But environment also offers the best chance to outperform, according to distinguished fixed-income veteran
Barry Allan is back in the game – and he means business. The distinguished fixed-income portfolio manager is the subadvisor for the Horizons Active High Yield Bond ETF through his DMAT Capital Management firm, which he founded in 2019.
With nearly 40 years in the business, Allan is a distinguished figure in the space. Prior to DMAT, he founded Marret Asset Management in 2001, leaving 18 years later with the firm managing more than $4.4 billion in assets. He’s now teamed up with Horizons ETFs, which was named ETF Champion of the Year (Tammy Cash) and claimed the silver award for The Equisoft Award for Fund Provider of the Year at the 2020 WP Awards.
He returns to the fray at an inflection point in fixed-income investing. He told WP that the current environment is the worst risk-reward profile he has ever seen but that this also is the best opportunity he has ever encountered to outperform your peers and the market.
He explained that with credit spreads and yields at record lows and default risk as high as it's ever been, investors are at a dead end with respect to returns.
“If rates go up, you’re going to lose money and if rates go down because the economy weakens, you're going to lose money,” he said. “It’s a function where there is nowhere to turn. That’s why I designed the Horizons Absolute Return Bond Fund in a way that we can shift from areas of the fixed-income complex that either have the best risk-reward, or the least-worst risk-reward. If we do a reasonable job at it, I think we can produce a 5% to 6% over a full cycle when fixed income yields are approximately 1.5%.”
Allan sees opportunities, right now, in shorter duration, higher quality high yield bonds and longer duration government bonds, where he is eying potential double digit returns after the first few months of the year. While many think government bond yields are going to rise, he's not as optimistic on economic growth in 2021.
“I've been doing this almost 40 years and every time I see excessive optimism, like we have right now, something else happens,” he said. “The capital gain opportunities are in 10-to-30 year U.S. treasury bonds – and I think bond yields will go down next year and not up.
“Right now we are in shorter duration government bonds, but they're highly liquid and we can easily move to longer term ones, especially if the 10-year US government bond gets to 1.15% to 1.2% yield from around 90 basis points today, and I think there is a 10-15% return in owning 10-to-30-year government bonds next year.”
Central to this, of course, is active management. Investing passively right now, with the index yielding 1.5%, means taking on volatility risk to get a negative real return. Any management mistake will be punished and Allan views his experience as hugely beneficial.
He said: “If you look back at the past 10 years, the value of experience was pretty low because you made money on whatever corporate bonds you owned and whatever stocks you owned; the central bank's goal was to make markets go up.
“Experience taught you to be more cautious because the risk reward was really poor. This meant most experienced people generally underperformed and the kids out of school, who had never seen anything else, outperformed. At some point, risk matters and 2020 was that point when risk mattered again.”
Allan warned advisors and investors against the current excessive and extreme optimism. He stressed he is not bearish on the market but that his long-term view on the growing mountain of public debt is that, frankly, it will not end well.
The pandemic has accelerated a path we started on after 2008, and we are now in an extended period of zero interest rates, low inflation, and weak but positive economic growth supported by massive monetary and fiscal stimulus. The world’s debt doubled from 2008 to 2019, and in 2020, 30%-40% more debt has been added in just nine months.
Here’s where Allan long-term outlook becomes stark. This stimulus is not a bridge to when the economy can heal itself but more of an income replacement, which will work until the taps are turned off. The question is, therefore, how long the markets are willing to tolerate huge government deficits? He said governments have no choice but to keep the money flowing.
“It’s like when you're on a bicycle on a very steep slope and there is a little bit of ice on the road,” Allan said. “If you put on the brakes, that’s going to be worse than if you keep pedalling and hope it starts to level out a bit. But as soon as you put on the brakes … you can see when they decided to taper quantitative easing in 2013, the world freaked out.”
Paying back this level of debt is virtually impossible, while inflation – which many expect to happen – won’t work, Allan said. He believes rising inflation without rising interest rates will likely cause credit spreads to widen to compensate, meaning the cost of capital for corporations will rise to match inflation. That will cause a severe recession and inflation to fall again.
He said: “The third way [out of this] is you default. Eventually, we will end up in the form of default which we can call a 'massive debt forgiveness program', where the central banks will own virtually all government debt and the central banks have funded those debt purchases by printing money, so it’s not really real anyway. At some point, I think the central bank will take all the bonds and give them back to the government, the government will cancel them, and then we'll start over .
“The question is what are the economic circumstances that lead the central banks and the governments to get together to do that. There’s only one economic circumstance and that’s a severe recession/depression where none of the monetary policies are effective.”
He added: “There is not a good outcome to this. There is not an outcome that isn't extremely painful for everybody. The real issue is when. The evidence suggests that it could be decades before this happened. My sense is it not multiple decades, but sometime in the next 10 years."