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Finding a fixed interest alternative

Updated: Feb 14, 2023

Central banks are destroying fixed interest as an asset class. The cycle of interest rate cuts and quantitative easing has decimated bond yields across the curve. As at the date of writing (17 August 2021), 10-year and 30-year German bunds are yielding -0.47%pa and -0.02%pa respectively.


There is no rational fundamental reason why an investor would buy a 30-year bond with a negative yield. Some investors are forced to allocate money to sovereign bonds and hence are captive buyers. Other investors are speculating that more central bank buying will push bond prices higher and hence are trading based on liquidity flows rather than fundamentals. No-one can come up with a fundamental reason why it makes sense to buy a bond that will return less in 30 years than the original outlay. This especially applies in the current market environment given the recent spike in inflation.


Recent monetary and fiscal stimulus initiatives have resulted in too much money chasing too few investment opportunities. The search for yield has also reduced yield spreads to near all-time lows. And this has occurred during a global pandemic!


How much lower can bond yields go? As I discussed in my research note The Scourge of Asset Price Inflation, central bankers – outwardly at least – seem to be largely unconcerned about asset price inflation and other market distortions resulting from artificially low interest rates and bond yields. Recently, however, CNBC reported that there is growing support within the Fed to announce the tapering of bond purchases later this month.


Regardless, there is a lower bound to bond yields (and hence an upper bound to bond prices). We’re not too far from that point in Germany with the prospect of institutions physically storing money being openly discussed. The concept of the reversal rate – the rate at which further interest rate cuts will be counterproductive – has also gained traction (although it has been largely dismissed by the ECB).


With yield spreads and sovereign bond yields close to historical lows (and close to the reversal rate), the prospect of generating capital gains from selling bonds prior to the maturity date is greatly diminished. And holding bonds to maturity, particularly risk-free bonds, is almost guaranteed to generate a negative real return.


The diversification benefit from holding bonds is also being undermined. Lofty equity market valuations are predicated on low interest rates. When interest rates rise and this valuation support dissipates, bond and equity markets are likely to fall in tandem.


So what’s a good alternative to fixed interest investing?


Ideally, any bond substitute should offer a secure income stream and equity market diversification benefits. We provide below a brief overview of the main alternatives, including our preferred choice: low risk market neutral hedge funds.


Property

Property is a broad asset class that includes residential, office, retail, hospitality, industrial and special purpose property (such as child-care centres).


Some property types are facing structural challenges which could undermine their ability to generate future income. Retail is having to compete with online shopping and is losing the battle. Hot desking, made possible due to people working from home more frequently following the onset of Covid, could also enable companies to reduce their office footprint. Covid has also decimated, at least temporarily, the hospitality sector.


At the other end of the spectrum, residential property has benefited from high demand driven by low interest rates and constrained supply. Other property types, such as industrial, have also benefited from low cap rates which have pushed up valuations and reduced yields.


The following chart shows the annual historical dividend yield for the GICS4 sector Industrial REITs for Asia Pacific equity markets over the last 12 months (assuming equal weighting all stocks). The decline in yield has been particularly steady since 2015.


Chart 1: Industrial REIT Yields

Source: Bloomberg, OQ Funds Management


In broad terms, property investors are faced with structural challenges and/or inflated valuations which has resulted in a significant decline in yields. We believe this has reduced the appeal of property as an asset class.


Private Equity / Venture Capital

In the search for diversification benefits and the prospect of generating strong returns, more investors have been allocating money to private equity. Herein lies the problem: there is too much money chasing too few investment opportunities.


This is epitomised by the proliferation of SPACs. These cashboxes have been attracting substantial inflows and, unless the money is invested within two years, the managers have to return the funds to investors. The pressure to secure a deal is intense and it’s pushing up the value of unlisted assets.


Unicorns – private companies which are valued at over $US1 billion – used to be a novel concept. They were rare, almost mythical – hence the name. Now, numerous tech companies have ascended to unicorn status.


Commenting on the growth of Unicorns, The Economist on July 24, 2021 remarked:


“The world’s unicorn herd is multiplying at a clip that is more rabbit-like. The number of such firms has grown from a dozen eight years ago to more than 750, worth a combined $2.4trn. In the first six months of 2021 technology startups raised nearly $300bn globally, almost as much as in the whole of 2020. That money helped add 136 new unicorns between April and June alone, a quarterly record, according to cb Insights, a data provider. Compared with the same period last year the number of funding rounds above $100m tripled, to 390. A lot of this helped fatten older members of the herd: all but four of the 34 that now boast valuations of $10bn or more have received new investments since the start of 2020”.


The subtitle of the article in The Economist is The venture-capital boom is a risk for investors—and a gift for everyone else. We agree that venture capital currently represents a risk for investors. It’s a bubble which is likely to burst.


Infrastructure / Utilities

Over the last two decades, my ex-employer – Macquarie Bank – managed to transform itself from a niche investment bank into a global infrastructure powerhouse. They benefited from savvy asset selection and an unprecedented decline in bond yields. Success attracts attention and now infrastructure is a crowded space. Numerous investors are looking for assets with stable cashflows and it’s pushing up the value of infrastructure assets.


Public utilities which have been privatised also offer secure cashflows but the yield is subject to regulatory resets which take into account the risk-free rate. Hence, valuations are effectively capped.


The smart people at Macquarie Bank realise this and have shifted their attention to renewable energy sources. We also believe that infrastructure and utilities are less attractive than they used to be. Yields have decline sharply and future capital gains are likely to be much lower than in the past.


Hedge Funds

According to a recent article in the Financial Times (published 16 August 2021) hedge funds are staging a “revival”. The title of the article is A hedge fund revival? Industry hopes a dismal decade is over. The article references the outlook for bonds and the extreme flows into private equity:


“The gloomy outlook for bond market returns in the coming decade has led to a scramble for plausible alternatives, and hedge funds are some of the biggest beneficiaries. Moreover, the fundraising environment for private equity and venture capital firms is so red hot that surplus investor money almost inevitably has to slosh over into hedge funds.”


Hedge funds is a broad asset class. Of the different hedge fund strategies, equity market neutral tends to have the lowest risk profile, both in terms of return volatility and correlation with equity markets. Many long/short equity hedge funds have significant market beta and concentrated stock and industry bets, particularly if stock selection is based on fundamental analysis. Global macro funds also tend to be characterised by large bets and high return volatility.


Within the equity market neutral category, quant factor funds have two key risk advantages:

· High stock breadth: this is an important requirement for all quant factor funds given the fundamental law of active management: IR = IC * sqrt(Breadth).

· Low risk bets: this is because returns should be driven by factor bets expressed through stock positions rather than by taking risk bets such as large net exposures to countries or sectors.


Potentially negating these advantages is high leverage. This is the main reason why many quant factor funds performed so poorly during the Great Quant Unwind in August 2007. The recent Archegos liquidation also highlights the risks posed by excessive leverage.


In addition to having high stock breadth and tight risk constraints, the OQ Asia Absolute Alpha Fund has relatively low leverage. Our annualised volatility target is around 7% pa and we are able to reach this target with relatively low gross exposure, typically less than 240%. Historical alpha generation has also been extremely strong which should enable us to generate an attractive headline return with low return volatility.


We are also able to mitigate risk via our macro non-systematic overlay. This part of our investment process is focussed on tailoring our stock selection and portfolio construction methodologies so that they are better suited to the current market environment. This is particularly important when the market environment is challenging for our systematic investment process, such as around turning points in market sentiment.


We believe the OQ Asia Absolute Alpha Fund, with is strong track record of alpha generation and relatively low risk profile, provides an attractive alternative to fixed interest investments. In a low interest rate world where many bonds, including long duration bonds, have extremely unattractive yields and many investment strategies are extremely crowded, it offers some important benefits.

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