Investing for the Late Cycle
On May 8, 1984, the Chicago White Sox beat the Milwaukee Brewers 7-6 after 33 innings. It was the longest baseball game ever played, lasting a whopping eight hours and 25 minutes. Baseball analogies are prevalent in investing and for good reason. Baseball is the only one of the major professional sports that does not adhere to a time limit, a trait shared by market cycles.
- Yogi Berra
It’s tough to make predictions, especially about the future”
The bull market is now in its eighth year, making it the second longest in history next to the market from 1991 to 2001. Market watchers debate whether we are late in the business cycle, but for investors, the question is how you invest in this type of market without knowing if we are playing a game of nine innings or 33.
The unique feature of this cycle is its low-rate environment. Low interest rates have encouraged clients to reach for higher yielding assets. This reaction may be less about greed and more about necessity, particularly for those investors in or close to retirement. The increase in investors’ exposure to asset classes with historically higher standard deviation and greater tail risk may be concerning in its own right.
Perhaps more concerning is that these asset classes have a significantly higher correlation with equity markets. This significantly elevates the “sequence of return” risk that can ruthlessly undermine a seemingly well-planned retirement portfolio.
The only sure-fire way to avoid this problem is to die early. In case you find this solution unfavourable, the next best thing is to seek investment strategies that diversify sources of risk to provide better outcomes for clients. Asset managers have been trying to fill this gap with innovative and creative products that focus on less traditional fixed-income asset classes and more benchmark agnostic investment strategies.
We have come to market with our Mackenzie Unconstrained Fixed Income Fund and Mackenzie Unconstrained Bond ETF (MUB). These products are designed to help clients find more yield while managing risk. Our unconstrained strategy has an emphasis on attractive returns available in credit markets, aiming to identify and invest in the best risk/return opportunities across sectors, across the credit quality spectrum, and within a company’s capital structure.
Our funds also offer a strategy that will provide some risk mitigation while trying to maintain a healthy yield (4.16% for MUB, 5.72% for Unconstrained Fixed Income as of June 30, 2017). At the simplest level, Steve Locke and his team construct a portfolio of intensely scrutinized high yield bonds, leveraged loans, EM debt and investment grade corporate and government bonds. The team adjusts the allocation to these asset classes based on their judgment of valuations and where we are in the credit cycle. Higher quality investment-grade bonds offer some diversification for the higher yielding portion of the portfolio, but with high yield and leveraged loans constituting between 50%-70% of the portfolio since inception, tail risk can still be a concern. We mitigate this risk by employing a put strategy on all of our high yield bond exposure at all times. So far it has worked.
As you can see below, we have provided clients with meaningfully better yields and allowed them to avoid the worst of the downside.
This is not to say that our unconstrained strategy (or any others) are inherently designed to replace a core investment grade fixed-income portfolio. As you can see in the correlation matrix below, the Mackenzie Unconstrained Fixed Income Fund does not exhibit the negative correlation to equities that core investment grade portfolios often do, but it does provide meaningful diversification benefits to portfolios with global and/or Canadian equity exposure. The Fund also provides better diversification against equities than high yield bonds.
For many investors, accepting yields that the low-rate environment offers is difficult. The stark choice many investors face is to either reach for yield or accept a level of income that does not meet expectations. As we have seen, many investors have decided to take the risk. We do not know how long the game will be, but if we are past the seventh inning stretch, then allocating to a higher yielding strategy with downside protection can be an attractive way to achieve client objectives.