10/05/2018

Looking for a Conservative Defined Outcome Alternative for Fixed Income?

On a recent trip to the Baltimore/Washington D.C. region, I had the opportunity to meet with several financial advisors over lunch to discuss their methods of mitigating risk within their credit portfolios. We discussed the viability of using a conservative defined outcome strategy that is designed to provide a tail-risk hedge to the equity market, while also serving as a good replacement vehicle for a portion of their fixed income portfolio.

During our discussion, several key themes emerged:

  • First, how should advisors and investors position their fixed income portfolios?
  • Second, with yields still at historic lows, there is uncertainty regarding how bonds may perform going forward and whether a decline in fixed income markets would trigger an overall market downturn.
  • Third, is there an upside to blending a portion of defined outcome strategies with ones fixed income portfolio?

These issues brought up by the advisors reminded me that 2018 has been the year where the bull market for bonds finally has come to an end after a three-decade run with declining yields. It seems that the culmination of relatively low yields and declining bond prices have created a difficult market environment for fixed income. However, adding to the complexity of holding fixed income are two additional issues:

  • Risky credit such as high yield is trading at historically tight spreads over safer fixed income categories (e.g., U.S. Treasurys and investment-grade credit) meaning that reaching for yield is a riskier than usual proposition; and
  • For diversification purposes, the negative correlation between equities and fixed income in more recent bear equity markets cannot be relied on going forward.

Traditional thought among advisors was that the red box (below), representing both a bear credit and equity market, could not really occur. However, with yields expected to continue to increase off historically low numbers, we may revert to longer historical market scenarios where credit and equity were not necessarily negatively correlated. In fact, some market participants believe the next downturn can be led by credit which would result in the red box scenario.

 

Expected Performance of a Traditional 60/40 Equity/Credit Portfolio

 

As a result, a prudent move going forward may be to reduce a portion of an investor’s fixed income exposure, especially within riskier fixed income categories. Consequently, the main issue is how to replace this credit exposure. Over the last few years, investors have tried several alternative strategies and enhanced yield product with mixed results. In fact, most alternative products have a low level of definition regarding outcomes which can easily lead to disappointment when returns do not pan out as expected.

Let’s face it, fixed income is rather well defined. A single bond is expected to provide a return of principal in addition to the stated yield. There is also an understanding that a default may occur with different probabilities based on the credit worthiness of the issuer. Once an investor purchases a few bonds or simply invests in a portfolio, whether in a fund structure or otherwise, some of this definition is lost. Yet, there is still a general understanding of the underlying characteristics of the portfolio as well as expectations.

Conservative defined outcomes are also rather well defined. Despite default risk, a structured note for instance will provide a high level of definition. Once an investor purchases a few notes or simply invests in a portfolio of defined outcomes, some of this definition is lost but the characteristics and expectations are generally still very well defined. As a result, defined outcome strategies can be good candidates to replace a portion of credit exposure.

A principal protected strategy may be a prudent diversifier for more quality credit. When exploring replacements for higher yielding, lesser quality credit, a defined equity tail risk solution may be a good option. In both instances one could expect the defined outcome strategy to outperform the credit strategy given a bear market in both fixed income and equity asset classes – a real possibility. While not illustrated in the tables below, both defined outcome strategies should outperform the equity markets in bear scenarios as well in most instances[i].

 

Hypothetical: Principal Protected Defined Outcome Strategies (Equity) Vs. Quality Credit Exposure[ii]

 

The above table illustrates expected outperformance when comparing an equity based principal protected strategy to that of an investment grade quality credit or better in varying hypothetical outcomes. Barring a default by the issuer, the principal protected product will mature at a value of at least par. As a result, the principal protected product should outperform in all credit bear markets.

 

Hypothetical: Defined Tail Risk Equity Hedge Vs. Low Quality Credit Exposure[i]

 

The above table illustrates expected outperformance when comparing an equity based, tail risk strategy where there is some level of downside exposure (e.g., 10% to 15%) to that of a low quality, higher yielding credit strategy in varying hypothetical outcomes. The results look identical to that of the first table. Given the current low spreads of higher yielding credit strategies, a bear market in credit would result in both a loss due to increasing yields as well as increasing spreads.

 

Expected Performance of a Traditional 60/40 Equity/Credit Portfolio

 

It is generally prudent to protect from the worst potential outcomes in an investor’s portfolio. Given a higher likelihood of a scenario where both equity and credit markets decline, a defined outcome strategy may be a solution in helping to mitigate that worst-case scenario.

 

 

[i] The table is meant to provide a generalized view of which returns will outperform in selected market environments. It should not be assumed that all market permutations within a selected market environment will result in the respective outperformance of one product or another.

[i] Defining a bear market as a drop of > 10%; there is still risk dependent on type of defined outcome used of defaults by an issuer.

[ii] The table is meant to provide a generalized view of which returns will outperform in selected market environments. It should not be assumed that all market permutations within a selected market environment will result in the respective outperformance of one product or another.