Generating Higher Fixed Income Returns in a Low Interest
Rate Environment

The flight to safety has driven down yields. Where can fixed income investors find higher return, higher collateralized opportunities today?

October 16, 2008
Sponsored by Rochdale Investment Management

by Garrett R. D’Alessandro, CFA, AIF®, Chief Executive Officer and President, Rochdale Investment Management

The role of fixed income investments within a diversified portfolio is well understood. Investing in bonds may help you preserve capital and potentially provide offsetting returns when other investments, such as stocks, are delivering negative returns. However, yields on U.S. fixed income are lackluster for many investors, particularly those needing income. What is a fixed income investor to do?

Today the return on U.S. government bonds is fairly low and when considered relative to inflation, government bonds are even less attractive. From a risk perspective, though, the U.S. government bond represents, at least at this time, a low-risk fixed income investment as we head into a recession. Normally in advance of and during a recession, corporate bond spreads widen relative to treasury bonds, causing corporate bond investors to experience interim declines in the fair market value of bonds in their portfolio. Leading up to the current period, in general, the interest rates available from corporate bonds have been quite low relative to government bonds. The low spreads, coupled with the uncertainty brought about by the credit crisis, have led to a situation where many investors are seeking the safety of government bonds and only the highest quality corporate bonds.

The laws of supply and demand illustrates why fixed income investors seeking maximum safety during this credit crisis might want to, for a portion of their portfolio, capitalize on the tendencies of most investors to move more money into U.S. government fixed income securities. The majority of fixed income investors view bonds as their “safe money,” and we expect the flight to quality to continue for some time.

The very strong demand is being driven by the credit crisis, a recessionary U.S. economy and potential downgrades for weak banks. When demand is high and supply is not changing, prices rise and hence yields decline. In this context, demand for U.S. government and high-quality corporate bonds is rising, while the supply has not. Negative real rates of interest for such bonds cannot persist indefinitely, but we believe they will persist until substantial improvement develops in the financial sector.

Presently the market for credit availability is tight globally. The liquidity pressure faced by banks diminishes their willingness and ability to offer loans and shrinks the available supply of credit to middle market borrowers. This leads to higher rates on traditionally lower risk loans, thus generating potentially attractive and rising rates of return to fixed income investors participating in these loans. Well-run, credit-worthy businesses seeking collateralized loans are finding their financing needs unmet or met but at higher interest rates. The limited supply of credit versus demand plus the current recessionary environment leads to higher than average yields.

Some words of caution are in order. High rates of interest alone do not qualify a bond as an attractive investment. Other factors to consider are the ability of the company to repay the loan, as well as the form and structure of collateral provided in the event of default. The less specific the collateral, the less desirable the investment. Recent history has witnessed many prominent companies default on their bonds. Since the collateral in this case was the general assets of the parent company, all creditors have to undertake the painful process of getting in line along with all other creditors. A lesson learned is that what seems like adequate collateral rarely is and after all the expenses of litigating the bankruptcy, bond holders usually experience significant losses.

We prefer greater relative safety when we seek out higher interest rate fixed income investments. In the event of default, what really matters is the value and accessibility of the collateral. That is why we suggest that investors seek higher interest rates in non-public fixed income offerings such as trade and project finance. Usually these loans have strong hard asset collateral that is specifically identified and limited to only one creditor. The collateral has to have a value well in excess of the loan to take into account the exigencies of the forces that cause fluctuations in asset value. The collateral also has to be directly accessible to the borrower in event
of default.

While the credit market has tightened globally, the market for trade finance credit has only slightly been impacted. Lenders in the structured and secured segments of the trade finance market have not pulled back from making these loans, as the banks view the structured and secured loans as not only the safest type of trade finance loans, but the most well secured and providing attractive yields.

In today’s fixed income markets, finding companies with a strong ability to repay and strong collateral that is specific to the bond is neither easy nor usually found in the public fixed income markets. Why? Because these loans, while attractive, are not large enough to be syndicated and sold to the public. If you could earn higher rates of interest than that available in the public markets with good quality borrowers who are willing to place hard assets in excess of the loan value as collateral, you keep these types of fixed income investments versus making them widely available to others.

For qualified clients, the private loan market offers potentially highly attractive rates of interest in excess of the associated risk. Given the higher interest rates and risk mitigated by hard collateral, we believe a fixed income investor seeking higher rates of interest should consider this segment of the fixed income market for a portion of their portfolio.

Securities such as these can provide better diversification and cash flow than can “safer” U.S. government and AAA corporate bonds, which are not specifically secured. Particularly in international markets, there are many stable and secure borrowers who can fully collateralize loans with commodities production, food products, infrastructure development and other security whose demand is recessionary resistant. Moreover, the shorter-term nature of these loans, such as one to two years in duration, coupled with the principal and interest amortization, means that investors quickly see return both on and of capital. Moreover, such international loans typically are floating-rate and based on LIBOR (London Interbank Offered Rate), which has outperformed and been uncorrelated with U.S. inflation on a long term basis.

A few firms specialize in such fixed income investments and can provide access to these nonpublic opportunities. These firms have significant expertise in debt and structured trade credit research required for evaluating and monitoring the underlying investments.

This is a special segment of the fixed income market that investors should consider in any market, but particularly now given the present weak U.S. fixed income market. These nonpublic loans offer higher rates of interest and excellent collateral in areas such as middle market business loans, trade finance loans and commercial real estate. They all offer the safety of collateral to cover the principal and yet pay higher rates of interest. Looking beyond the U.S., international floating yield fixed income investments may offer the greatest opportunity for income, return and diversification within a fixed income portfolio.

For more information, visit Rochdale Investment Management.

Garrett R. D’Alessandro, CFA, AIF®, is Chief Executive Officer & President of Rochdale Investment Management, a private client money manager specializing in personalized portfolio management for high net worth individuals and families. For more information or for a confidential analysis of a client’s portfolio, please call Patrick J. Vignone, CPA, at 800-245-9888 or e-mail info@rochdale.com.

This publication is for informational purposes only and is not intended to be a solicitation, offering or recommendation by Rochdale or its affiliates of any product, transaction or service, including securities transactions and investment management or advisory services. The opinions expressed in this publication should not be considered investment, tax, legal or other advice and should not be relied on in making any investment or other decision.

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Investment Management.