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Introduction

 

Traditionally, fixed-income has been the ballast within a portfolio and not a source of alpha.  Yet, with the application of a systematic approach that actively rotates among traditional fixed-income securities, investors can discover a new source of potential return stream that may normally be overlooked.

For investors whose approach is passive,  the expectation of future returns from traditional fixed-income securities appears to be subpar at best.

In this post, I will discuss the background that is the motive for developing the new Cornerstone Income model and then in the next post, I will discuss the model in greater detail.

 

A Rising Rate Environment. Maybe.

The thesis for rising interest rates hardly needs repeating.

Interest rates have declined from 15% in the early 1980’s to practically zero in the recent past.  We know that this enormous tailwind to fixed-income securities cannot and will not be repeated.  Historically, high and declining nominal interest rates served as a powerful return stabilizer for fixed-income. However, with rates now at all time lows, the stabilizing impact of yield is reduced, and this income buffer may be insufficient to offset losses from rising rates.

At the same time that central banks have suppressed rates globally, they have issued a record amount of new debt that bears with it an ever-rising cost of financing (carry).  Central banks’ attempts to sustain the global recovery have left investors stranded in a low yielding and highly uncertain environment.

Now couple historically low interest rates with an out of control deficit.  In the U.S. alone, the current U.S. federal budget deficit is running $1T dollars and the U.S. debt/GDP is at 104%.  This implies a need to issue bonds to finance the out of control spending.

Typically, more supply (issuance) means higher yields for bonds.  The problem is that bond prices move inversely to interest rates.  As rates rise, bond prices lose in value.  And based upon current rates, a mere 1% increase in long-term Treasury rates could result in a 20% loss in price which would wipe out 7 years of income.

The bottom line is that there is little room left for interest rates to fall, and tons of room for rates to rise, creating an unfavorable risk/reward ratio.

Please note that I am not joining the chorus of analysts predicting that interest rates will rise.  Frankly, I do not know nor does anyone else.  The future is unknown.  I am simply pointing out that fixed-income investing is skewed unfavorably at this time and to invest in this asset class and be successful moving forward is going to take a different approach than what has been done over the last thirty years!

There are certainly arguments to be made that we could remained mired in low interest rates for awhile longer.  Given that the amount of debt in the system at all levels (government, corporate, and personal) is so high, even the slightest uptick in rates will have a drag effect on the economy because of the added cost to servicing the debt not to mention increasing the cost to borrow for homes and other large capital items.

Additionally, central banks are pulling back in stimulus. The Fed will, albeit slowly, keep raising rates and reducing its balance sheet and the ECB will end QE by the end of 2018. In short: In 2019 there will be a lot less artificial stimulus to go around as the cost of financing is increasing and earnings growth will be slowing down.

Again, this is not about making a forecast but more about addressing the process to how investors approach fixed income securities.

So investors have two options.  Do what has always been done and hope that it works out ok or utilize a process that is designed to manage downside risk should it become necessary.

The choice is yours.

The more important point here is passive fixed-income investing appears very unattractive at this moment in time.  In an asset-class that many investors consider “safe’, the downside risk is high and the current returns being paid to accept this risk are paltry.

The risk-reward equation has become increasingly asymmetric amid rising bond valuations and concerns over reduced market liquidity.

And because today’s coupon yields are so low, bonds have an even greater sensitivity to any increase in yields.

Indeed, in this year alone, many passive fixed income ETFs show negative returns as the 10-Year Treasury has increased from 2.06% to a high of 3.11% over the past 12 months:

Exchange Traded Fund2018 YTD Performance
AGG-1.53%
IEF-1.86%
TLT-2.57%
BSV-.30%
BND-1.69%

Further, from an income perspective, the protracted and deepening low yield environment has forced a search for higher-yielding fixed-income assets, leading to an increase in the use of alternative credit. This has pushed investors up the risk spectrum, potentially conflicting with their risk reduction objectives.

Given these facts I believe a tactical fixed-income approach is more necessary today than it has ever been before.

An absolute return fixed-income strategy that focuses on extracting alpha and removing the impact of market performance on the return stream.

A strategy that aims to produce positive returns in all market conditions.

Which is exactly what I have designed for our new Cornerstone Income strategy.

The goal of the strategy is to provide investors with an alternative to making a passive bet with say something like AGG or BND.

The primary objectives are:

  1. Provide income (no miracles here…we ARE in still in a low interest rate environment).
  2. Preserve Capital during market declines and generate gains where possible.
  3. Protect against bond losses during periods of rising interest rates.

In my next post, I will discuss how Cornerstone Income has been constructed and how it might do in meeting these three goals.

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