Blog1.jpg

Source: Wikipedia (for general use)

March 15, 2016

Highlights:

  • As the current seven-year bull market ages amidst an uncertain economic and interest rate environment, investors would be prudent to start stockpiling ‘income’ over the next cycle.
  • Despite central bank efforts to push lenders out into the risk spectrum, investors in risky fixed income and alternative products have experienced significant drawdowns over the course of this bull market.
  • Investors may gripe that there is not much income available today to stockpile for tomorrow, but that is the current environment we invest in given ongoing threats of deflationary risks and central bank policies driving towards negative rates. 
  • If investors can defer 2.50-3.00% of income and stock it away for 5 to 10 years, then they will likely be one step ahead of the game when they draw upon their investments in the next cycle.

 

A Bull Market Ages – Feast or Famine?

“Joseph was thirty years old when he entered the service of Pharaoh king of Egypt. And Joseph went out from the presence of Pharaoh and went through all the land of Egypt. During the seven plentiful years the earth produced abundantly, and he gathered up all the food of these seven years, which occurred in the land of Egypt, and put the food in the cities. He put in every city the food from the fields around it. And Joseph stored up grain in great abundance, like the sand of the sea, until he ceased to measure it, for it could not be measured.” Genesis 41:46-49

On March 9, 2016, the U.S. equity bull market reached its seven-year anniversary.  Since the depths of the 2008-09 financial crisis (3/9/2009), the S&P 500 returned 241.3% while Barclays US Aggregate returned 36.4%.  It has not been smooth ride for U.S. equity investors as there have been multiple drawdowns of 10% or greater (Exhibit 1) over this seven-year bull market.  More recently, the sell-offs in August/September 2015 and January 2016 led to drawdowns of 12% and 13%, respectively.  This bull market has had its share of potholes as the global economy has yet to find surer footing following the last recession.

Exhibit 1 – S&P 500 (3/9/09 – 3/09/16): Maximum Drawdowns (Local +/- 60 Days)

 Ex 1.png

The reference to Genesis is not to suggest that the markets will be entering into a Biblical seven-year cycle of famine following seven years of feast.  However, like Joseph, investors, particularly those drawing upon their investments for income, should consider stockpiling ‘returns’ as this bull market ages in the face of increased economic uncertainty, and in the face of dwindling income options.  As the world continues to grapple with the deflationary forces resulting from the massive debt build up during the prior cycle, world central banks have resorted to unorthodox monetary policies to stave off renewed risks of recession.  More recently, several central banks have implemented negative interest rate policies (NIRP):

Central banks that have announced negative deposit rates:

  • Dansmarks Nationalbank: 7/9/2012
  • European Central Bank: 6/2/2014
  • Swiss National Bank: 12/18/2014
  • Sveriges Riksbank: 2/12/2015
  • Bank of Japan: 1/29/2016

The purpose of negative rate policies is to jump start financial institutional lending, rather than parking reserves at the central banks.  So far, negative rates have not reached the retail deposit holder, although there were some reports of negative mortgages in Denmark.  With respect to the U.S., the Fed has entertained negative rates as a policy tool to deal with further downdrafts in global weakness.  The global financial system is increasingly geared towards borrowers over lenders, as long as the borrower is a safe credit.

 

Have You Gone Yield Shopping Lately? 

According to bankrate.com, 1-year CDs yield 0.28% while 5-year CDs yield 0.83% (not much higher for jumbo CDs).  3-year fixed rate annuities (A+ issuer, no MVA) yield 1.2-1.7%.  Money market funds yield next to nothing.  Investors have been starved for income and have increasingly had to take on more market risk to get any kind of yield.  However, risky debt markets such as high yield (Exhibit 2) and master limited partnerships (Exhibit 3) have experienced significant drawdowns that have wiped out a good chunk of income. 

Exhibit 2 – Barclays U.S. High Yield (3/9/09 – 3/09/16): Maximum Drawdowns (Local +/- 60 Days)

 ex 2.png

Exhibit 3 – Alerian MLPs (3/9/09 – 3/09/16): Maximum Drawdowns (Local +/- 60 Days)

 ex 3.png

Investors that have sought refuge in non-correlating, high risk-adjusted returning hedge funds have not fared much better as they’ve also experienced significant drawdowns (Exhibit 4).

Exhibit 4 – HFR Global Hedge Funds (3/9/09 – 3/09/16): Maximum Drawdowns (Local +/- 60 Days)

 ex 4.png

As we commented in 2016 Market Outlook, ‘simple’ has worked as safe municipals and government Treasuries, with their minuscule yields, have provided some of the best risk-adjusted returns in this environment.  However, investors looking for yield in safer assets will need to take on some market risk, notably risk to interest rate changes and Fed tightening.  Currently, Fed Funds futures are only pricing in one rate hike this year, but unexpected inflation, via wage increases, could shock the market into anticipating a quicker pace of tightening.  Indeed, Fed Vice-Chair Stanley Fischer recently warned about “seeing the first stirrings of an increase in the inflation rate...”

The main risk to fixed income securities is duration risk or sensitivity to interest rate changes risk. These are followed by other types of risk such as extension risk associated with callable bonds and mortgages, as well as default risk for non-sovereign bonds such as corporates and structured asset-backed securities.  As of the time of this writing, these are the characteristics of some of the main core bond options (data source: Bloomberg):

 

Yield to Worst

Modified Duration

Barclays U.S. Aggregate

2.9%

5.7 years

S&P National Muni

2.4%

4.8 years

Barclays Intermediate Credit

3.0%

4.2 years

 

According to Bloomberg’s scenario analysis, if rates were to increase 1% across the curve, then these core bond options would lose 4-5%.  Currently, the 10-year Treasury yield is 1.95% but it had dropped as low as 1.66% during the depths of the mid-February market sell-off.  Indeed, implied bond market volatility (Exhibit 5) is starting to pick up, although we’ve seen spikes before only for the market to settle down as investors buy on any major uptick in Treasury yields.  The upshot is that rates have likely bottomed barring some unforeseen slide into global deflation, and even if rates don’t see a meaningful rise from here, we could still be in for a bout of volatility. 

Exhibit 5 – Implied Bond Market Volatility Starting to Pick Up

 ex 5.png

 

Retirement Income Planning: Stockpiling Income Now for Later Use 

3D believes in a time-segmented approach to retirement income planning as opposed to systematic withdrawal programs which seem to be the default for most individual plans (going into too much detail would require a separate article).  The main issue with the latter approach is the ‘sequence-of-returns’ risk (see ‘The Lifetime Sequence of Returns: A Retirement Planning Conundrum” authored by Wade D. Pfau).  In essence, dollar cost averaging works when investing in the market, but works against you when withdrawing from the market.  This is primarily due to the impact of market volatility, where contributions help smooth out the impact but distributions lock in losses and decrease account values; these losses are more difficult to recover upon market upturns (Exhibit 6). For example, a decrease of 50% in value with no contributions requires a 100% return to get back to breakeven.  However, making a contribution of 10% after the decline requires only an 81.8% return to break even, whereas taking a 10% withdrawal then requires a 122.2% return to break even. 

Exhibit 6: Accumulation vs Withdrawal of a 60% S&P 500 / 40% Barclays Aggregate Bond Portfolio

 ex 6.png

Source: Bloomberg

A time segmented approach would call for immediate income needs (Segment 1) to be met by safe assets with little to no risk to capital.  Later segments (Segments 3 and beyond) target higher growth goals such as addressing higher spending risk (i.e. medical, vacations), inflation risk, and/or intergenerational wealth transfer.  These latter segments can be invested in riskier asset mixes that target higher rates of return.  Time segmentation means that current income needs are addressed with near-term buckets (invested in ‘safe’ assets) where later segments are left untouched so as to minimize the sequence of return risk by maintaining the longer time horizons that allow investors to ride out market volatility and grow assets over the long run.  Using this strategy, achieving miniscule yields on ‘safe’ assets does not mean that income drawers must ratchet down expectations on spending; nonetheless, they should not reach for risky yield due to the drawdown risk.

Time segmentation best balances the conflicting needs of ensuring sufficient income today versus sufficient income tomorrow. Systematic withdrawals are income plans set on autopilot and fail to address the sequence of returns risk. 

Segment 2 or the Retirement Income No-Man’s Land

This brings us to the theme of stockpiling income today in the face of an aging bull market and uncertain rate environment.  Segment 2 is commonly referred to as the ‘Deferred Income’ segment or the ‘on-deck’ segment, to be tapped into once Segment 1 reaches maturity.  Segment 2 presents a conundrum for many planners because it cannot be adequately addressed with income options of the type used in Segment 1 but the relatively short time horizon of approximately five years makes it less amenable to taking on equity risk or risky fixed income investments.  Investors with a five-year horizon still face drawdown risk since they are not afforded enough time to ride out any volatility.  Below are some of the primary investment vehicles used to defer income along with key risks / drawbacks:

 

 

Vehicle

Yield-to-Worst or to Surrender*

How is Principal Risk Managed?

Drawbacks

A-Rated 5-Year Fixed Rate Annuity (5-Year Rate Guarantee)

2.25 – 3.00%

Principal backed by insurance company (and partially by state reserve fund)

Surrender charges, insurance fees

 

Principal guarantee comes from the insurance company and is partially backed by a state reserve fund.

Hold-to-Maturity Bond Portfolio

5-Yr Gov’t: 1.48%

Interm Corp: 2.77%

If held to maturity and no defaults, then principal is returned to investor. 

Principal volatility from rate and credit risk, particularly in the initial years. 

 

Expensive to build and monitor a diversified bond portfolio.

Guggenheim Bulletshares (2021) (BSCL)

3.22%

ETF consisting of corporate bonds held to maturity. 

 

If held to maturity and no defaults, then principal is returned to investor. 

Primarily invests in lower rated investment grade corporates which carry higher default risk than higher-rated securities.

*Stated yields as of 3/15/2016.  Source located in embedded links

Investors may gripe that there is not much income available today to stockpile for tomorrow, but that is the current environment we invest in given ongoing threats of deflationary risks and central bank policies driving towards negative rates.  If investors can defer 2.50-3.00% of income and stock it away for 5 to 10 years, then they will likely be one step ahead of the game when they draw upon their investments in the next cycle. 

Partnering with 3D for Retirement Income Planning Solutions

3D’s investment strategies are tailored for outcome-oriented solutions, whether for retirement income planning or risk-managed target date options for retirement plans.  We will also be rolling out new ETF-managed portfolios specifically tailored for Segment 2 (Deferred Income) planning.  We label these portfolios Targeted Fixed Income with the intent of approximating the risk profile of a hold-to-maturity bond portfolio but using individual ETFs. We are in the process of rolling out the strategies over the 2nd quarter of this year, but here is a preview of their features:

  • ETF-managed portfolios designed to approximate the risk of a hold-to-maturity bond portfolio (5- and 10-year vintages).  In other words, as the maturity date approaches, the underlying net asset value becomes less susceptible to interest rate volatility. 
  • Upon maturity, the net proceeds will be returned to investors.
  • More attractive yield with similar risk versus what is available from other comparable strategies.  Interest rate risk is managed through the use of hybrid/floating rate ETFs. 
  • Targeted Fixed Income is dynamically managed as 3D positions the portfolio where the firm believes investors are best compensated for the underlying risk exposures.
  • Targeted Fixed Income brings investors the best attributes afforded by ETFs, namely:
    • Low cost fixed income exposures
    • Transparency to the underlying securities
    • Diversification
    • Tax efficiency due to ETF-related activities (harvesting of gains/losses, redemptions from other investors)
 
The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future.  It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy.  It is for informational purposes only.  The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate however 3D Asset Management does not warrant the accuracy of any of these.  There is also no assurance that any of the above are all inclusive or complete. Past performance is no guarantee of future results.  None of the services offered by 3D Asset Management are insured by the FDIC and the reader is reminded that all investments contain risk.  The opinions offered above are as of March 9th, 2016 and are subject to change as influencing factors change. More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2 which is available upon request by calling (860) 291-1998, option 2 or emailing sales@3dadvisor.com or visiting 3D’s website at www.3dadvisor.com.

Please contact us if you would like to learn more about how we partner with advisors for their retirement income planning needs. 

 

Contact Us