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Does Fixed Income Need Fixing?

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The Case for the DRS as a Capital Preservation Vehicle

Across Swan’s client base, there are some who uti­lize the Defined Risk Strat­e­gy (DRS) as an alter­na­tive to fixed income. Tra­di­tion­al­ly, bonds have played two roles with­in a port­fo­lio: gen­er­a­tion of yield and pro­tec­tion of prin­ci­pal. How­ev­er, the world­wide “new nor­mal” mon­e­tary pol­i­cy of ultra-low or even neg­a­tive inter­est rates and mas­sive liq­uid­i­ty injec­tions into the finan­cial sys­tem has parched savers of yield. These days, savers are forced to choose between yield or pro­tec­tion of principal—they can­not have both.

With its empha­sis on not los­ing big and supe­ri­or bear mar­ket per­for­mance, the DRS could seek to fill the cap­i­tal preser­va­tion role in a port­fo­lio that bonds have been ful­fill­ing.

The DRS and Capital Preservation

Morn­ingstar has two alter­na­tive fixed income cat­e­gories: Mul­ti-sec­tor bond and Non-tra­di­tion­al bond. Mul­ti-sec­tor bonds have a broad man­date where a strat­e­gy can go into high yield, for­eign devel­oped, emerg­ing debt, etc. Non-tra­di­tion­al is even broad­er. It includes the pre­vi­ous, but it can also do things like deriv­a­tives, inter­est rate swaps, and cred­it default swaps. Also, Mul­ti-sec­tor tends to be more strate­gi­cal­ly allo­cat­ed where­as Non-tra­di­tion­al tends to be more tac­ti­cal­ly allo­cat­ed.

Category Performance - Where the DRS Fits: DRS as a Distribution Vehicle, Part 1

Against the cat­e­go­ry aver­ages for Mul­ti-sec­tor Bond and Non-tra­di­tion­al Bond, the DRS per­forms quite well. In terms of absolute return, DRS out­per­forms tra­di­tion­al and alter­na­tive fixed income by a wide mar­gin. The volatil­i­ty of the DRS is cer­tain­ly high­er than any of the bond options, but the DRS’s supe­ri­or Sharpe ratio of 0.67 indi­cates the addi­tion­al risk was more than ade­quate­ly reward­ed with addi­tion­al return.

Bond Category Comparison - Does Fixed Income Need Fixing - Swan Insights

Source: Zephyr StyleAD­VI­SOR. Cap­ture ratios cal­cu­lat­ed on a quar­ter­ly basis.

The point of this exer­cise, how­ev­er, is to see how the DRS might per­form in a cap­i­tal preser­va­tion role along­side the alter­na­tive fixed income options. The betas of the DRS and the alter­na­tive fixed incomes to the S&P 500 index are all low, and the cor­re­la­tion of the DRS to the S&P 500 is actu­al­ly low­er than the alter­na­tive fixed cat­e­gories. The quar­ter­ly down-mar­ket cap­ture of the DRS is almost iden­ti­cal to that of the Non-tra­di­tion­al bond cat­e­go­ry, and the max­i­mum draw­downs are sim­i­lar. Based on these results, one can make the case that the DRS could be uti­lized as a fixed income alter­na­tive for pre­serv­ing cap­i­tal.

While the above table indi­cates that tra­di­tion­al invest­ment grade bonds rep­re­sent­ed by the Bar­clays U.S. Aggre­gate are the least cor­re­lat­ed to the S&P 500 and offer the best down­side pro­tec­tion, that might not always be the case going for­ward. It is ques­tion­able whether investors are tru­ly aware of the mag­ni­tude of the risks embed­ded in tra­di­tion­al invest­ment-grade bonds.


Risk-Free Return or Return-Free Risk?

When investors make the deci­sion to move into non-invest­ment grade or alter­na­tive fixed income, they are will­ing­ly tak­ing on more cred­it and liq­uid­i­ty risk. But the biggest risk to invest­ment grade bonds is, of course, inter­est rate or dura­tion risk. Just like sys­tem­at­ic, mar­ket risk is the 800-pound goril­la in the equi­ty mar­kets, inter­est rate risk is the pri­ma­ry dri­ver of bond returns.

Accord­ing to Morn­ingstar, the aver­age dura­tions (i.e., inter­est rate sen­si­tiv­i­ties) for dif­fer­ent fixed income strate­gies are in the table below. Giv­en dif­fer­ent lev­els of inter­est rate ris­es, the expect­ed loss­es across these strate­gies are as fol­lows:

Morningstar Category Averages - Does Fixed Income Need Fixing - Swan Insights

Source: Morn­ingstar Direct, 6/30/18, Swan Glob­al Invest­ments

While neg­a­tive num­bers are seen across the board, the above table of dura­tion and return doesn’t tru­ly high­light the mag­ni­tude of inter­est rate risk hang­ing over the mar­ket. Accord­ing to a recent Bloomberg arti­cle, Gold­man Sachs esti­mates that bond hold­ers stand to lose $1 tril­lion if rates rise unex­pect­ed­ly by just 1%:

Lurk­ing in the bond mar­ket is a $1 tril­lion rea­son for the Fed­er­al Reserve to go slow on inter­est-rate increas­es. That’s how much bond­hold­ers stand to lose if Trea­sury yields rise unex­pect­ed­ly by 1 per­cent­age point, accord­ing to a Gold­man Sachs Group Inc. esti­mate. A hit of that mag­ni­tude would exceed the real­ized loss­es since the finan­cial cri­sis on mort­gage bonds with­out gov­ern­ment back­ing, Gold­man Sachs ana­lysts Mar­ty Young and Charles Him­mel­berg wrote.”1

Over the last few years, some mar­ket watch­ers have made the joke that invest­ment-grade bonds were once risk-free return, but today, bonds are return-free risk. That state­ment doesn’t seem too far off the mark these days, and it is one of the rea­sons why some prac­ti­tion­ers are using the Defined Risk Strat­e­gy in place of bonds in their port­fo­lios.

In a fol­low-up blog, we exam­ine how a sys­tem­at­ic with­draw­al plan can be applied to the DRS to cre­ate income.


About the Author:
Marc Odo, Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions - Swan Global Investments

Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Client Port­fo­lio Man­ag­er, is respon­si­ble for help­ing clients and prospects gain a detailed under­stand­ing of Swan’s Defined Risk Strat­e­gy, includ­ing how it fits into an over­all invest­ment strat­e­gy. For­mer­ly, Marc was the Direc­tor of Research for 11 years at Zephyr Asso­ciates.



Important Notes & Disclosures:

*Orig­i­nal­ly pub­lished June 2016


Swan Glob­al Invest­ments, LLC is a SEC reg­is­tered Invest­ment Advi­sor that spe­cial­izes in man­ag­ing mon­ey using the pro­pri­etary Defined Risk Strat­e­gy (“DRS”). SEC reg­is­tra­tion does not denote any spe­cial train­ing or qual­i­fi­ca­tion con­ferred by the SEC. Swan Glob­al Invest­ments offers and man­ages the Defined Risk Strat­e­gy for investors includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. All Swan prod­ucts uti­lize the Swan DRS but may vary by asset class, reg­u­la­to­ry offer­ing type, etc. Accord­ing­ly, all Swan DRS  prod­uct  offer­ings  will  have  dif­fer­ent  per­for­mance  results  and  com­par­ing  results among the Swan prod­ucts and com­pos­ites may be of lim­it­ed use. Swan claims com­pli­ance with the Glob­al Invest­ment Per­for­mance Stan­dards (GIPS®). Any his­tor­i­cal num­bers, awards and recog­ni­tions pre­sent­ed are based on the per­for­mance of a (GIPS®) com­pos­ite, Swan’s DRS Select Com­pos­ite, which includes non­qual­i­fied dis­cre­tionary accounts invest­ed in since incep­tion, July 1997 and are net of fees and expens­es. All data used here­in; includ­ing the sta­tis­ti­cal infor­ma­tion, ver­i­fi­ca­tion and per­for­mance reports are avail­able upon request. The bench­marks used for the DRS Select Com­pos­ite are the S&P 500 Index, which con­sists of approx­i­mate­ly 500 large cap stocks often used as a proxy for the over­all U.S. equi­ty mar­ket, and a 60/40 blend­ed com­pos­ite, weight­ed 60% in the afore­men­tioned S&P 500 Index and 40% in the Bar­clays US Aggre­gate Bond Index. The 60/40 is rebal­anced month­ly. The Bar­clays US Aggre­gate Bond Index is a broad-based flag­ship bench­mark that mea­sures the invest­ment grade, US dol­lar-denom­i­nat­ed, fixed-rate tax­able bond mar­ket. The index includes Trea­suries, gov­ern­ment-relat­ed and cor­po­rate secu­ri­ties, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency). Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. Swan’s invest­ments may con­sist of secu­ri­ties which vary sig­nif­i­cant­ly from those in the bench­mark index­es list­ed above and per­for­mance cal­cu­la­tion meth­ods may not be entire­ly com­pa­ra­ble. Accord­ing­ly, com­par­ing results shown to those of such index­es may be of lim­it­ed use. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar ETFs and options in which the advis­er invests or writes may prove to be incor­rect and may not pro­duce the desired results. There is no guar­an­tee any invest­ment or the DRS will meet its objec­tives. All invest­ments involve the risk of poten­tial invest­ment loss­es as well as the poten­tial for invest­ment gains. Pri­or per­for­mance is not a guar­an­tee of future results and there can be no assur­ance, and investors should not assume, that future per­for­mance will be com­pa­ra­ble to past per­for­mance. Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970.382.8901 or vis­it  335-SGI-081318

By |2018-10-02T11:18:24+00:00June 22nd, 2017|Blog|Comments Off on Does Fixed Income Need Fixing?

About the Author:

As Director of Investment Solutions, Marc is responsible for helping clients and prospects gain a detailed understanding of Swan’s Defined Risk Strategy, including how it fits into an overall investment strategy. Formerly Marc was the Director of Research for 11 years at Zephyr Associates.