Investors across the developed world have accepted the fact that the days of earning real returns without swallowing significant risk are over . . . at least for the foreseeable future. The Fed's interventions in the Treasury market ensure that real yields are not only negative but unattractive as income instruments even on a coupon rate basis. There's little risk of losing your principal with the Fed poised to redeem your paper, but that's only peripheral comfort when you need the income.
But some brave managers have done the deep research and determined which riskier assets are robust enough to keep paying net yields high enough to keep up with inflation and even generate a little actual income. Of course default is a bigger threat than it is in the world of government-backed securities. More can go wrong with these portfolios. Even so, the opportunity to target 5% returns or simply 2% above Treasury is worth pursuing if your clients were expecting to fund retirement on coupons that no longer protect purchasing power.
Global X supports ETFs that chase these return targets: TFIV has a fixed 5% income target and TFLT pursues a more modest 2% above 10-year Treasury. An interview with the outside manager follows.
Jay Jacobs: Given that the Fed is now indicating a more cautious approach to interest rate increases in 2019, how does this impact portfolio construction decisions, particularly for income-oriented investors?
Josh Emanuel: The Fed’s communication that their target interest rate will likely remain stable in 2019 is based on current economic and inflationary data, and their view is subject to change as the data evolves. So, we believe that there is still a possibility that the Fed may hike later this year if the economy outperforms expectations. Nonetheless, current interest rates for U.S. Treasuries leave much to be desired, as they are insufficient to meet the income needs for savers and retirees. For example, investors today can earn approximately 2.40% in two year Treasuries, significantly lower than six months ago, with very limited credit and/or interest rate risk. Our approach seeks to deliver higher risk and return relative to short-term Treasuries, but ultimately, lower or stable interest rates should lead to more demand for higher income-oriented securities in the future.
Given that interest rates have been falling, yields on traditional conservative fixed income remain insufficient for many investors who seek 5% or more in yield. As a result, investors are forced to take more risk in an attempt to achieve their income objectives by expanding the opportunity set to areas such as high yield, emerging markets debt, bank loans, equities, and MLPs. Key to this decision making process is the need to understand where investors are expected to be most compensated for the risks they take and how these investments correlate, in an attempt to improve the risk-adjusted return profile of their income portfolios.
JJ: The yield curve, as measured by the difference in the yields on 10-2 year treasuries has been extraordinarily flat recently. Do you think this changes how investors should approach their income investments?
JE: The flattening of the US yield curve is an indication that investor expectations about long-term inflation remain anchored. If the yield curve were to eventually become inverted, investors will not be incentivized to take interest rate risk, and less motivated to invest in risky assets. At that point in time, short-term bonds may offer an attractive risk-adjusted return profile, which will have negative consequences on credit risk, interest rate risk, and equity risk.
JJ: What under-the-surface risks do you think might exist in the fixed income world that is currently under-appreciated by investors?
JE: Valuations across traditional asset classes have become expensive relative to history, primarily due to a prolonged period of very low interest rates. With that, we have seen a compression in the yield premiums that investors get paid in higher risk parts of the income market, such as high yield bonds and bank loans. Today, there is very little discrimination based on corporate leverage (i.e. investors are demanding very little additional yield for companies with a high debt burden). This is a concerning trend, and as this trend continues, the risk in low quality bonds will continue to grow. That said, for investors who require more than 5% yield, investing in lower quality bonds as a part of a more diversified portfolio is necessary due to today’s low yield environment.
JJ: Are there any income-oriented asset classes that you think look inexpensive right now from a valuation perspective?
JE: We believe that emerging market bonds provide one of the most attractive risk-adjusted return opportunities to investors today. Emerging markets have faced considerable performance challenges over the past year, due in part to trade tensions, currency fluctuations, economic concerns, and a general preference for U.S. assets on behalf of investors. This has led to a material dislocation in valuations, and what we believe is a very attractive potential yield opportunity for investors.
JJ: Should investors worry about inflation accelerating given increasing tariffs, oil prices, and wages?
JE: We do not believe that investors should be overly concerned about inflation today. While we have seen clear signs of wage inflation and rising producer prices, there is no direct relationship between wage inflation and the Consumer Price Index, and rising producer prices have not resulted in higher consumer prices. If anything, we have seen deflationary pressure in core commodities, and we are concerned that higher interest rates and a flatter yield curve will cause real estate prices to roll-over. Today, real estate prices (i.e. rents) represent nearly half of Core Inflation, and will weigh on inflation if prices begin to decline.
JJ: People are living longer and consequently enjoying longer retirements. How does this affect portfolio management for investors as they approach retirement age or have recently retired?
JE: Longevity risk is absolutely a concern for many retirees, however the effect on portfolio management is a function of whether or not investors are fully-funded, which means they have saved enough to meet or outlast their retirement years. For investors who have not sufficiently saved for retirement, it may require taking more risk, albeit judiciously, to mitigate their longevity risk.
JJ: Do you think investors need to be more tactical in this late-cycle environment or ‘stay-the-course’ with longer term strategies?
JE: We believe that markets are very difficult to time, and promote an approach to remain invested over the long-term while being dynamic in where investors take risk. We believe that most tactical strategies, particularly those that rely on human emotion, tend to underperform longer-term disciplined approaches.
TFIV: The Global X TargetIncome™ 5 ETF seeks to provide broad exposure to income-producing asset classes using a portfolio of ETFs, with the goal of supporting an annualized yield of 5%, net of fees.
TFLT: The Global X TargetIncome™ Plus 2 ETF seeks to provide broad exposure to income-producing asset classes using a portfolio of ETFs, with the goal of supporting an annualized yield in excess of the U.S. 10-Year Treasury plus 2%, net of fees.