Fixed Income Facts and Fancy When Staring Down Inflation

An acquaintance got me thinking about the fixed-income universe.  I haven’t thought about it much lately for good reason.  Fixed-income investments are wiped out in high-inflation economies and the Federal Reserve’s implied policy of monetizing US sovereign debt dramatically increases the chances of high inflation.  The fixed-income universe is much broader than sovereign debt.  I ought to see if any income-generating instrument can survive high inflation.

The Dividend Yield Hunter lists multiple categories of fixed-income instruments that go way beyond bonds.  I was not aware that exchange-traded debt existed in forms other than preferred stock (not really debt, but acts like it) and funds.  The Tennessee Valley Authority, for example, lists its bonds on exchanges for the public to trade (TVC and TVE are examples). The usual cast of characters like MLPs, royalty trusts, and REITs round out exchange-listed offerings.  I’ve never considered business development companies (BDCs) as fixed-income investments because they are unique ways to invest in undercapitalized small companies, sort of like VC firms but publicly traded.  Dividend Yield Hunter lists BDCs as fixed-income, presumably because they must pay out their earnings like other pass-through entities. BDCs are also searchable over at QuantumOnline, and that site also lists exotic things like income deposit securities.

Fixed-income investing is a fine stabilizing element for a diversified portfolio in normal times when interest rates are at their long-term historical average and the national debt-to-GDP ratio is manageable.  Americans are not living in normal times any longer.  Most fixed-income investments will see their principal destroyed when high inflation reduces the dollar’s value to nothing.

These are the types of fixed-income investments I have decided to avoid due to their vulnerability to inflation.

US sovereign debt of any kind. The Fed is going to swallow these things whole when foreign central banks sell them in a panic. The QE needed to absorb the world’s outstanding stash of Treasuries will have to be monstrously huge.

Coupon debt of any kind.  This includes any corporate debt or municipal bonds that pay a fixed coupon based on the bond’s face amount.  That face amount will be worth less than nothing after hyperinflation ends. Say goodnight, internotes.

BDCs. I don’t care how generous the cash flow from repaid loans looks right now.  BDCs are highly sensitive to short-term interest rates and real rates will skyrocket at the onset of high inflation. Their funding is unsecured, which means investors have little recourse to recover assets after bankruptcy.  No thanks. Finally, their assets are loan portfolios.  High inflation is a debtor’s dream come true because it allows them to pay existing debts with future dollars that are worth less than current dollars. Inflation will destroy BDC loan portfolios. These are the crucial differences between BDCs and other private equity vehicles.

High yield debt. No way, ho-say. This was the first debt category to crack when the market turbulence of 2007 became the crisis of 2008. Junk bonds are always the first to be wiped out in any market downturn because their issuers have weak earnings or troubled business models.

These are the types of fixed-income investments I am open to considering, given the caveats mentioned. Their common denominator is their basis in a hard asset sector.

MLPs. I like pipeline MLPs as a play on hard asset servicing.  Oil and gas are energy hard assets whose demand will be price inelastic during high inflation.  My concern is whether FERC regulations will prove to be so onerous during hyperinflation that they destroy the pricing power of MLPs and their pipeline operating companies.  I cannot rule out regulatory risk with pipeline MLPs. I may have to wait until renewable MLPs are active.

Royalty trusts. These are collections of orphaned oil and gas wells whose owners do not need to spend capex to upgrade them. They pass their earnings through to trust holders as the wells’ reserves run down.

REITs. These are the trickiest to consider. Some residential REITs will fair poorly during hyperinflation if their holdings are concentrated in urban areas that are hostages to rent control ordinances.  Those will not retain their pricing power during hyperinflation. Commercial REITs will fare better but many REITs own a mix of properties. The best sector bet for me may be iShares Dow Jones US Real Estate (IYR), an ETF of REITs, but based on its dividends it’s currently trading more than twice what it should be worth.

I feel like restating my enmity for actively managed funds of any kind, including fixed-income. Bond mutual funds are no longer needed now that index funds and ETFs exist.  Active management of fixed income portfolios is for institutional investors and corporations who must immunize their portfolios against interest rate moves or match durations to liabilities. They have specific goals in liability-driven investing. The larger investing world doesn’t need to constantly fine-tune a fixed-income portfolio.

I must also reiterate my disdain for the superficial analysis some fixed-income investors use to evaluate the attractiveness of securities. I’ve heard some investors claim that MLPs and REITs trading for less than book value are bargains, but if those same entities have low ROEs then there’s a reason they trade at such discounts. The market is discounting their ability to generate cash flow because a low ROE indicates they use capital inefficiently. They may be paying too much for debt because of past negative credit events or committing capital to operating payouts (like lawsuit settlements or regulatory fines) instead of facilities maintenance or improvements.

Finally, it’s worth noting that rising volatility hurts the valuations of fixed-income investments. The VIX is currently trading below its historical average of about 20. Any rise in the VIX hurts fixed-income securities, with or without hyperinflation.

I’m staying the heck away from fixed-income investments. I’ll keep my eye on only those few types that generate cash flow from hard assets like commodities or real estate.

About Anthony Alfidi 128 Articles

Affiliation: Alfidi Capital LLC

Anthony Alfidi is the Founder and CEO of Alfidi Capital. His firm publishes free investment research with honesty and humor.

Mr. Alfidi holds a Bachelor's degree in human resource management from the University of Notre Dame (cum laude) and an MBA in finance from the University of San Francisco. He is a life member of Beta Gamma Sigma, the academic honor society for business majors. He has been a private investor since the 1990s.

Visit: Alfidi Capital

Be the first to comment

Leave a Reply

Your email address will not be published.


*