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Is Traditional Fixed-Income Investing ‘Broken’?

In the coming days, maybe weeks, we’ll learn whether President Trump nominates current Fed governor Jerome Powell or Stanford University economics professor John Taylor to replace Janet Yellen as Chair of the Board of Governors of the Federal Reserve System.

Yellen took office on Feb. 3, 2014, for a four-year term which is scheduled to end Feb. 3, 2018.

So, who will be the next Fed chief, and what happens to interest rates under a new Fed chief, and what advice do experts have for those saving for and/or living in retirement who want interest income?

“With Trump, you never know,” said Sameer Jain, a partner with ActiveAllocator.com. “Might be Powell, as our wonderful president is a bit of an iconoclast.”

But no matter whether it’s Powell or Taylor, or if Yellen stays on, Jain offered this observation: “Interest rates will be on an upward trajectory with good economic news, but I expect the Fed to continue to be detached, objective and not influenced by the appointment in any radical way. Lower interest rates make Trump look good in the short run.”

That said, Jain had the following advice for those seeking income in retirement. “Traditional fixed-income returns continue to remain low and outperforming efficient markets is difficult,” he said. “It is increasingly hard to ignore emerging fixed-income investing risks from interest-rate and credit-spread widening. I don’t see inflation as a risk at all. Investing passively in traditional fixed-income exposes investors to low expected returns, has little scope for capital appreciation, comes with significant interest rate risk, and forsakes opportunities in unlocking an illiquidity premium, as well as excludes niches in credit investing.”

With traditional fixed income, he said, reduced risk appetite is being expressed through a preference for holding shorter-duration assets, pursuit of interest rate neutral strategies and an expectation of a higher illiquidity premium. “This is an inevitable, albeit difficult to time, rising-rate environment,” he said.

Thus, he said, the best way to invest for retirement is not to think about fixed income as “fixed.”

“Traditional fixed income is broke,” said Jain. “Rather an investment thesis needs to have its basis 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.”

According to Jain, portfolios need to be constructed so that they are more resilient to economic downturns, to changes in credit and market risk and to macroeconomic conditions. “The idea being to preserve the attractive features of traditional fixed income — stable, consistent, predictable returns — but potentially mitigate its risks as well as provides opportunities for capital gains,” he said. “Any thesis for retirement savings should include elements of current income, low volatility and low correlation to other investments, and can provide portfolio diversification benefits.”

So, in the case of an interest-rate-neutral strategy, Jain suggested “anything that does not make or lose money.”

That would include, he said, such as interest-rate arbitrage within fixed-income sectors, or relative value within same sector equities (long/short), or statistical arbitrage within equities.

As for portfolios that are resilient, he suggested two types:

A long portfolio: “Anything that makes/preserves money when interest rates go up; TIPS, core real estate where rent increases are pegged to interest-rate increases, and many forms of real assets,” he suggested.
A short portfolio: “Anything that loses money when cashflows are discounted at a higher rate — as the base interest rate influences most asset pricing — such as for long-duration bonds, and sovereign bonds in less developed countries,” he said.