Many investors are drawn to fixed income because it provides
steady income, and has the ability to diversify portfolio risk.
Fixed income investors contend with the challenges of very low
expected returns, a paucity of skilled managers who have the
potential to outperform the benchmark in what is a fairly efficient
asset market as well as take on interest rate, credit spread and
unexpected inflation risk.
Complementing traditional fixed income investing with
investing may be a better way forward. Returns in durable income
are seen to be a combination of both passive exposure to general
market factors and active investing decisions often resulting in
market outperformance. Durable income sources are agnostic to
underlying instruments and to the markets in which they trade. It
is the investing and trading methods to either arbitrage
opportunities or in other ways create and unlock value that creates
income and preserves capital.
By creatively using expressions to access real assets, too often
overlooked liquid fixed income asset subtypes and investing with
active managers focused on pursuing absolute returns (with aligned
incentives), portfolios can be structured that maintain the
attractive features of traditional fixed income while mitigating
attendant risks. Financial innovation and new products now provide
flexibility to repackage various fixed income return sources in a
way that better meets long-term capital preservation and income
goals. Assets with shorter duration, safer and backed with real
assets, an optimal holding period, moving defensibly, being alert
to changing credit standards can be a good way to participate in
markets. And that is what creates durable income and capital
Perils of Fixed Income Investing
Passive exposure to traditional sources of fixed income may no
longer necessarily be an optimal investing strategy. Traditional
fixed income investors may no longer be getting compensated for
taking the risks that they do - risks from widening spreads, rising
interest rates, as well as exposure to unexpected inflation.
Fixed income investing has 'not been working' for some time now.
Our examination of the Barclays Capital U.S. Aggregate Bond Index,
one of the most diversified fixed income indices over the last ten
Low absolute returns:
The index offers investors very little excess return; a paltry 40
basis point premium relative to cash over the last 10 years.
No capital appreciation:
Nearly all the return in diversified fixed income has come from
only interest income (i.e. driven by interest rate risk) and
almost none from capital appreciation. Investors forego the
benefits of value created from making good buy and sell market
timing and security selection decisions.
Low risk adjusted returns:
The index has a Sharpe ratio of just 0.1. This is very low in
both absolute terms and when compared to most investing
strategies. Investors are decidedly not getting compensated for
the risks that they take.
No illiquidity premium:
Since the underlying securities in fixed income investing are all
very liquid, such a strategy offers zero opportunity for
investors to appropriate valuable illiquidity premiums.
Significant interest rate risk:
For every 1% increase in short term interest rates, the index
declines by almost 4.48%; the sensitivity to interest rates
measured by the duration of the index. Any short-term increase in
interest rates could therefore significantly impair returns.
Durable Income offers a better alternative.
Durable Income is Different from Fixed Income
Durable income investing is very different from fixed income
investing for it has different asset characteristics as well as
sources of risk and return drivers. Such differences can be a
source of both resilient long term income and skills based excess
returns, as well as a valuable investment diversification tool.
Intuitively, durable income cash flow streams are relatively stable
and predictable - say for example in the case of a long term
infrastructure investing concession, often resulting from either a
captive customer base, or from long-term contracts, or regulated
pricing schedules, and limited competition or licensing. Stable,
income producing, occupied, core real estate is yet another
example. In these two instances the stable cash flows generated by
mature infrastructure assets, such as electricity transmission
cables, roads, and oil pipelines are analogous to the rental income
streams in core real estate. These stable cash flows provide
resilient long-term income - in other words durable income.
Durable income has stable resilient cash flows derived from
multiple return drivers - not just interest rate bets. In other
words, it seeks to provide what fixed income often does not
)) potentially higher absolute returns; (ii) both capital
appreciation and income return; ((
)) potential for higher risk adjusted return; (iv) unlocking an
illiquidity premium when warranted; (iv) long-term resilience; ((
)) and niche opportunities in credit investing.
Durable income is a wide category but with shared features:
- Expected Returns: High-single digits.
- Source of Returns: Periodic stable cash flows.
- Effect of Asset Value Growth: Modestly positive.
- Opportunity for Active Management: High.
- Investing horizon: Mid-to-long term.
- Liquidity: Varies.
- Effect of Inflation: Sometimes hedged with inflation linked
- Effect of Interest Rate Increases: Modestly negative/
neutral; inflation correlation partially hedges nominal interest
Durable income is not a replacement, but rather, something
complementary and a better way to get fixed income like asset
characteristic exposure. Durable income is a broad category and
diversifies away from traditional fixed income investing.
Durable income drivers include interest rate, credit spread,
Illiquidity and alternative risk premiums.
(click to enlarge)
As Exhibit 4 indicates, some asset subtypes, such as treasury
bonds and credit default swaps, provide access to just one source
of return - interest rates and credit spreads respectively. By
contrast, other sectors generate return from multiple sources. For
example, investing in private oil & gas partnerships, or in
private infrastructure, or in private real estate provides multiple
sources of return: interest rates, credit spreads, liquidity and
alternative risk premium. The more the sources/drivers of return,
the lesser the dependence on a particular market factor, and the
more resilient the investing thesis. And this sets the basis for
Durable income and differentiates it from traditional fixed income
Exhibit 5 below summarizes salient differences between
traditional fixed income and Durable Income investing.
(click to enlarge)
Achieving a Durable Income
One example of how to achieve a durable income is through
investing in the infrastructure sector, which provides for stable
recurring income returns; their cash flow streams are analogous to
coupon payments from bonds.
Investing in infrastructure involves applying private sources of
capital to achieve meaningful public ends by investing in equity,
equity-linked and debt instruments of businesses that design,
build, operate, own or have long-term concessions in physical
assets. Examples include tolls from transportation (bridges,
tunnels, roads, railways, urban transit, maritime ports, and
airports), energy (electricity generation, transmission,
distribution, oil and gas pipelines, storage), communications
(cables, towers and transmission networks) and water (treatment
plants, distribution systems, and sewage and wastewater
Infrastructure investments have different risk and return
profiles from traditional investments. These differences can be a
source of both valuable durable income and an investment
diversification tool. Typically, demand for infrastructure services
is largely inelastic and is relatively unaffected by the business
cycle, resulting in a relatively low correlation between returns on
infrastructure and market returns. Infrastructure is sometimes
viewed as a close proxy, though certainly not a perfect substitute,
for real estate assets. The stable cash flows generated by mature
infrastructure assets, such as electricity transmission cables,
roads, and oil pipelines have some similarities to the rental
income streams in core real estate. However, infrastructure
businesses typically feature more potential for upside and downside
variation than the fixed rentals in real estate.
Traditional fixed income returns are very low and outperforming
efficient markets is difficult. It is increasingly hard to ignore
emerging fixed income investing risks from unexpected inflation,
interest rate and credit spread widening. Investing passively in
traditional fixed income exposes investors to low expected returns,
has little scope for capital appreciation, comes with significant
interest rate risk, forsakes opportunities in unlocking an
illiquidity premium, as well as excludes niches in credit
Durable income is a complement to traditional fixed income
investing in an inevitable (albeit difficult to time) rising rate
environment. Durable Income, unlike traditional fixed income, has
its foundation in multiple resilient drivers of return; interest
rates, credit spreads, illiquidity and alternative risk premiums
amongst others. The more the sources/drivers of return, the lesser
the dependence on a particular market factor, and the more
resilient the investing thesis.
Durable income, unlike traditional fixed income is intended to
be more resilient to economic downturns, to changes in credit and
market risk and to macroeconomic conditions. Durable income seeks
to preserve the attractive features of traditional fixed income -
stable, consistent, predictable returns - but potentially mitigates
its risks as well as provides opportunities for capital gains.
Durable income characteristics include current income, low
volatility and low correlation to other investments, and can
provide portfolio diversification benefits. Durable income
investing, when implemented through active management, is a
potential source of both market based (beta) and skills based
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
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