Quick Thoughts: Sourcing Income in Bonds, Real Estate, and Multi-Asset Solutions

Read more below from the roundtable:

Stephen: Ed, you’ve spent almost 30 years focusing on multi-asset income strategies. Given the low interest-rate environment that we’re currently experiencing, how should investors be thinking about income?

Ed: The decline in interest rates has had a profound effect on our asset allocation decision making, and we’ve seen many of our multi-asset portfolios swing toward risk assets, and more equity content. For our income-focused portfolios, the asset allocation decision was a greater challenge as many other sectors within fixed income took their cue from Treasuries, offering less attractive yields as markets recovered during a large part of 2020. At the same time, the dynamic within equity markets favored growth equities over dividend-paying equities. Many higher-growth companies, such as those in the technology sector, really benefited from the conditions during the pandemic due to the prominent change in our livelihoods and the work-from-home environment. In our view, the focus on growth equities and the uncertainty surrounding the pandemic created tremendous dislocations more broadly across equity markets; for our income-oriented strategies, it was an opportunity to pivot towards dividend stocks.

Going forward, given relatively modest total return expectations from a lot of asset classes, income will remain a pretty attractive element for investing, whether it comes from dividend stocks or hybrid assets. This really gets to the point of there not being a free lunch. If you think in the most basic terms—asset allocation, the 60/40 portfolio, traditional fixed income, particularly with rates where they’ve been—income generation has been a fluid dynamic over the last decade or more. The 10-year US Treasury note dipped to a low of 50 basis points (bps) in the summer of last year and is now back to 1.5%. This impacts valuations and the opportunity set as we see it.

That’s why I think the introduction of hybrid assets has been a critical component to income investing in this environment. A simple way to think about them would be to think of equities with potentially bond-like characteristics or on the other end of the spectrum, as bonds with equity-like characteristics. Equities with bond-like characteristics include things like convertible securities, structured equity, even the utility sector, which I think most would acknowledge have some characteristics of both asset classes. Real estate can be a really important component in solving that income need for many of our clients. I would put that in the category of equity-type assets with bond-like characteristics as well.

On the flip side, bonds with equity-like characteristics move us out into the credit spectrum within fixed income. High yield and floating rate term loans would be important tools in solving some of that income need in this pretty challenging, low yield environment. But in many respects, we think there’s a real challenge in seeing positive total returns in fixed income, which we have started to see play itself out in a lot of fixed income segments. Yet, as a portfolio manager, pivoting solely to dividend stocks certainly would have real implications for portfolio risk expectations. Again, the introduction of hybrid assets has been a critical component to income investing in this environment.

What are factors we are watching to drive our asset allocation? Dovish policy remaining supportive, a rebound in global growth continues to be important themes. And then, finally, the expectations for inflation. The US Federal Reserve (Fed) has certainly delivered this message on point with what appears to be some inflationary pressures that we’re seeing in the economies today. At this point we still are in the camp that these should not become overly problematic.

Stephen: Mark, for so many investors looking at fixed income, the possibility of interest rates rising had caused concern and many have reduced their allocation to fixed income. How are you thinking about income or even income versus gains within fixed income?

Mark: Given where rates are, the expectation almost unanimously is rates have to rise. And while over some reasonable period of time, we don’t disagree with that, it’s a little bit more complicated than that, in terms of making the statement that fixed income isn’t attractive in its various flavors.

Negative total rates of return are unusual. Historically, they certainly happen. 2013 was a case in point. They do happen, but they are also usually followed by periods of time when returns are exceptional, given the rise in interest rates and usually some overreaction.

I think that what many investors are missing are a couple of things. Number one, that higher interest rates necessarily mean a negative total rate of return…all in all, you have to take into account the income, but also our expectations of future interest rates, something we call “the forwards.” And many times, when you look at nominal interest rates or real interest rates or other sectors, investors over-anticipate and therefore, if rates rise at a gradual pace or at a pace consistent with existing expectations, it does not necessarily mean a negative total rate of return. There still is value in bonds in income in specific sectors.

The second thing in terms of the overall philosophy is that if income is low, will bonds act as a diversifier if we see a different environment than what we’re in today? The scenario for 2021 is fairly rosy from an equity point of view, an earnings point of view, for the economy, Fed policy, etc., right on down the line. Will bonds help if somehow that rosy scenario is disrupted? We push back hard on those that say, “No, they won’t. Rates are just too low. The correlations have shifted and therefore, our bonds don’t serve the same instrument or the same sector that they have historically.” We just think that that is flat out wrong and that if we do get into a different sort of environment, or if, hypothetically, we start to raise interest rates and we see that start to pinch economic growth or earnings or equity markets, bonds will behave as they have for my 43 years in the business. There are always those periods of time where correlations do go to one…but we do think that they will continue to provide the income, they will continue to provide the diversification for investors going forward.

From a diversification point of view and a flexibility point of view, as compared to last year when spreads were very wide in fixed income, yields were somewhat all over the place, and we wanted to take advantage of that, given the recovery we thought would take place this year is a bit of a different type of a category, different year, and through active management in portfolios, which is what Western Asset does, and particularly in flexible portfolios or unconstrained portfolios, we now shift our focus from just a so-called beta trade “own investment grade” course because spreads are so wide, the implied default rates built in are too high. Now, looking specifically at reopening trades, where we think as the economy grows, as COVID-19 fades, we all hope there are certain sectors within flexible portfolios that can increase the income of a fixed income portfolio, relative to a more traditional fixed income portfolio.

Stephen: Commercial real estate for institutional investors is often 10% to 15% of their total investment, but for individual investors, they haven’t generally had access to commercial real estate. Onay, can you walk us through what you mean by commercial real estate, what the sectors are, and how you think about that from an income investing point of view?

Onay: When we talk about commercial real estate and principally talking about institutional grade real estate, a lot of retail investors have not had access. Within the commercial real estate universe, we typically are talking about the major four food groups: industrial warehouses, multifamily, retail and office.

Industrial warehouses are taking over the warehouse space to take advantage of the rise in e-commerce activity that we’ve seen over the past decade, which has in particular accelerated over the past year—it’s now about 20% of total spending.

We also see the multifamily subsector. So, apartments, in contrast to home ownership where we have a number of people who either rent by choice or by necessity. Apartment buildings are part of the institutional commercial private real estate sphere.

We also have retail that ranges from everything from malls, big shopping centers, to neighborhood centers, and grocery anchored retail. During the pandemic, for example, fewer restaurants were open. Grocery shopping and grocery anchored shopping centers did pretty well.

Lastly, we also have the office sector, which has certainly gone through some changes over the past year, but we continue to believe there’s going to be some consistent demand, particularly as we reach herd immunity and most of us end up back in our offices, as opposed to our home offices.

We have some alternative subsectors within real estate that are continuing to gain some strong capital markets reception. There are a number of them, self-storage, for example. Life sciences is a big one, given the significant amount of both public and private investment in health care and that has never been perhaps more prominent than over the past year, given the amount of money that was invested in vaccines. We’ve seen a lot of capital going into the life sciences sector and all the alternatives.

Hotels and the hospitality subsector are part of commercial real estate. It’s a smaller component of what most institutional investors are investing in these days, given it tends to be higher volatility, perhaps doesn’t provide as consistent a level of income, but hospitality is also a factor.

And then, going to the impetus behind increases in allocations to commercial real estate over time, particularly from institutional investors, number one is low correlation—it does not behave like fixed income or stocks. It had low volatility last year; while public markets saw pretty significant drawdowns, perhaps 30%-40% in some cases, the institutional commercial real estate index really saw a drawdown of only about 2.5%. Total returns were still positive with about a 4% income return, so slightly positive total return, even in this crazy environment.¹

So, a low correlation, diversification benefits, durable income. Low volatility, as we’ve talked about. And then, also finally, the potential for attractive total return.

Stephen: With all the changes with the pandemic and the economy, within those different sectors within commercial real estate, where are you seeing opportunities and frankly, where are you seeing things that aren’t going so well in real estate?

Onay: The increased demand for e-commerce, it’s about 20% of total retail spending. Now, that’s up from about 16% at the start of the pandemic. Demand for industrial warehouse space continues to be quite robust. It’s been in the institutional side, one of the best, or the best-performing asset class over the past one-year, five-year, seven-, and 10-year periods. So, number one, industrial warehouses. Number two, multi-family, i.e., apartments. Even though we saw challenges and may not have been able to work from the office when we were working remotely, most of us were doing so from home. Some of us can afford to own or choose to own a home, but many of us, in the US population, continue to be renters. And so, there continues to be stable demand for apartment products.

We also know that affordability in the US is at all-time lows. There continues to be strong demand for multifamily, which ends up being one of the resilient and defensive asset classes, given that we can adjust leases, basically, on an annual basis. Whereas many of the other property types, leases are two years, with probably more five- to 10-year terms. In multifamily, you can adjust leases really quickly and benefit on the upside. On the other side, we saw some challenges with retail—malls have had some challenges. Office space has had some challenges, as we’ve seen significant drops in occupancy and in many institutional portfolios, we’re still seeing physical occupancy levels below 30%. We do think that will turn around in time.

The city continues to be a hub for culture, for innovation, for collaboration. So longer term the impact of the pandemic on the office sector will be determined, and will continue to evolve, but we firmly feel there’s going to be a place for the physical office as well. That’s a little bit of contrast. It really has been a tale of two cities with quite bifurcated results in what we’ve seen in the different property subsectors.

Stephen: Ed, historically, you saw a lot of opportunities in high yield, fixed income. What are your thoughts, both within fixed income, but also relative to your equity opportunities, and obviously there’s a correlation between high-yield securities and equity there?

Ed: We have seen some pretty nice performance from high yield, partly because spreads had widened out in 2020. More recently relatively short-duration fixed income sectors have certainly benefited, but we’ve seen spreads contract overall, and within high yield really fall to some record low levels. New issuance of single B-rated corporates has been coming with low single-digit coupons, which is something we’re not used to seeing historically. So, we’re being a lot more selective within the high-yield asset class, focused on active management.

Stephen: Mark: unconstrained strategies. Where do you see opportunities within the fixed income set at this point?

Mark: To add to the comments that Onay and Ed have mentioned already—the value folks that we are—last year was a completely different situation. In terms of the valuations, we saw in the midst of the pandemic in some of the, what I would call the safest, high-quality securities, like investment-grade corporate bonds. And that was our initial aggressive move last year to add to that exposure. Below that, in order of risk-adjusted return expectations, was high-yield bank loans, and emerging market debt with a preference for dollar-denominated over local. And on the bottom—the area in which we had the most concerns—was in securitized and unstructured debt, particularly in the residential and the commercial side as Onay has laid out for us.

All in all, flash forward to today and given our macro view and with the support of monetary authorities and fiscal policies, we think that this year is going to be a pretty good year. However, valuations have changed, as we’ve all been talking about, and therefore, when you look at something like an investment-grade corporate, at least the index, we’re back to where we were pre-pandemic—less of a compression of spreads in our minds, and therefore, down a few notches. What has risen, however, are those sectors that have not benefited quite as much and specifically, things like high yield, certain sectors, certain issues, bank loans, given the floating rate nature and yield that’s higher than high yield. Emerging markets fit the description to us of a reopening and a recovery trade, eventually. Some awful things they are living through right now, but we do think if we continue to see growth that they will perform well. And then, finally, looking at commercial and residential real estate as part of our flexible portfolios or all broad market portfolios, keeping in mind, though, the overall risk that’s consistent with each of those objectives.

Stephen: Onay, how are you thinking about inflation, the opportunities or danger from inflation, and how a commercial real estate portfolio might perform if we have inflation?

Onay: We do see the risk of moderate inflation going forward. The good thing is that with commercial real estate, we have an opportunity to hedge against a rising inflationary environment. So, number one, if we are in a rising inflationary environment, we’re typically in a period of growth, right? We are rebounding. I think most expectations have growth in the US pegged at somewhere around 6%. In a rising growth environment, landlords typically have a little bit of leverage because there is significant demand, and accordingly, we can adjust our rental rates to meet the demand that we’re seeing. We can do that with the new leases and then, on an ongoing basis, we can typically do fixed annual or periodic rent increases tied to either inflation or another rate. Inflation, typically, could be around 2%-3%- we would try to get 2%-3% rent increases pegged into the lease. Rising rents usually beat rising inflation rates. In many respects, you can continue to have the strong level of durable income, which will increase over time as you continue to see growth in the environment, and we have an opportunity to continue to perform well on an income basis.

Certainly, we have to be cognizant that as inflation increases, the discount rate or the rate of return in which investors demand in order to invest in real estate also increases. That has the potential to impact longer-term asset values. One of the things that we’re seeing functioning as an arbiter on that increase on the back end is the fact that we’ve seen such large increases in commodity prices—specifically, steel, for example, and wood. And the fact that construction prices are increasing so much makes developers need to pause and think before they put more demand, more inventory into the system, which also serves as a way to check the balance between supply and demand of real estate. So even in an inflationary environment, we have some other checks in addition to the fact that we often are able to increase rents and net operating income in a growth environment.

Stephen: Mark, how are you looking at inflation as we roll into 2022, and what do you thank about 2023 and beyond?

Mark: Huge debate for all of us and just to cut to the quick, the majority of our group is relying on the historical secular reasons that inflation is here as still being very relevant. Fed credibility, technology, globalization, demographics, et cetera, also questioning the amount of fiscal policies that we’re seeing put in place—which are extraordinary—all can lead to inflation. Not a proven fact, in our opinion. The minority of our group is shaking their heads, saying, “What are you guys talking about?” This is a Fed like we haven’t seen since the 1970s-they want inflation. They want very low unemployment. They want climate constraints, et cetera. Secondly, the fiscal side is much, much different than we’ve seen. And finally, this minority says the social side is something completely different than what we’ve seen over the last four years. You put all that together and we’re likely to see higher nominal growth and higher inflation rates going forward. We want to keep a very open mind to it…we have to say today that we are at this inflection point and that for the next five, 10, 15 years, inflation is going to be considerably higher. So far, we are thinking once we get past these bottlenecks, which are scary, that we possibly will see inflation return to a more comfortable range.

Stephen: Ed, looking out past 2022 and beyond, will inflation be in a comfortable range?

Ed: I think a lot of what Mark said, certainly, resonates with our team, especially that dynamic of having a difference of opinion within our team. I think every investment team that we’ve engaged with in Franklin Templeton has described a similar dynamic. But our team focuses on some unique aspects of it. Yes, it’s always dangerous to say, “this time is different, or things are changing,” but I think it’s important to understand that, even in the last decade, we had dynamics like labor force participation rates expanding; we had certainly those long-term effects of the global labor arbitrage, particularly with China. I think certain aspects of those relationships are changing. The one thing that may be a bit different with demographics is we’ve had such incredible wealth creation in this cycle. Do we see a similar return of the labor force that we saw after the financial crisis when we had tremendous wealth destruction and many people needed to return to the labor force? There are just a lot of complex issues that I know will occupy a significant amount of time for our investment team as we move forward. But I think we ultimately fall in the same camp that inflation is not likely to become problematic. But, what that comfortable rate is, I think remains a significant question.

Onay: As you talk about the huge amount of wealth creation in the US over the past year, in particular now, by our estimates, we have about US$17 trillion in pent-up consumer demand, which should support real estate—so retail, apartments, et cetera. When we think about employment growth, which is one of the huge drivers of real estate, one of the things that gives me both comfort and also a little bit of dismay is that the majority of the wealth created in the stock market over the past year really has been from the top 2%, right? I have very little fear or concern that we won’t see a huge return to the workforce in coming quarters. Will that return be slower? Perhaps. As people get more comfortable with being vaccinated and with the protocols that we have in each of our offices, et cetera, but very little concern from my perspective, with respect to us getting back to full employment or what we thought would be full employment.

Mark: Onay, I think your comments are similar to ours. And the way we look at this and why we’re willing to be patient is a good way to put it. If you run this experiment and you close down economies around the globe for essentially one year, and then you restart them, it’s not going to be smooth. Fortunately, there are the advancements and the game-changers, the vaccines, and the improvements that we’re seeing in the economy. I kind of equate it to the old car you fire up after years, and it kind of spits and sputters, it smokes, but eventually you get the thing running pretty well. And that’s exactly what we think we’re going through. Therefore, on the labor side, like a lot of other shortages, given the dislocations that we’ve all been through over the last year, we also believe as you do, I think, that we will get people back into the labor force. Yes, there are some folks 55 and over who are saying, “The markets are great. Unlike the financial crisis. I’m going to retire.” It will take some time for people to move, to retrain, to get back to work, to figure out if it’s home or if it’s the office, but we do think that these bottlenecks on labor, as well as other areas, will eventually dissipate and that we will see that inflation rate come back to more acceptable levels.

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