Portfolio Construction Must Adapt to New Realities
As each week passes, unlike any point in the modern financial times, Treasury bonds, which have traditionally been the low-risk asset within balanced portfolios, have become a high-risk asset with yields approaching 0%. In this highly informative thought leadership, we asked HP Ventures Group to address the current environment and how as investors we can adapt and find alternative opportunities that can fill in the gap for fixed income in our asset allocation.
Executive Summary
Treasury bonds, which have traditionally been the low-risk asset within balanced portfolios, has become a high-risk asset as yields have approached 0%, because they:
Generate very little income
Provide very little diversification because they cannot appreciate during periods of adverse equity performance
Will probably lose significant value during a period of rising inflation
No other major asset classes can provide diversification during periods of adverse equity performance
In response, asset allocators should adopt strategies by selling bonds that are reaching their maximum price and replace them with investments that:
Generate cash flows that pay a reliable income stream to investors
Increase in value during a period of rising inflation
Asset Allocation Must Adapt to New Realities
Financial advisors focus on asset allocation to help clients construct portfolios that balance risk and reward to be consistent with their subjective financial goals. Equities have been the main source of investment return and risk in such a portfolio. Return is generated by the long-term trend of economic growth. Risk is generated during recessions, which are temporary periods of economic downturn that cause significant declines in stock portfolios.
Due to the volatility of equities, asset allocation has traditionally relied upon bond investments to balance the risk of equity portfolios. Bonds are thought to be the less risky part of the portfolio because they generate reliable income and tend to rise in value during periods in which stocks are declining. For this reason, intermediate-term Treasury bonds have been combined with equity investments to create so-called “60/40,” “balanced,” or “target date maturity” portfolios.
The widespread popularity of these three types of portfolios is understandable; they have worked well over the past several decades. During 2020, the most rapid stock market decline in history has been followed by one of the most rapid rises. Yet, as the chart below shows, a balanced portfolio of U.S. stocks and bonds (dark blue line) limited the overall portfolio volatility and the portfolio value has risen to within a few percent of its pre-Covid19 peak.
But we can also get a glimpse of the future of U.S. balanced portfolios by looking at the performance of European and Japanese balanced portfolios over the same period. European and Japanese stocks fell and subsequently rallied within a few percent of the 2020 highs, just as in the U.S. However, in Europe and Japan, bond yields were at or slightly below 0% in early 2020, meaning that bond prices had reached their ceiling price. European and Japanese balanced portfolios have lagged U.S. balanced portfolios. The reason? European and Japanese bond prices did not increase during this period, while U.S. bond prices did.
However, now that U.S. bond yields have approached 0%, the potential for U.S. bond price appreciation is limited. The low-risk assets, Treasury bonds, have become the high-risk assets because they:
Generate very little income
Provide very little diversification because they cannot appreciate during periods of adverse equity performance
Will probably lose significant value during a period of rising inflation
In other words, the price of Treasury bonds cannot rise much further but can lose value in other scenarios, which is a negatively asymmetrical risk/reward that all investors should avoid. Therefore, financial advisors have a new choice to make. They must either adapt their foundational asset allocation strategy or accept the risk that their clients’ expectations for portfolio performance will not be met.
How to Adapt?
As Treasury bond yields approached 0%, they have morphed from a “risk-free” asset to a “high-risk” asset. In the past, a financial advisor might have paid more attention to equity risk within portfolios. But now more attention should be paid to bond risk, and how that affects that overall portfolio risk. Given the poor risk/reward of Treasury bonds, a good start would be to eliminate them from client portfolios.
But what should replace Treasury bonds in a client’s portfolio? First, we need to recognize that no other major asset classes can perform the diversification role that Treasury bonds previously did.
For example, other bonds such as corporate and high yield bonds, are potential substitutes, but credit risk fluctuates in the same direction as equity risk, so they do not protect equity portfolios from downside risk. They generate annual income of 1-6%, depending on credit quality. But they would likely lose value in rising inflation scenarios. Finally, Chart 1 below is from a recent Federal Reserve report, showing that the Treasury market dwarfs the corporate and high yield markets, so an exodus from Treasury bonds and into corporate and high yield bond could drive their prices higher than intrinsic value.
Chart 1 also shows that the size of the real estate markets is deep enough to handle inflows from those who sell Treasury bonds. Real estate investments also may not provide downside protection for equity risk, but twenty years ago real estate prices held up while the Internet Bubble crashed. Real estate investments can generate much higher cash flows than Treasury bonds, and often more than corporate and high-yield bonds. Real estate investments also should perform well in rising inflation scenarios. However, real estate investments are not as liquid as publicly-traded stocks and bonds (nor are they as volatile), so real estate is probably a better substitute for investors with longer time horizons.
Within real estate, some assets are riskier than others. The chart below shows the capitalization rate (“cap rate”) on the four major types of real estate. Historically, apartment properties are viewed as low-risk investments compared to other commercial real estate sectors, which tend to be more closely associated with economic fluctuations.
How Can HP Ventures Group Help?
Apartment cap rates vary due to differences in geography, age, and size, among other attributes. However, over the past several years, HP Ventures has offered 6% annual preferred returns on newly constructed, stabilized apartment buildings in Chicago. Based on current market conditions, HP expects to offer the 6% annual preferred return on future projects. Per a recent study by CBRE, Chicago is the most diversified urban economy in the U.S., and annual apartment construction is a small percentage of existing inventory, making Chicago a stable investment destination. Because of these factors, we believe that stabilized Chicago apartment buildings may be an appropriate investment for investors who seek higher income generated by the building’s existing cash flows, in addition to inflation protection.
For example, a 6% annual preferred return is 20x the 0.30% offered on a 5-year Treasury bond (“5T”). Put another way, an investor can generate the same amount of annual income from an investment in an HP property while only investing 1/20 the amount of capital. While neither an apartment building nor 5T can guarantee diversification for equity portfolios, HP properties should provide inflation protection while 5T cannot. Even without an increase in inflation, HP’s underwriting standards seek properties that we believe can generate 12-15% IRRs over a holding period of 5-7 years.
As far as timing is concerned, we believe that large institutional investors, who have owned Treasury bonds for income and diversification, face the same problem as smaller investors. Therefore, we expect to see large investors adapt by moving out of Treasuries and into assets that can produce much higher cash flows, including real estate. We believe it is better to adapt before they do, because the movement of their capital will probably have an impact on relative prices.
Thanks to our Special Contributor
Peter Cook, Partner
Partner, Director of Capital Markets
5000 West Lawrence Avenue
Chicago, Illinois 60630
(630) 202-2100
HP Ventures Group LLC - Development Services is a real estate asset management firm, focusing on multi-family properties in the Chicago region. HP manages all facets of a property’s life cycle, from acquisition, through development, to property management. Our properties include high-end residential and mixed-use buildings.
At HP, we welcome the opportunity to speak with you about how investments in HP’s projects may help you meet your investment goals.