Download a Durable Income Characteristic

The Case for Durable Income
REISA USE ONLY. Session 12.
Sameer Jain
Chief Economist & Managing Director
[email protected]
(646) 861-7726
6/10/2013
Table of Contents
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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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Macro Economic Conditions & Investor Sentiment
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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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The Challenge of Fixed Income (1)
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
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The Challenge of Fixed Income (2)
Sub sector Returns Demonstrate Unpredictability & Variability
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The Challenge of Fixed Income (3)
Rising Rates Will Reduce Bond Values, Erode Capital
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The Challenge of Fixed Income (4)
Fixed Income Subtypes Now Have Increased Embedded Risk
Short Duration
Bonds
Floating
Rate
Security
Diversified Bond
Funds
Mortgage
Backed
Securities
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
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
Active
management
creates little
value add after
fees
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Summary: Perils of Fixed Income Investing
Allocation to traditional Fixed Income alone may no longer satisfy long-term
investment and income needs
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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
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Traditional Fixed Income No Longer Meets Durable Income Criteria
Durable Income is product agnostic investing framework with dominant
characteristics, including…..
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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
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May include real assets, natural resource partnerships, oil & gas,
infrastructure, timber, real estate
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Durable Income Investing Improves Traditional Fixed Income Investing
Durable Income preserves fixed income’s attractive features while mitigating
its attendant risks
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Provides steady income and capital appreciation to create higher absolute returns
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Reduces volatility to create higher risk adjusted returns
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Add greater stability to traditionally-constructed portfolios
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Provides long term resilience through reliance on multiple drivers of return
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Durable Income is About More Resilient Investing
Reliance on multiple drivers of return
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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Durable Income is Based on Active Management
Durable Income has its source in both market fundamentals and manager
skill. This creates added resilience.
Fundamentals
"Beta"
Basis
Growth
Credit
Public Debt
Sources of
Return
Asset selection
Market timing
Skill
"Alpha"
Control value-added
 Proprietary access
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Durable Income Complements & Enhances Traditional
Fixed Income Investing
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Durable Income Summary
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
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Real Assets Are a Potential Source of Durable Income
Oil & Gas - Real Estate – Timberland – Farmland - Infrastructure
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
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Real Assets Have Provided Investors with
Attractive Risk-Adjusted Returns
…a Durable Income Characteristic
Notes: 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%).
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Real Assets Have Exhibited a Low
Correlation to Financial Assets
…a Durable Income Characteristic
Notes: 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.
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Real Assets Have Provided Investors with
Enhanced Portfolio Diversification
…a Durable Income Characteristic
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%).
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Real Assets Can Potentially Better Preserve
Capital Than Financial Assets
…a Durable Income Characteristic
Notes: 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.
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Real Assets Have Potential to Continue to
Provide High Current Income
…a Durable Income Characteristic
Notes: 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.
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Real Assets Have Provided an Important
Correlation and Hedge to Inflation
…a Durable Income Characteristic
Notes: Correlations are based on quarterly absolute values for the January 1995 – September 2011 time period. U.S. Consumer
Price Index data is seasonally adjusted.
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Proper Real Asset Portfolio Construction is
the Foundation for Durable Income
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 to
Investors…
Notes: For Illustrative Purposes Only
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Appendix
Examples of Durable Income Characteristics of Real Assets
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Private Real Estate
Energy
Timberland
Farmland
Infrastructure
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Risks and Disclosures
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