This is the first part of a two part article that evolved from my efforts to establish for myself a "lower if not low risk" income stream for the upcoming 3-5 year period. While none of us can predict the exact timing of the turn in interest rate policy, it is clear that these historically low interest rates will not persist indefinitely and that we may be closer to the end of the "zero interest rate policy" or ZIRP than the beginning. I view this policy shift as representing the most significant risk for traditional savers at this time.
The thesis of this article is that investing will become much more difficult, especially for fixed income investors, once the tailwinds of decreasing interest rates become the headwinds of increasing interest rates. I write this article, not because this is unknown to most readers, but it has appeared to me that many fellow investors with whom I discuss investing seem to be insufficiently concerned about this looming change. Many traditional savers, who have typically relied on government and municipal fixed income securities, will be at greatest risk of capital impairment as we move into a period of secular rising interest rates. Once interest rates begin to rise, we will not be back to this "place" (historically low interest rates) again for a long time, certainly not in my lifetime.
The purpose of this article is two-fold:
The first purpose of this article (covered in Part 1) is to stimulate a rethinking of how retail investors should invest for income in both the upcoming 3-5 year period as well as longer term. Over the past half decade, there have been a number of changes in the environment of fixed income investment. Individually, they may not seem significant; however, collectively they represent a significant shift in the landscape of fixed income investing. I believe that these changes require new investment approaches.
The discussion of this first purpose can itself can be broken into two elements:
The first element discussed relates to zero interest rate policy (ZIRP) and how ZIRP has impacted savers, both by reducing significantly income from fixed income investments as well as by driving the asset prices of nearly every asset class to very high levels. This is especially true of "traditionally safe" fixed income investments on which retail investors have traditionally depended for much of their income. These asset classes have become significantly more risky over the past period and fixed income investors need to begin to view these types of investments differently as the underpinning (historically low interest rates) for those valuations begins to change.
The second element or risk to "traditional savers" is the changing environment on how creditors and bondholders are being treated relative to competing interests. Changes in attitude towards balancing the interests of lenders and borrowers have created new risks that many retail investors may not have recognized, with a shift to a more borrower-friendly attitude which is detrimental to lenders and savers.
While these individual developments are not news to many investors or readers of Seeking Alpha, the author has read much less about the confluence of these factors and urges the reader to reflect upon the implications of this confluence of rising interest rates along with a deteriorating climate for savers and lenders.
A special factor complicating effective decision making is the inexperience that both investors and financial advisors will have had in investing in secular rising interest rate environments, which we have not seen since the early 80s. Unless you were born before 1960, your entire investing career will have been in a declining rate environment. The experience gained during that period may not be appropriate when rate policy changes and the flow of declining rates becomes an ebbing of rising ones. I realize that "This Time, It's Different" are the four most dangerous words in investing; however, I do believe that "This Time, It's Different… For You" may well apply here as many readers will have never invested in an environment similar to what we are about to experience.
The second purpose of the article (covered in Part 2) is to suggest methods on "how to protect yourself", offering potential approaches (one Rule and a few Tactics) that will help to better "weather the coming storm" as well as suggest some approaches that should be avoided. In order to recapture income lost by reducing "traditionally safe" instruments, the author will suggest some tactics that can be used to restore income while continuing to manage risk.
Specifically, the author will suggest six approaches, offered to be used as diversification alternatives to "traditionally safe" investments, to lower risk portfolio while still generating acceptable income:
- Encourage investors to use diversified approaches given the highly unpredictable, turbulent markets as we move into a new, rising rate environment (think "taper tantrum" as an example).
- Shift investments away from some types and jurisdictions of municipal bonds to reduce the uncompensated risk that has developed in this sector,
- Shift from "traditionally safe", long maturity, fixed income instruments to variable rate instruments,
- Shift from "traditionally safe", long maturity, fixed income instruments to shorter overall maturities and, in addition, use ladders to remove significant maturity risk from the portfolio ("limit and ladder"),
- Shift a portion of the traditionally safe, "fixed income" instruments to the "higher income" securities; and
- Take advantage of the much higher income offered from some options to reduce the risk of the entire portfolio by increasing the cash portion of the portfolio (barbelling the portfolio).
As with the discussion of risks, few of these tactics will be new to SA readers, but the combination and overall approach might stimulate a re-examination of the fixed income portion of portfolios as well as provide some thought starters for other, perhaps less conventional approaches, to address a "once in a half-century" challenge.
II. The Changing Landscape:
Please find below a headline summary of issues creating an ever more challenging environment for "traditional savers". For the sake of brevity, I raise each point without extended discussion; for those points of particular interest to any reader, they will have the opportunity to pursue further research on their own. Many of these points have been discussed in other well-written articles and require no restatement here. The point of the article was to highlight the confluence of these factors, not to describe each in detail. The number of issues suggests a rising risk level, just by summing of the individual risks identified. However, one thesis of this article is that the confluence and interaction of these factors will increase the impact on investors beyond a simple sum of the individual risks, creating a yet higher risk environment.
A. The Punishing Impact of ZIRP
ZIRP may have helped the economy, but it has been a punishing policy for small investors. Economists and policymakers continue to argue that it is necessary to prop up the economy; be that as it may, it continues to punish those who provide the savings and capital stock to the economy and rely on reasonable investment income as a key part of their income. The policy is in its sixth year with some suggestions that the policy could change in June or September 2015 (just prior to article submission, speculation heated up that it would be sooner versus later due to a relatively strong jobs report).
Income investors need to forget the pressure that ZIRP has put on them so that bad investments are avoided. One doesn't need to invest in something to generate more income (i.e., push out maturity to capture higher rates and income), only to have the capital for that investment impaired significantly as rates change direction. One does need to make sure that any investment made at this point can reasonably continue to provide steady income at existing market levels without resulting in a long term or permanent impairment of capital. Small investors need to look forward, not backward, and worry about the next challenge, not the last one.
Emerging from the analysis of valuation impact of upcoming interest rate increases was a strategy and a decision for my accounts to avoid significant losses from those increased interest rates, even if smaller losses would still be absorbed using alternative investments. In this way, a "knockout punch" from interest rate changes is avoided, even if smaller impairments occur from the diversified asset risks that are substituted. ZIRP has driven up the values of nearly all assets, creating risks for those same asset classes once interest rates begin to reset "back towards normal". My strategy is to be hurt in several, little ways (e.g., higher than average defaults on bank loans) rather than be devastated by what is the central risk of 2015.
If there was ever a time to pay heed to that brilliantly whimsical description by Jim Grant, "return-free risk", it is now. Return free risk is approaching historic highs.
(While I was writing this article, Robert Shiller issued a warning about a debt bubble. Having predicted two bubbles already, this third warning should warrant appropriate attention.)
B. Investor Confidence Undermined by Volatility
While this element may not create losses per se, the anticipated volatility, often observed at times of change in trend, will undermine small savers' confidence in their investments.
If there is doubt about volatility at the point of trend change, then just go back to look at the markets during the time of the "taper tantrum". Even if that volatility was due to a "head fake" by the markets, volatility increased significantly during that time. Investors will be dealing with high volatility as well as trends changing unfavorably for them, if they are still holding vulnerable investments (i.e., long-term, fixed income debt). Even if these "head fakes" do not result in paper losses, the resulting volatility will erode many investors' confidence in their investments, accelerating reduced valuations beyond the impact of interest rates.
Investors who have confidence in their approach (i.e., their investment positions) will be less likely to be stampeded out of their positions at unfavorable prices; on the other hand, sales of securities under duress will likely result in an impairment of portfolio value which cannot be afforded.
C. Increased Uncertainty in Municipal Bond Investments Due to Legacy Pension Liabilities
A recent, excellent article in the National Law Review discussed learnings from the recent Detroit and Stockton municipal bankruptcies. Needless to say, creditors did not fare well in these proceedings, even when they were nominally senior to or "pari passu" with the pensions. In these cases, creditors became de facto junior to the pensions even if these securities were equivalent to or senior to the pension funds as issued.
If you are investing in municipal bonds, it would be worth reading this article (or articles like it) to understand "where you stand" relative to other competing interests in the case of a liquidation. Quoting from the article, "In Detroit, the settlements and compromises in the plan resulted in treatment of unsecured pension creditors that was generally more favorable than the treatment of unsecured bondholder and other unsecured financial creditors."
In moving forward, municipal bond investors must consider pensions owed state workers as senior to senior unsecured claims for General Obligations of the State, regardless of what the prospectus has claimed about the seniority of bond claims versus other creditor classes or the legal precedents. While perhaps not establishing a legal precedent, given some of the nuances of the cases, these are the practical implications established in both the Detroit and Stockton cases.
There are specific jurisdictions which have sizable legacy pension obligations which put the municipal bonds at risk. Illinois is one state which has a sizable pension obligation that, along with other obligations, is putting significant pressure on the finances. If I owned Illinois GO municipal debt, I would begin to reduce that level of ownership (but no need to panic or dump instruments at unattractive prices) for those securities, as this is a prime candidate for municipal debt owners to be hurt due to changed priority for pension liabilities versus creditor liabilities. The tax advantages for municipal debt do not outweigh the risks for the significant impairment that may result from owning certain states' GO debt.
Recommendation: Investors can no longer put their municipal bond investments on autopilot. If you are a direct owner of municipal debt, you will need to keep yourself informed as to the status of the individual state's conditions. Some are in acceptable shape; however, there are a significant number of states that are being stressed by the current state of the economy, legacy obligations and low tax revenues. In addition, those states with legacy obligations will have increased significantly in risk due to the recent court precedents regarding the seniority of those obligations as compared to obligations to bond creditors. Barron's has periodical analyses of the "state of the state" finances, which you should be reading (or something like it) if you hold a significant percentage of your assets in municipal debt. If you don't want to do this level of work, use closed-end funds or avoid municipals altogether.
D. Bond Issuers "Changing the Rules after the Game is Played"
Puerto Rico has recently (June 2014) changed the security standing behind the municipal debt used to capitalize the Puerto Rico Electric Power Authority (PREPA). The government of the state has done this unilaterally, rather than renegotiating the backing of these bonds or calling them in and reissuing new bonds with reduced security standing behind them.
Recommendation: When any jurisdiction changes significantly the basis under which any of their securities have been issued, sell all of their securities. Changing the rules unilaterally after the game is played is a sign of an unreliable debtor (as well as one preparing to default); as such, you don't want to own any of their debt, even if your tranches are not yet affected. Unless you are an experienced "distressed creditor", for which this article is not targeted, get out of Puerto Rico municipal debt (this recommendation is a couple of years late) and, more to the point of this section, any jurisdiction which begins to "change rules unilaterally" should be avoided or sold. Honorable creditors live up to their agreements and negotiate fairly to address agreements where the terms cannot be met; on the other hand, honorable creditors do not arbitrarily change rules or cram down changes of terms ex post facto. Protect yourself.
E. Governments, Regulators and Academics Attempt to Address TBTF by Promoting "Unbalanced" Debt Instruments, Unreasonably Favoring All Parties Except the Instrument Owner
Governments have an obvious need to address Too Big to Fail (TBTF). A key issue is increasing the amount of equity and managing leverage at the banks as a way to ensure adequate capitalization to take future "hits" from future crises while avoiding taxpayer-funded bailouts. I support 100% this effort on their part to avoid an implicit government guarantee for banking activities and avoid future bailouts.
Unfortunately, one of the proposed solutions are securities to be issued by banks called Contingent Convertible Bonds. I have already written an article on this subject and there is no desire to republish the article. Suffice to say that these are securities that have "all the qualities of a bond, except security"; that is, they carry bond growth potential (none) and bond returns (LOW) while carrying equity risks (high relative to that compensated for by the coupon). In a misguided effort to address what is indeed an important issue, this proposed solution by regulators and academicians is very unbalanced, excessively favoring borrowing banks and lenders, while nearly ensuring that the lenders will lose their money either through interest rate risk (recommend perpetual status on fixed coupon securities) or default risk (these are suddenly converted to equity, in some cases by regulators using obscure standards) while describing these securities as "bonds", which they decidedly are not (when it counts).
Recommendation: Avoid these instruments unless you can get equity returns (9%+) on the coupon to compensate for the underlying equity risk. Better yet, just avoid them altogether. The preferred shares of banks are vastly preferable to these instruments.
F. Impact of Influential Policymakers Driving Unbalanced, Pro-Debtor Policies at the Expense of Creditors
Some may take issue with my characterization, but it appears that there is a broad effort on the part of academics to "support the economy" by staking out excessively pro-debtor, anti-creditor policies. While this might be positioned as a noble effort to revive the economy, and one needs to give their motives the benefit of the doubt, the "shoot first, ask questions later" has evolved into "expunge debt now, and don't worry about the economic impact upon creditors".
In a letter to the Financial Times, Professors Stieglitz, Pissarides, Goodhart and Miller wrote about the need for debt relief for Greece. In this letter, they commented that support for debt relief was an ethical and pragmatic (my emphasis, to which we will return briefly) stance. They went on to propose: an increase in the grace period for five years, outright debt reduction, and significant additional money for supporting growth of the economy, targeting exports.
In other articles, another prominent economist has bemoaned the inability for Argentina to unilaterally "cram down" more favorable terms on the remaining creditors who have not yet accepted modified terms for their debt.
I do not plan to argue with prominent economists about whether debt relief, with the stimulus provided to the debtors and a concomitant economic blow to the creditors, would net out as either an economic or social good to the world's economy. If I were, I would likely point out that Ireland, who embraced austerity and managed their liabilities responsibly, is doing the best of all of the impacted PIIGS countries. Alternatively, I might point out that not only will debt relief provide some space for a "government intent on pursuing reforms - challenging corruption and tax evasion" (from the FT letter), but will provide equal relief for a government that has absolutely no real intention of doing so. However, that is not an appropriate scope of discussion for this article.
What is not arguable is that these policies will have extremely negative impacts on those creditors who originally attempted to help those countries and organizations by lending them money. Academics and policymakers have recently fallen all over themselves to promote the concept of "debt relief", encouraging at every turn that every modern problem can be solved by the creditor (usually described as hedge funds rather than retired investors) simply extinguishing the obligations taken on by those debtors. These are prominent people who will have the ear of government and organizations that, in turn, will be making policy decision on debt relief. There may be some philosophical argument or some macroeconomic theory that may result in a net positive for the economy if these "debt relief" paths are taken; however, it represents an unarguable negative for those who have done the lending. You need to keep yourself out of the way of this force, as creditors (you) are being viewed currently by regulators, policymakers and academicians as "mere" collateral damage, undeserving of their attention or concern. That some academicians view forced debt relief on creditors as "Ethical and Pragmatic" represents Exhibit One for this argument.
We have covered a number of new challenges for fixed income investors in this section. These challenges come from two general causes. The first cause is the historically low interest rates, providing meager returns while driving asset values very high. The second cause is a general shift in the balance of the interests of creditors versus other parties (especially public and private pensions); in turn, the pensions are critically underfunded in some cases due to those same low returns as well as reduced contributions to those funds. The confluence of these factors has made "traditionally safe" investments more risky, especially when one considers the very low returns being captured by those same investments. Approaches to be able to generate income while becoming less vulnerable to the very high, current risks of "traditionally safe" investments is the focus of Part 2.
Please remember the key rule for savers: Protect Yourself.
Disclosure: No guarantees or representations are made. The Owl is not a registered investment advisor and does not provide specific investment advice. The information is for informational purposes only. You should always consult a financial advisor.
Disclosure: The author is long GS-A, MFA.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.