The Death of Fixed Income
Alex Hansson ’13 (International Trade, Finance and Development) is an Analyst at Tribus Capital Partners in Zurich, Switzerland. Previously he was External Asset Management Analyst at Credit Suisse.
A few weeks ago I found myself sitting in the James Joyce Wine Cellar in Zurich listening to a talk by the Chief Investment Officer of one of the world’s largest asset managers’ fixed income division. Surrounded by ageing wine bottles and Swiss bankers in grey suits, the CIO put down his glass of Chateau Neuf du Pape and proclaimed, “You know, I’ve been investing in fixed income all my career, but I feel obliged to tell you that fixed income as an asset class is dead.” That was the last sentence of the speech.
Now I don’t frequent too many of these events, but ending a presentation on that kind of a bombshell was not something that I’d ever experienced before. The Swiss bankers around me shifted nervously in their seats thinking something else was coming. But the CIO did not follow up the statement with any caveats. He was undoubtedly out to provoke and had we pushed him a little he would have most likely followed up his statement with the usual spiel that one should be careful with statements like ‘this time it is different.’ He would have probably added that fixed income in terms of developed markets sovereign and corporate bonds would at some point in the future again be an interesting investment.
Nonetheless, finding out fixed income was dead was pretty exciting. Moreover, the statement was in line with a trend I had been witnessing for the past couple months whereby capital was flowing into a new asset class – alternative fixed income.
But, before moving on to this, it is worth spending a few minutes on the death of fixed income, whether temporary or not. Classic portfolio management theory will tell you to put 60% of your assets in equities (e.g. at its most basic through a S&P 500 Index ETF) and 40% in bonds (e.g. at its most basic through a Bond Index) in order to achieve diversification and lower the portfolio’s volatility. Without getting too deep into the technicalities, the thinking goes that equities outperform bonds in the long run – hence the overweight. However, bonds are included because they lower the volatility and increase the diversification of the overall portfolio. They lower the volatility because they are less risky than equities. Moreover, bonds have historically moved inversely to equities and this diversification effect has served the purpose of smoothing out the return profile of a balanced portfolio in times of market turbulence. Seeing as, nearly all investors have regular liquidity needs for, for instance, a regular mortgage payment, a smoother albeit lower return profile in the long run is more attractive than high volatility with a higher return in the very long run.
So what has changed? Norman Villamin (CIO Coutts) was recently quoted as saying that bonds used to offer an asymmetric payoff relative to equities whereas now you are left with a “symmetric asset class.” Put another way, bonds still serve the purpose of protecting capital when equities are down but no longer give you any meaningful upside. In other words by having 40% bonds you lower volatility but you no longer achieve diversification. Explaining exactly why, at least from a developed markets perspective, is not straightforward. Some analysts have highlighted that rates have been kept low to encourage lending given the slower than expected recovery in the US and Europe. Other analysts have pointed to lower inflation and central banks not feeling the pressure to increase rates. In any case, with very low returns you also have very low volatility. With low volatility even if this effect moves inversely to equities it will not be ‘strong enough’ to provide the desired counterbalancing effect. Think of two grown men on a seesaw where one gets replaced by a child, no matter how much the child jumps up and down on the plank, they will not significantly propel the man into the air. Whatever the reasons for this phenomenon, most seem to agree that a low rate environment will be the norm for some time to come.
Many investors realize that if rates remain low it will become more difficult to find bonds yielding attractive returns without taking on excessive risk. In terms of fixed income this generally means looking towards emerging market debt or distressed corporate bonds. To be clear some investors have successfully gone down this route, such as, Michael Hasenstab (CIO Franklin Templeton) who has became famous for his bullish speeches on Ukrainian debt. Nonetheless this dynamic has led to many investors leaving fixed income in favor of equities. That trend is clearly reflected by the fact that the largest fund by assets under management has over the last year shifted from the PIMCO Total Return fund (a fixed income product) to the Vanguard Total Stock Market Index (an equity product). The leaving of Mr. Gross from PIMCO no doubt also contributed to this shift.
With the recent prolonged bull market most investors have shut their eyes to the increased volatility and enjoyed the attractive returns they have seen from their portfolios. However, some sophisticated investors have elected not to move their fixed income exposure to equities. Some have chosen to put assets into well-known alternatives like private equity or real estate. But these asset classes do not offer the same advantages that fixed income did.
As outlined above fixed income was liked because, first, it was relatively low risk. Second, it paid a steady regular coupon, which was liked not just by private investors but especially pension and insurance funds, which have regular liquidity needs. Third, it paid a handsome return of anywhere from 5.00% to 8.00% (historically seen). To put that into perspective, a ten year German Government Bond pays you less than 1.00% currently. A private equity or real estate investment conversely can mean having to lock up capital for ten years, with no regular coupon payment, and with no guarantee for handsome reward.
Given this, many of these sophisticated investors have turned to a different asset class that has emerged largely as a product of new lending opportunities. It is often referred to as Alternative Fixed Income. These opportunities have to a large extent emerged as a product of new banking regulations. Simply put, banks have been forced to move away from certain types of lending and new non-bank credit providers have stepped in to fill this void offering new investment opportunities. Indeed, according to Alliance Bernstein, since 1980 the nonfinancial corporate and mortgage credit outstanding has grown by ca. USD 18.9tn whereof USD 15.0tn can be attributed to non-banks.
This trend of lending by non-banks has been accelerated largely as a product of post-crisis regulation. In Europe, the most important regulation framework for this trend has been Basel III. This framework stipulated that banks now have much higher capital requirements as well as having to take on higher operational costs for certain types of lending. This has been most pronounced for investments with longer investments horizons, which therefore cannot match bank-liability structures subject to daily liquidity requirements.
There are literally hundreds of structures that have emerged to take advantage of this systemic shift. The biggest opportunities for alternative credit providers have been in corporate loans, commercial real estate loans, residential real estate loans, and infrastructure loans. Many new organizations have been set up and are raising capital from investors in order to lend to corporations and real estate developers in the same way banks used to. The lenders pay a coupon on the loan, the new firms take a cut, and the investor gets a regular coupon payment at a tolerable risk and a much higher return than they would have in traditional fixed income.
This systemic shift has created opportunities along the entire supply chain of lending. It stretches from the most logical to the most niche areas you can think of, and no doubt this is just the beginning. Below I will give two examples of the most common constellations.
Most commonly you see new organizations made up of former bankers. They leave or are made redundant by their employer. They take with them an intimate knowledge of that bank’s loan book as well as the skillset to analyze other banks’ loan books. They then raise capital in a fund structure (funded by our sophisticated investors above) and begin buying loans from banks that can no longer be kept on their balance sheets. This can take many different forms. The easiest is a pure purchase at a discount where the new organization takes over the loan. Typically this happens via a Collateralized Loan Obligation (CLO) which is a securitized asset backed by a pool of debt. Another variety is a situation where banks have debt on their balance sheet which is highly attractive from a return perspective but which they cannot keep on their balance sheet. They therefore use something called Regulatory Capital Relief Trades (CRTs) in order to temporarily transfer risky assets off their balance sheets to one of these new organizations which in turn charge interest on the assets while on their balance sheets. Finally you have situations where the bank will give an organization access to their pipeline of loan opportunities. This setup is rarer and requires a very close relationship between the bank and the new organization. Essentially, these new organization can sift through bank’s pipeline of lending opportunities and chose to take on any loans they find attractive. In return the bank receives a share of the profits.
The other more common constellation of new organizations is direct loans that banks used to be able to do. Indeed, many of these organizations are whole teams that used to do the same thing at their former employers. A great example is Renshaw Bay. Renshaw Bay was setup by the former co-CEO of J.P. Morgan’s Investment Bank – Bill Winters. The firm runs a real estate strategy that is “focused on direct, whole loan origination of commercial real estate loans… and seeks to take advantage of the lack of financing available to real estate borrowers”. They also run a structural finance strategy, which looks to “capitalize on opportunities driven by regulatory change and the retreat of capital.” There are now new organizations (or old organizations which have seen a significant uptick in demand) that are doing the same thing in corporate loans, real estate loans, infrastructure loans, or even leverage loans to private equity firms.
It is still relatively early days and no one yet completely understands the full implications of this systemic shift. Perhaps the setup is better, seeing as you have more specialized niche players, often with much of their internal capital at risk, and unhindered by bureaucracy associated with banks running these new organizations. Or perhaps this setup is riskier, since at the same time you also have small, inexperienced, and at times highly leveraged organizations with less oversight then banks used to have. Added to this increasing numbers of pension funds and insurance companies are investing in these structures. Undoubtedly there will be some financial cowboys who have cut corners in order to have first mover advantage. At the same time you will undoubtedly have a lot of smart people who will make themselves and their investors a lot of money. Clearly, it is going to be very interesting to monitor these developments to see whether this shift turns out to be a good one or a bad one.