It is clear that the massive efforts of central banks in the developed world are undermining one of the pillars of the financial system as we have known it to date: what is generically referred to as fixed income. And it is not only bondholders or annuitants who will suffer losses – or, at best, a lack of income – but, alongside them, there is a whole world of institutional investors who also depend on stable long-term returns, such as insurance companies and public and private pension funds. What are these investors doing in the face of a lack of income and the bleak outlook for fixed income? The answer is as varied as the profiles of those affected.
Most institutional investors are «addicted» to returns; in other words, they cannot settle for negative or meagre returns over a long period because the survival of their own business model depends on those returns in the long term. They are recklessly taking on greater risks to keep minimal returns afloat, which allow them to gloss over the situation in the short term. But this solution is not sustainable over time, as defaults will eventually come to light and have a devastating impact on actuarial calculations, annuities, pensions, etc. You can read about the devastating effects here which represented only a slight decline in projected revenues, according to a study by the McKinsey Global Institute.
The million-dollar question is where to find sustainable long-term returns in the current climate of financial repression. And the answer must be sought far from the fixed-income market, which is affected by central banks’ massive asset-purchase programmes. It is true that investors, eager for returns, are also creating certain bubbles in other assets such as mortgages, direct corporate loans or peer-to-peer (P2P) lending, but there are still interesting niches available if we do not wish to throw ourselves headlong into the equity market.
However, we must not confuse assets that still generate attractive returns with the stable returns that traditional fixed-income bonds have generated for decades (a stability that has now come to an end due to the bubble created by quantitative easing). Such assets, such as mortgages in markets with rising property cycles, corporate direct lending, P2P lending platforms or ILSs, exhibit a level of volatility that should not be underestimated. Anyone investing in alternative income-generating assets must understand that their valuations are volatile, their markets are narrower and their liquidity is limited. However, if chosen carefully, we can still find very good investment funds that invest in assets offering a more than acceptable risk-return profile.
The bad news for retail investors is that we are talking about so-called alternative investments, that is, funds that are not regulated under the UCITS framework and most of which are not registered in Spain for marketing purposes. Does that mean that alternative fund management is unregulated? Not at all. The EU regulates under the framework AIFMD alternative investment funds, in the same way that conventional fund management is regulated under the UCITS framework. An increasing number of fund managers and funds worldwide are adopting European regulatory standards, whether as UCITS or AIFMD funds, although unfortunately, in many cases, registration to market these products in Spain is not a priority for all fund managers. Furthermore, there are many other interesting alternative funds regulated in other jurisdictions, such as the US, which do not yet have an AIFMD equivalent.
The sad outcome of all this is that retail investors, the vast majority of whom do not have the minimum of 250,000′- eur required to hold a their own investment vehicle, enabling them to access all types of funds, both alternative and conventional, they are forced to continue investing in the overheated traditional fixed-income market or to accept the volatility of equities across their entire portfolios. And in the current climate – which is set to persist for years to come – alternative investment is essential if one wishes to avoid the risks of the current fixed-income bubble bursting. Only through the strategies of brilliant alternative fund managers will we be able to achieve returns comparable to those of traditional bond investors. Admittedly, this comes with higher volatility and monthly liquidity (rather than daily, although liquidity issues are also beginning to emerge in the fixed-income market), but it is income nonetheless, and with a risk-return profile that is far more rational than that offered by today’s deranged fixed-income market.
Apart from generating alternative income, it is also possible to scrape together some returns across the full range of funds known as absolute return, event-driven, arbitrage, quantitative and market-neutral funds, amongst others; however, it is difficult to find managers in these areas who are consistently successful over time. Once again, If we have to limit ourselves to funds registered in Spain, the options are reduced to just 10% of the total number of funds in the world, and there is a clear need for our own fully transparent investment vehicle, one that allows us to access any fund in the world whilst deferring tax liability, just as with any Spanish SICAV or fund. Another option would be to achieve attractive long-term returns on equities, but in that case we are no longer talking about income but rather volatile, long-term investment in equities. Of course, we can also make or lose money by buying safe-haven assets such as the Swiss franc or precious metals, but this involves a much more speculative element and is far removed from the income- or bond-oriented profile that concerns us here.
In short, any investor seeking to continue investing conservatively will need to move away from the risks associated with traditional fixed-income investments in favour of alternative income sources. As we have already explained, this is not easy without a minimum of 250,000′- eur and a own investment vehicle. If an investor does not have this, they would be well advised to forget about recurring income and focus on the long-term performance of a carefully selected group of equity fund managers. And to navigate the equity market with the tailwind of economic growth behind you (which, incidentally, is also on the wane), you should look to growing economies such as India, Vietnam, China, etc., or target the resurgence of phoenixes such as Brazil or Russia.
Fixed income will not offer a decent risk-return profile again until excess debt has been cleared, solvency has been restored, central banks have reduced their balance sheets, economic growth has picked up and interest rates have normalised to above 2%. What a distant prospect, isn’t it? Well, that’s the situation: investors in fixed-income and bond markets must seek alternative sources of income or face extinction, just as their traditional sources of income will.
P.S. By the way, today the Spanish Treasury has placed more than 4,010 million euros of debt winning more money than ever… and people are actually willing to lend money to the Government, even though they’ll lose out! We’re heading straight for a E.L.E. for full-time rentiers.