer of securities. Forward-looking statements are necessarily speculative in nature. It can be expected that some or all of the assumptions or beliefs underlying the forward-looking statements will not materialize or will vary significantly from actual results or outcomes.
DISCLOSURES AND INVESTMENT DEFINITIONS
The Bloomberg Barclays U.S. Aggregate Bond Index measures the U.S. investment grade fixed rate bond market. The index is calculated on a total return basis.
Bloomberg Barclays U.S. Corporate High Yield Bond Index is an unmanaged market value-weighted index that covers the universe of fixed rate, non-investment grade debt.
The Bloomberg Barclays U.S. Corporate Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by U.S. and non-U.S. industrial, utility, and financial issuers that meet specified maturity, liquidity, and quality requirements.
Credit Suisse Leveraged Loan Index is a market-weighted index that tracks the performance of institutional leveraged loans.
The Russell 2000® Index is a market capitalization-weighted index of the 2,000 smallest companies in the Russell Universe, which comprises the 3,000 largest U.S. companies. The index is calculated on a total return basis with dividends reinvested. The index is unmanaged, its returns do not reflect any fees, expenses, or sales charges, and is not available for direct investment.
Bloomberg Barclays U.S. Mortgage-Backed Securities (MBS) Index measures agency mortgage-backed pass through securities (fixed-rate and hybrid ARM) issued by GNMA, FNMA, and FHLMC. The index is calculated on a total return basis.
Bloomberg Barclays U.S. Treasury Bill 1-3 Month Index is an unmanaged index which includes all publicly issued zero-coupon U.S.Treasury Bills that have a remaining maturity of less than 3 months and more than 1 month Bloomberg Barclays U.S. Treasury Bellwethers indices track on-the-run U.S.Treasury issuance for the 3m, 6m, 2y, 3y, 5y, 10y, and 30y issues.
Bloomberg Barclays Asset-Backed Securities Index include pass-through, bullet, and controlled amortization structures. The ABS Index includes only the senior class of each ABS issue and the ERISA-eligible B and C tranche. Bloomberg Barclays CMBS Investment Grade Aaa Index is the Aaa component of the CMBS: ERISA Eligible index, which includes investment grade securities that are ERISA eligible under the underwriter’s exemption.
Bloomberg Barclays Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market.
J.P. Morgan Emerging Markets Bond Index Plus (EMBI+) is a traditional, market capitalization weighted USD denominated sovereign emerging markets index with a unique liquidity ranking methodology to provide investors with the most liquid set of issues within the asset class.
The S&P 500® Index is a free-float market capitalization-weighted index of 500 of the largest U.S. companies. The index is calculated on a total return basis with dividends reinvested.
The indexes are unmanaged, their returns do not reflect any fees, expenses, or sales charges, and is not available for direct investment.
Credit Ratings noted herein are calculated based on S&P, Moody’s and Fitch ratings. Generally, ratings range from AAA, the highest quality rating, to D, the lowest, with BBB and above being called investment grade securities. BB and below are considered below investment grade securities. If the ratings from all three agencies are available, securities will be assigned the median rating based on the numerical equivalents. If the ratings are available from only two of the agencies, the more conservative of the ratings will be assigned to the security. If the rating is available from only one agency, then that rating will be used. Ratings do not apply to a fund or to a fund’s shares. Ratings are subject to change.
Default Rate is most commonly referred to as the percentage of loans that have been charged off after a prolonged period of missed payments. Defaulted loans are typically written off from an issuer’s financial statements and transferred to a collection agency. In some cases, a default rate may also be a higher interest rate charged to a borrower after a specified number of missed payments occur.
Alpha is a risk adjusted measure of an investment's excess return relative to a benchmark. A positive Alpha indicates that the investment produced a return greater than expected for the risk (as measured by Beta) taken.
Beta is a quantitative measure of the volatility of a given portfolio to the overall market.
Sharpe Ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk.
Sortino Ratio measures the risk-adjusted return of an investment asset, portfolio, or strategy. It is a modification of the Sharpe ratio but penalizes only those returns falling below a user-specified target or required rate of return, while the Sharpe ratio penalizes both upside and downside volatility equally.
IMPORTANT RISK CONSIDERATIONS
Credit & Interest: Debt securities are subject to various risks, the most prominent of which are credit and interest rate risk. The issuer of a debt security may fail to make interest and/or principal payments. Values of debt securities may rise or fall in response to changes in interest rates, and this risk may be enhanced with longer-term maturities. High Yield-High Risk Fixed Income Securities: There is a greater level of credit risk and price volatility involved with high yield securities than investment grade securities. ABS/MBS: Changes in interest rates can cause both extension and prepayment risks for asset- and mortgage-backed securities. These securities are also subject to risks associated with the repayment of underlying collateral. Geographic Concentration: A fund that focuses its investments in a particular geographic location will be highly sensitive to financial, economic, political, and other developments affecting the fiscal stability of that location. Industry/Sector Concentration: A fund that focuses its investments in a particular industry or sector will be more sensitive to conditions that affect that industry or sector than a non-concentrated fund. Foreign & Emerging Markets: Investing internationally, especially in emerging markets, involves additional risks such as currency, political, accounting, economic, and market risk. Municipal Market: Events negatively impacting a municipal security, or the municipal bond market in general, may cause the fund to decrease in value. State Tax & AMT: A portion of income may be subject to some state and/or local taxes and, for certain investors, a portion may be subject to the federal alternative minimum tax. Bank Loans
Loans may be unsecured or not fully collateralized, may be subject to restrictions on resale and/or trade infrequently on the secondary market. Loans can carry significant credit and call risk, can be difficult to value and have longer settlement times
than other investments, which can make loans relatively illiquid at times. Derivatives: Investments in derivatives such as futures, options, forwards, and swaps may increase volatility or cause a loss greater than the principal investment. Leverage: When a fund leverages its portfolio, the value of its shares may be more volatile and all other risks may be compounded. Liquidity: Certain securities may be difficult to sell at a time and price beneficial to the fund.
Please carefully consider a fund’s investment objectives, risks, charges, and expenses before investing. For this and other information about any Virtus mutual fund, contact your financial representative, call 1-800-243-4361, or visit Virtus.com for a prospectus or summary prospectus. Read it carefully before investing.
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