Liquid Alternatives: One Solution For Navigating The Challenges From Unprecedented Low Bond Yields
Writing in GMO’s 2Q Investor Letter, Matt Kadnar highlights liquid alternatives as a potential solution to duration interest rate risk.
In a note titled “A Roadmap For Navigating Today’s Low Interest Rates,” GMO’s Matt Kadnar warns investors of three challenging fallouts from today’s unprecedented low bond yields. These are: replacing the income bonds used to provide; the loss of depression protection arising from bond yields having little or no room to fall; and protection against the twin risks of rising inflation and rising interest rates. (gmo.com)
Kadnar on interest rate risk
Investors, for the last three decades, have not had to worry about rising interest rates. However, the risk from unanticipated inflation could put paid to that complacency.
Kadnar: “While the prospect of unanticipated inflation may seem quite far removed today given the deflationary shock caused by the Covid-19 crisis, we believe inflationary seeds are being sown. We are experiencing unprecedented monetary and fiscal stimulus on a global scale. The growing support of Modern Monetary Theory and its insouciance to risks associated with increasing government deficits increases the potential for inflation…
…the combination of massive money creation and fiscal stimulus, a supply shock coming from a retreat from globalization, and the potential failure of many small and midsized companies means the potential for inflation simply cannot be ignored by investors.”
According to Kadnar, an investor may still not believe in the prospect of rising interest rates. However, “there still appeared to be limited reward for holding duration” in their portfolio.
Liquid alternatives, value and resource stocks, and inflation-linked bonds are avenues that could lower interest rate risk (duration) while still generating income.
Kadnar on liquid alternatives:
- They generate a return better than cash but with relatively lower beta and shorter duration
- they are an important tool for generating overall returns for a portfolio and serving as a lower-duration substitute for bonds
- the long/short nature of liquid alts removes duration linked with both stocks and bonds
- (note however that in a deflationary bust liquid alts cannot serve as the equity hedge that bonds have been)
- GMO’s allocations:
- Pure alpha (GMO Systematic Global Macro/GMO Fixed-Income Absolute Return)
- Alternative Allocation Strategy (a combination of GMO Risk Premium and GMO Event-Driven)
However, Kadnar leaves us with the caveat that investors should analyze their liquid alts strategies to understand the sources of return in the portfolio, how the portfolio will behave in stressful times, the fees unit of expected return, and the use of leverage.
Related Story: A Potential Golden Era Afoot For Liquid Alternatives
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