On February 25, 2021, CFA Society Toronto hosted a webinar. Keynote, Matt Kadnar is a partner and portfolio manager at GMO, a global investment manager with US$65 billion in assets under management. During the presentation he discussed how a low interest rate environment has affected his firm and how he has navigated those challenges.

Kadnar began by highlighting that government bonds are no longer able to provide their key functions to investors, which are to provide meaningful income and to act as a hedge against economic downturns. Notwithstanding the recovery from the 2020 lows, government bond yields remain at historically low levels across the world. This creates obvious challenges for savers and investors seeking lower volatility assets.

Less obvious is the detrimental impact low yields could have on the ability of bonds to provide positive performance during the next bout of macroeconomic turmoil. Research from GMO shows that in five of the past six bear markets for the MSCI World Index, ten-year U.S. Treasury notes delivered positive performance. Across all six bear markets, U.S. Treasury notes averaged a 10.9 percent capital gain, while global equities suffered steep declines.

PERFORMANCE OF U.S. TREASURY NOTES DURING SIX BEAR MARKETS

Source: Datastream, MSCI, GMO

However, in each of those prior instances, the U.S. Federal Reserve was able to reduce interest rates to stimulate economic growth. The current environment of rock-bottom yields might mute the performance of ten-year bonds if a similar bear market were to present itself.

For instance, consider what happened to ten-year bonds in each of the G10 markets at the beginning of the COVID-19 crisis. Those countries where short rates were meaningfully positive at the beginning of the crisis witnessed decent gains in their ten-year bonds. On the other hand, those countries where short rates were near or below zero saw average bond returns of -1.3 percent.

COVID-19 CRISIS BOND RETURNS AND STARTING SHORT RATES

Source: Datastream, GMO
Note: Short rates are levels as of 1/31/2020 and bond returns from 2/19/202 to 3/23/2020

With the low-rate environment leaving bonds with lower expected returns and higher risk (especially as inflation starts to creep higher), what should an investor do? There are no simple solutions because there are no equivalents that offer the same functions as government bonds. Expanding an investor’s opportunity set is likely to lead to better risk–return trade-offs.

Because long bonds are particularly vulnerable to increasing inflation due to their longer durations, investors may consider options to help alter the duration to better withstand an environment of rising inflation and rates. Kadnar presented the following alternatives:
• Floating-rate securities
– Structured products
– Bank loans
• Opportunistic credit
– High-yield debt
– Emerging debt
• Liquid alternatives
• Value equities

Floating-rate securities
Floating-rate instruments help reduce duration and risk in an environment of rising interest rates. Although leveraged loans have grown in popularity over the past decade, GMO prefers asset-backed securities and other structured products, believing they offer a better risk–return profile compared to leveraged loans.

Kadnar offers words of caution about the steady rise of covenant-lite loans, raising concerns that this will weaken protections for loan owners and ultimately lower recovery rates. Asset-backed securities, on the other hand, are often overlooked and unloved. These complex instruments represent a fragmented, inefficient market. However, after thorough analysis, they can offer investors a wide set of opportunities to add alpha.

Opportunistic credit
High-yield and emerging debt may present attractive opportunities during times when yield spreads widen, such as in the past year. More recently, as spreads have narrowed, a more patient and prudent approach is needed.

With high-yield debt, security allocation will play a more important role in generating returns. GMO argues that we are likely to face a long bankruptcy cycle as the economic recovery continues to unfold.

Emerging market debt also offers significant potential for security selection alpha because of the liquidity of the asset class and the macro uncertainty in many of the countries comprising the emerging debt universe.

Liquid alternatives
Liquid alternatives have generally disappointed investors because of their high fees and the commoditization of many strategies. Nonetheless, Kadnar recommends keeping an open mind, as such assets can be useful tools for generating overall returns for a portfolio and serve as lower-duration substitutes for bonds.

Plenty of liquid alternatives have less economic risk than equities yet can provide higher expected returns than cash and bonds. When selecting a manager for these strategies, Kadnar suggests avoiding commoditized strategies. It is important to understand the sources of return for the strategies that are employed and how the portfolio will behave in times of stress. Finally, he advises investors to be mindful of fees and how leverage may be prudently employed for capital efficiency. Importantly, be wary of backtests!

Value equities
In addition to being historically cheap relative to the market, value stocks also help lower the duration of a portfolio. Since value stocks tend to have higher dividend yields, an investor theoretically receives more of their cash flows earlier than they do with growth stocks (which make an investor more dependent on cash flows further into the future).
Finally, within value equities, resource-based stocks offer an upside to a recovering global economy and a hedge against future inflation.

Conclusion
Today’s low-rate environment means we can’t rely on the same investing playbook we used in the past. As the old adage goes, past performance may not be indicative of future results. Investors will have to keep an open mind and employ more creativity as they look for bond replacements to build their portfolios. 

Data for this article was sourced from GMO’s 2Q 2020 Quarterly Letter and GMO’s presentation entitled “A Roadmap for Navigating Today’s Low Interest Rates” by Lydia Cottrell, Michelle Hicks, and Matt Kadnar, presented at a webinar hosted by CFA Society Toronto on February 25, 2021.

Ben Inker & Matt Kadnar, 2Q 2020 GMO Quarterly Letter, GMO, 2020, https://www.gmo.com/americas/research-library/2q-2020-gmo-quarterly-letter/