sameer jain chief economist & managing director [email protected] (646) 861-7726 sameer jain...
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Sameer JainChief Economist & Managing [email protected](646) 861-7726
The Case for Durable Income
REISA USE ONLY. Session 12. 6/10/2013
• Macro Economic Conditions & Investor Sentiment• The Challenge of Fixed Income• Traditional Fixed Income is No Longer Durable Income• Durable Income Improves Traditional Fixed Income Investing• Real Assets - a Source of Durable Income• Appendix – Examples of Durable Income Characteristics of Real Assets
– Private Real Estate– Energy– Timberland– Farmland– Infrastructure
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Table of Contents
• Abundant liquidity, low interest rates, accommodative monetary stance to keep traditional fixed income returns low
• Market volatility on account of sequester, political impasse, barriers to debt ceiling resolution to create periodic re-pricing shocks and raise risk aversion
• Reduced risk appetite expressed through preference for holding shorter duration assets, higher illiquidity premium and pursuit of interest rate neutral strategies
• Deleveraging in financial, household, corporate sectors well underway. Government deleveraging trajectory remains unclear
• Outperforming efficient traditional fixed income markets without taking excessive credit and interest rate risks increasingly difficult
• Investing risks from spread, interest rate and credit widening and unexpected inflation to continue to rise for next few years
• Investors searching for elusive higher yield, durable fixed income, inflation hedge, less correlated assets, capital growth with lower risk
• Stable consistent income from real assets a viable alternative to traditional fixed income in inevitable rising rate environment
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Macro Economic Conditions & Investor Sentiment
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Characteristics of a ‘Perfectly’ Diversified* Fixed Income Portfolio
•Low absolute returns: 40 basis point premium relative to risk free rate for last ten years•No capital appreciation: Returns from only interest income (i.e. driven by interest rates) . No returns from good buy and sell market timing and security selection decisions
•Low risk adjusted returns: Sharpe ratio of just 0.1. Investors not getting compensated for the risks that they take.
•No illiquidity premium
•Significant interest rate risk: For every 1% increase in short term interest rates, the index declines by almost 4.48%•Excludes niche opportunities in credit investing. Excludes bonds with equity-type features , private placements, floating-rate issues, structured notes, as well as illiquid securities with no available internal or third-party price source
* Barclays Capital U.S. Aggregate Bond Index. August’03- August’13
The Challenge of Fixed Income (1)
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Short Duration Bonds
FloatingRateSecurity
Diversified Bond Funds
MortgageBackedSecurities
Bank Loans Municipal Bonds
Emerging Market Debt
High Yield
Low sensitivity to interest rates
Coupons reset with increasing interest rates
Professional management and broad diversification
Securitization reduces risks
Stable coupons tied to rising interest rates
Interest income exempt from Fed tax
Multiple drivers of return
Higher returns
Low yield does not meet income objective
Part of High Yield universe
Interim price fluctuations
Opaque underlying mortgage character
Buyer –Seller mismatch during stress periods
Deteriorating financial and local economy conditions
Sensitive to volatility and segment illiquidity
Sensitive to interest rate changes
Credit risk widening
Reduced interest rate risk but does not insulate credit risk
Maturing bonds forcibly liquidated at different dates
High loss severity in challenged properties
Downward pricing pressures, swings and capital loss
Less information transparency in govt. finances
Valuation, fundamental, momentum factors difficult to forecast
Sensitive to credit quality changes
Active management creates little value add after fees
NAV fluctuates daily as driven by changing prices, not value
Convexity, prepayment, extension and model complexity
Market volatility affects funding costs and access
Have experienced significant NAV declines
Challenging growth conditions from developed market spillovers
Borrowing rate increase may diminish liquidity and reduce prices
Fixed Income Subtypes Now Have Increased Embedded Risk
The Challenge of Fixed Income (4)
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Allocation to traditional Fixed Income alone may no longer satisfy long-term investment and income needs
• Low expected returns• No capital appreciation• Low risk adjusted returns• No illiquidity premium• Excludes niches in non traditional credit investing
These problems are exacerbated by Fixed Income’s vulnerability to
• Interest rate risk • Credit spread widening• Unexpected inflation
Summary: Perils of Fixed Income Investing
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Durable Income is product agnostic investing framework with dominant characteristics, including…..
• Generates periodic, stable cash flows• Low volatility• Low correlation to other asset classes• Asset value growth potential• Active management/ skills based returns• Mid to long term investment horizon• Variable liquidity• Inflation hedge• Agnostic to underlying instruments and markets
• May include real assets, natural resource partnerships, oil & gas, infrastructure, timber, real estate
Traditional Fixed Income No Longer Meets Durable Income Criteria
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Durable Income preserves fixed income’s attractive features while mitigating its attendant risks
• Provides steady income and capital appreciation to create higher absolute returns
• Reduces volatility to create higher risk adjusted returns
• Add greater stability to traditionally-constructed portfolios
• Provides long term resilience through reliance on multiple drivers of return
Durable Income Investing Improves Traditional Fixed Income Investing
The more the sources of return, the lesser the dependence on a particular market factor, and the more resilient the investment thesis.
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Reliance on multiple drivers of return
Durable Income is About More Resilient Investing
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Durable Income has its source in both market fundamentals and manager skill. This creates added resilience.
Sources ofReturn
Fundamentals "Beta"
Skill"Alpha"
Growth
Credit
Public Debt
Basis
Asset selection
Market timing
Control value-added
Proprietary access
Durable Income is Based on Active Management
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Durable Income is accretive to Fixed Income portfolios to both meet ongoing income needs as well as match long dated future liabilities.
• Traditional fixed income exposes investors to low returns, unexpected inflation and new risks from interest rate and credit spread widening
• Durable Income has multiple return drivers which provides for resilience
• Durable Income preserves attractive features of fixed income while mitigating its risks. It complements and augments
• Durable income is a product agnostic philosophy and a framework
• Real Assets are a potential source of Durable Income
Durable Income Summary
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Real assets are generally characterized by high barriers to entry, essential services, relatively inelastic demand, large investment scale, and long duration cash flows
Portfolio benefits include:
• The ability to earn attractive risk-adjusted returns relative to other asset classes
• Low correlation to traditional financial investments, and low correlation between real assets sectors
• Enhanced portfolio diversification and reduced portfolio risk
• Capital preservation
• Current income for investors in advance of capital appreciation
• Inflation hedge
Oil & Gas - Real Estate – Timberland – Farmland - Infrastructure
Real Assets Are a Potential Source of Durable Income
…a Durable Income Characteristic
16Notes: Returns are calculated on a time-weighted basis for the January 1995 – September 2011 time period. Risk is calculated as the standard deviation of annual returns. Sharpe Ratios are based on a risk-free rate corresponding to the T-Bill return annualized over the same time period (rf = 3.38%).
Real Assets Have Provided Investors with Attractive Risk-Adjusted Returns
17Notes: Correlations shown use quarterly interval data for the January 1995 – September 2011 time period, corresponding to the earliest available yearly data set for all indices.
Real Assets Have Exhibited a Low Correlation to Financial Assets
…a Durable Income Characteristic
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Notes: Efficient frontiers constructed based on data spanning the January 1995 – September 2011 time period. Portfolios diversified with Real Assets represent constant allocations of 7% to S&P 500 Oil Index, 7% to NCREIF Townsend Value Added Index, 2% to NCREIF Farmland Index and 4% NCREIF Timberland Index. Highlighted diversified portfolio represents allocations of 50% to S&P 500 and 30% to Barclays U.S. Aggregate Bond Index. Traditional 60/40 portfolio represents allocations of 60% to S&P 500 and 40% to Barclays U.S. Aggregate Bond Index. Sharpe Ratios are based on a risk-free rate corresponding to the T-Bill return annualized over the same time period (rf = 3.38%).
Real Assets Have Provided Investors with Enhanced Portfolio Diversification
…a Durable Income Characteristic
19Notes: Annual returns are based on a sample size of 21 quarterly periods of negative performance by the S&P 500 in the January 1995 – September 2011 time frame.
Real Assets Can Potentially Better Preserve Capital Than Financial Assets
…a Durable Income Characteristic
20Notes: NCREIF twelve-month yields are based on current income return of respective indices for the four quarters ending 31 March 2011, as reported by NCREIF. TIPS data is based on Barclays Capital TIPS Real YTM Index.
Real Assets Have Potential to Continue to Provide High Current Income
…a Durable Income Characteristic
21Notes: Correlations are based on quarterly absolute values for the January 1995 – September 2011 time period. U.S. Consumer Price Index data is seasonally adjusted.
Real Assets Have Provided an Important Correlation and Hedge to Inflation
…a Durable Income Characteristic
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Several sectors within real assets, including real estate, energy, timberland,agriculture, infrastructure and mining, water rights and carbon credits…
Assets that generate capital appreciation, while also providing current income toInvestors…
Notes: For Illustrative Purposes Only
Proper Real Asset Portfolio Construction is the Foundation for Durable Income
Private Real Estate Energy Timberland Farmland Infrastructure
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Appendix
Examples of Durable Income Characteristics of Real Assets