- I'm going to jump right in here, and I promise I will let you get a word in edgewise. But you say in your report that you came out with this two month, and it's a great report, you pose two questions. Number one, how do you achieve a respectable income without taking on too much risk, and what's the right trade off for reasonable income? I think those are two of the biggest questions investors can have. But you say you can't answer it unless you address the white elephant in the room, which is the title of your report. So what is this white elephant?
Sure. Well, you know what, I think the white elephant is that often, we always talked about things in terms of interest rates, but my feeling is, if you're an income investor, you're thinking about it in dollars.
And we looked at it. And said, listen, if you were thinking about 30 years ago that I was going to save for retirement, what you did is you probably looked at a laddered government bond portfolio and said, well, what does it yield? And at the time it was about 7%. And you said, OK, well, if I could save up $1 million, that would give me $70,000 in income. That would look pretty good.
And you fast forward 30 years later, and that laddered government bond portfolio is yielding about 1.25%. In your income, that is about $12,500, and, boy, that's a real big difference. And so the white elephant in the room, is, A. Boy, that's a considerable income difference and it's a startling place to be.
And the second part of this is that what has happened is that folks have started to change, actually, the definition of what fixed income is, and as that definition has changed, the very risks that we're taking trying to kind of chase yield has been adding and changing really how people's actual investment portfolios are structured in terms of risk.
- OK, I know we're going to get into some of that, the structure, and factors, and the kinds of things that are available to people in terms of how we define fixed income. But if we look at interest rates, traditional interest rates, I think a lot of people think that really it was the 2008 financial crisis which kind of sparked the beginning of low interest rates. But you've got a chart here, which is incredible. A 700 year chart. Where did you find this, and what does it show?
Yeah, that's what shows, right, when you put financial geeks in a room and get them to start looking at things. These are the results of them. And really what we're looking at here is, believe it or not, 700 years ago, we looked at what were interest rates at when there was a giant pandemic.
And this was during the bubonic plague, believe it or not. And I think the takeaway of this is, if you look at it in terms as this, is that, first of all, you've just got to look at that and go, what an astonishing just relentless pursuit with a few bumps along the way to where we are today, which is near zero.
But the second part is that it does show really the power today of what would the world look like without the monetary policy that we have and really the modern financial system that we live in this very modern world. And, boy, we have really made incredible strides over the centuries, and today we are actually in a much better place than we would have been without really all our modern advances that we've come up with.
- It's an incredible chart, but I know for some people who may remember that '80s style spike of interest rates, and some people are concerned that we could see rates do something like that again as central banks try and battle inflation or those types of things. But you don't see that happening, so why not?
- So I think that the starting point of this is that a lot of this really is based on, let's face it. None of us were walking this planet 700 years ago, but we do certainly remember the 1980s. And we have these real big fears from this time, which is understandable. But I think that, when you look at it in the context of what we've gone through in the last 18 months, putting the world economy basically into a coma and then bringing it back out again, these are short term pains of bringing an economy back to life again. And I think that really is the starting point of where we need to look at it in the short term.
Now in the longer term, I think we have to think about this. In terms of both inflation and interest rate, there is a lot of headwind for interest rates to go up from here. Where the public sector is just piling up the debts, the private sector, both individuals and companies, are on a much different trajectory. And they're much in a place that is far more inclined to be not piling up their debt, but to be reducing it. And that's really what we saw in the end of the last four recessions, and we're certainly seeing that now.
Then when you look at demographics, and productivity, and inequality, and monetary policy and the bond market itself, where there's a tremendous supply and a lot more of it coming, it starts to draw a picture that we're going to see interest rates low for a real long time.
- You were just outlining the problem of rates being low given what's going on, and it doesn't look like they're going up anytime soon. Not great for things like fixed income. So that begs the question, why do we even need fixed income right now? Given that lots of these assets, as you talked about earlier, are yielding zero or negative real returns right now, why have them at all?
- Look, I think that's a question that a lot of folks were asking themselves in January and February of 2020 as well because interest rates were really low before the pandemic. But I don't think that was a question that many people were many investors were asking themselves when we got into the massive drawdown in equity markets. And really even credit markets were really impaired during the spring of 2020 as the reality of the pandemic really started to set in.
And when folks were looking at their investment portfolios at that time, they were really pleasantly surprised to say, well, wait a minute. These very low yielding assets are actually the best performing part of my investment portfolio, and even as markets rallied, through the end of the year, these really safe assets still were some of the best performing.
And so what I really want to hit home as your starting point is that, on the government side, first and foremost, is for the potential to build the hedge portfolios. When in times of trouble, these are areas where money will move into and they act as a terrific place to hedge. The other part of this is that it adds it to the longer term ingredient of diversification and a different correlation for movement inside of a portfolio, which is really, really important when you want to build a portfolio that is producing return and better safety. Now the other aspect is-- sorry, Kim. Go ahead.
- No, you go ahead.
- The other thing I think you want to think of the fixed income too is that it's not all equal to one. There's also investment grade, and there's high yield, and there's other components to fixed income. Now, you're taking on a little bit more risk, and what it's producing is still a pretty reasonable income as well.
- Sorry, and I didn't mean to jump on you there. But I guess you're alluding to that too in terms of it's not just one class, but within the class what you're looking at are different factors. And I know that you say that the traditional 60-40 fixed income allocation, it just isn't going to work today. So what are the ways you evaluate this? How do you how do you manage your allocation for risk within a portfolio?
- At the end of the day, we look at the term asset allocation in many ways as just as a label to describe something. But it might not describe risk management as well as you would like it to do. And so for us, we say, you want to actually boil down your investment portfolios down to its level of DNA because we think that, ultimately, investments have a DNA. And that DNA is structured in something that we call risk factors.
And so you can have an equity investment, and you can have a fixed income investment. Look at many of the fixed income of today. If you have a high yielding fixed income investment, it has an awful lot of the same risk attributes as an equity investment does. Both of them would have what we call equity factor risk.
And so for us, we think it makes an awful lot of sense for people to keep that in mind, and then think about, instead of building a portfolio just thinking about asset allocation, also think about how can I better build a portfolio with better risk factor diversification.
- When you look at those risk factors, and I know you and I've talked about this before, you can think about the traits of something that performs like fixed income and things that move together. And I know that you can look into I say almost different fixed income assets. I'm not sure if I'm saying this right. But you can look at bonds. You can look at equities that have those traits, and you can look at alternatives. So maybe just take us through those in terms of how you think about it.
- Sure. Your starting point is that you can have bond investments, and your bond investments, I think you've really got to think about it in terms of what is your interest rate risk with that, and what is your duration risk of that? And so, for that, in the short term really, what you want to look at is kind of your short term duration kind of agency-protected bonds. And that's going to make an awful lot of sense for your portfolio.
In kind of the medium term where you're going to look for, that's where you're going to be looking at more of your investment grades, your quality credit type of risk that you're looking at in there. And your quality of your credit that you're getting is probably the most important thing you want to think about.
Now when you start to move beyond that, and you start to move into the equity component part of that, you can own a portfolio that has equity factor risk in it. But we can actually build an investment portfolio for somebody where we can hedge that equity factor risk, either almost take it outright, or we can significantly reduce it. So we can be buying income-producing equity investments but actually protecting the downside with it by mitigating that factor risk that's inside of it.
And, when we migrate into the alternative investments, it's a very, very similar scenario. But in that area, we can start adding, in the alternative side, we can also start thinking about currency risk, and we can also start thinking about the illiquidity risk.
And illiquidity is where you're looking at either like private debt, infrastructure type of investments that are more contractual in the nature of what they do, and they're longer term, the holdings. And they're not easy to invest in, but nor are they easy to be able to get your capital out of. But in investing in these, you actually can get a higher actually income out of them. It's just you've got to put the kind of capital in there that you don't want to immediately access and are more comfortable locking up over a longer term.
- Brad, great to have you with us, and great to have us thinking about the kinds of things people need to think about for an income generation when we're dealing with this low interest rate world. It's always a pleasure. Thanks so much, Brad.
- Thank you.