The thesis regarding the development and usage of fixed income funds seems reasonable on its surface. They look at a variety of factors, including volatility, benchmarks, correlation, and time horizon as a means of determining what assets are in their fund. The goal ultimately is a combination of capital preservation and income generation for the shareholder, paying out a consistent percentage of yield annually. Sounds reasonable, right?
However, when looking at the concepts of volatility, benchmarks, and correlation – all of these are based on the fundamental assumption that what has happened in the past will in fact happen in the future. For example, I’m certain that when the Illinois teachers negotiated a rate of growth of 7% in the pension fund in perpetuity decades ago, no one considered at the time the potential existence of a zero-interest rate world. Certificates of deposit (CD’s) were paying 6%; surely an extra 100 basis points (1%) is practically a layup. And yet here we are, decades later, realizing that achieving a 7% annual return just to keep up with that obligation is really quite difficult – so difficult that taxpayers in our state pay 3x the property taxes of neighboring states. The taxes on my house in 2022 will be greater than my mortgage, because no one could imagine a world that is different from the one they are in.
Thinking is important. Learning must be lifelong. Rules of thumb and other mental shortcuts can be costly, particularly when the world changes.
The IMF recently wrote a report on the effects of the COVID-19 pandemic on global fixed-income funds. According to the report, withdrawals stemming from fear caused market liquidity to severely dry up, which in turn caused a domino effect that contributed to more underperformance, which in turn caused more withdrawals up to the point where central banks were forced to intervene (IMF, March 2021). It also revealed a major weakness in the space – in the drawdown, they found investment managers to be selling more liquid assets first, causing portfolios to hold considerably outsized portions of assets that were more illiquid. So, suppose we have an event which results in a prolonged drawdown period, where instead of the market bouncing back up within six months it takes more in the range of a year to a year and half? Or a scenario where the velocity of drawdowns was even more pronounced? Well, now the illiquid assets have to be sold, or the firms are pulling from other pools of assets outside the fund through some sort of asset swap in an effort to accommodate those liquidations, and the house cards look rather sad.
Similarly, the IMF concluded that “Such behavior suggests that feedback mechanisms from the devaluation in securities prices to capital withdrawals by investors may have intensified and could have led to runs on funds, had liquidity conditions deteriorated further” (IMF, 2021). Once again, for all that is preached about volatility and benchmarks and correlation and time horizon, none of it had to do with the underlying risk of holding the positions in the first place, which is how the fixed income market nearly blew itself to smithereens a year ago, and may have done exactly that had governments not intervened. It’s as if these funds never considered the notion that should an event occur, they might all try to do the same thing at the same time, and run that line of thinking through to its eventual outcome “So what do we do differently such that if everyone is selling out of X at the same time, that we don’t get caught in the same riptide?”
Amusingly, this was far from the first time this question was discussed. In a 2016 paper from the New York Fed, Adrian et. al. suggested literally the same scenario. “Even if redemption risk has not increased, the price riskiness of corporate bonds could have increased owing to self reinforcing dynamics: when adverse news leads to lower returns, redemptions might force mutual funds to sell assets, which might reinforce the negative returns, thus generating additional redemptions (Adrian et. al., October 2016).
Well, that happened.
And this goes back to thinking, which is always a 100% allocation here. Thinking about just how little one is being paid out for the risk being taken on in the fixed income space, as noted not just by myself but others such as the New York Fed, one might draw the conclusion as I have that it’s not a good space to be in, no matter what goal you have in mind. Risk events occur too often, the yields are way too low, and it’s clear that even after two crises in just over a decade’s span, the industry as a whole does not value liquidity whatsoever. In my opinion, the term “fixed income” is literally a sales moniker, nothing more. The allocation I would give it is zero. None. Nada. Not a cent.
All of this reminds me of a quote from Charlie Munger, billionaire investor and Vice Chairman of Berkshire Hathaway, which I shall close this blog post with:
“The general system for money management requires people to pretend that they can do something they can’t do, and to pretend to like it when they really don’t. I think that’s a terrible way to spend your life, but it’s very well paid.”
Adrian, T., Fleming, M., Shachar, O., & Vogt, E. (2016, October). Market Liquidity after the Financial Crisis. FRB of New York. https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr796.pdf
IMF. (2021, March 16). The Behavior of Fixed-income Funds during COVID-19 Market Turmoil. Retrieved November 21, 2021, from https://www.imf.org/en/Publications/global-financial-stability-notes/Issues/2021/03/16/The-Behavior-of-Fixed-income-Funds-during-COVID-19-Market-Turmoil-49951