Equity-like Returns with Debt-Level Risk: Dream or Reality?
Introduction
Equities, or stocks, have always held a strong appeal for investors and have been a fundamental component of numerous investment portfolios for valid reasons. Historically, the S&P 500 (including dividends) have yielded an impressive average return of 12.8% from 1950 to 2023. Nevertheless, this trajectory has been anything but steady, characterized by significant events such as Black Monday (which saw the Dow plummet by -22%), the Internet Bubble Crash (resulting in a -78% loss for NASDAQ), and the Great Financial Crisis (where the S&P 500 experienced a decline exceeding -20%).
For those who prefer a more conservative investment strategy, bonds present an opportunity for stability, capital preservation, and offering a consistent flow of interest payments. From 1950-2023, the 10-year treasury bond has maintained an average yield of 5.4%, providing a “calmer” investment option compared to stocks, albeit with returns around 40% lower and without the highs and lows associated with the stock market. However this doesn’t mean there hasn’t been any fluctuations in its returns.
Here’s the average return per decade:
Source: NYU Stern School of Business
Given the contrasting return and risk characteristics of stocks and bonds, the 60-40 portfolio allocation (60% in stocks and 40% in bonds) has gained significant popularity as a recommended approach. Yet, one cannot help but wonder: Is it possible to achieve the benefits of both asset classes? Is it feasible to secure returns akin to equities while managing risks comparable to debt instruments? Let’s find out.
Understanding Equity and Debt Investments
Equity investments, commonly known as stocks, entail owning a portion of a company. Investors acquire shares, becoming partial owners and sharing in the company's successes or setbacks. The appeal lies in the potential for capital growth and receiving dividends. However, this potential for gains also carries inherent risks. If the company underperforms, fails to meet expectations, or falls out of favor, its stock price can plummet significantly. Take Tesla, for instance, whose stock price surged at the beginning of the pandemic but at the start of 2024 , the stock dropped by nearly 20%. History demonstrates that this isn't an isolated case for a single stock but exemplifies the unpredictability investors may face in the stock market. Instances such as market crashes, economic recessions, and geopolitical upheavals have marked periods of growth with abrupt downturns.
On the other hand, debt investments often entail providing funds to an entity, usually a corporation or government, in return for consistent interest payments and the repayment of the initial amount upon maturity. Bonds are a prevalent type of debt investment, valued for their reliability and ability to generate income
The historical performance of conventional debt investments, such as the 10-year treasury bond, typically yields an average of approximately 5.4% as mentioned. Although this figure may not reach the peaks seen in the stock market, the path is considerably more stable. Debt investments are recognized for their reduced volatility, offering a dependable income flow without the ups and downs commonly experienced with equities.
50 Year Annualized Returns
“Debt investments are recognized for their reduced volatility, offering a dependable income flow without the ups and downs commonly experienced with equities. ”
In comparing the risk and return profiles of equity and debt investments, a crucial balance comes to light. Equities offer higher returns but come with the risk of higher volatility and potential capital losses. On the contrary, debt investments provide greater stability and regular income but may lag in terms of potential returns.
To illustrate this tradeoff, take a look at the chart below that shows the difference in growth investments between stocks, bonds and T-Bills over a 50 year period. This chart serves as a powerful illustration of understanding the trade-offs investors must navigate when deciding on their portfolio composition.
Growth of $10,000 Investment
“I would say whenever you can get equity-like returns taking debt-like risk, that’s something you should do”
The Appeal of Equity-Like Returns with Debt-Level Risk
Given a choice, of course Investors would always gravitate towards investments with equity-like returns and debt-level risk. This objective is particularly appealing in today's volatile and uncertain market environment.
This type of risk and return profile has mostly been seen in alternative investments that have shown themselves to be uncorrelated to traditional markets. A good example of this is private debt. According to Morgan Stanley, private lending has had higher returns relative to volatility versus high yield bonds and leveraged loans, two of the more popular fixed-income options.
High Returns Relative to Volatility
Even in high-interest environments, direct lending has consistently outperformed these other asset classes, delivering an impressive return of 11.50%.
Direct Lending’s Outperformance in High Interest Environments
Preqin, on the other hand, projects an average internal rate of return of 9.8% in private credit from 2022 to 2028. This is comparable to the stock market's 10% average return over the last five decades but comes with significantly lower risk.
Case Study: Kirkland Income Fund
The Kirkland Income Fund (KIF) is a principal preservation focused passive high-yield income fund. The fund has delivered over 11% net compounded returns for 2022 and 2023 while using no leverage*.
We tracked the fund's performance since its inception alongside various asset classes. The chart below illustrates the risk and return associated with each asset class from April 2020 to April 2024.
The S&P 500 has continued to exhibit the most significant return within the timeframe analyzed, albeit accompanied by a notably higher level of risk or standard deviation. Meanwhile, KIF managed to secure the second-highest return during this period, while maintaining the lowest level of risk (standard deviation).
Conclusion:
Achieving equity level returns and debt-level risk is indeed possible through alternative investments. It's important to note that we're not suggesting that one's entire portfolio should solely comprise these types of investments. Instead, leveraging the appealing risk and return characteristics of these asset classes can serve as a valuable diversification strategy for your portfolio, and a return enhancer for the fixed income allocation.
The Kirkland Income Fund serves as an excellent example of a fund that has delivered equity-like returns with debt-level risk, despite challenging market conditions.
Is it time you considered adding alternative fixed income products to your fixed income allocation?
If you have any questions on this article or the Kirkland Income Fund, please don’t hesitate to reach out to me at chriscarsley@kirklandcapitalgroup.com.
*Note: Past performance is not indicative of future results
