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Investing in a Low Interest Rate Environment

Should indi­vid­ual investors change their approach? 

Individual investors are facing the reality of low interest rates and an inability to meet previous return expectations from fixed income.

Despite a few years of rising interest rates (i.e. 2016 – 2018), the last thirty years have seen nominal interest rates steadily fall. Post COVID has only exac­er­bated this situ­a­tion as the world is now facing a large demand shock leading to drop in GDP, higher unem­ploy­ment, and falling interest rates. If this envi­ron­ment persists for the fore­see­able future, how should indi­vid­ual investors react? Let’s examine the current situ­a­tion and then poten­tial alternatives.

How have investors performed in bonds the last decade?

There has been a bit of apathy on the investor’s part because fixed income has been a pretty good place to be invested. The prior decade watched the Barclays Aggregate Bond Index return 43.5%, or 3.68% annually. Of the 43.5% total return ~35% of that came from coupon income with remain­der from change in price

What does the bond index look like today?

Today, the yield on the Barclays Aggregate Bond Index sits at 1.18%. Given the path illus­trated above, it’s not diffi­cult to guess what this means for the future. The average maturity of the index is approx­i­mately 8 years, meaning that all else being equal, an investor would earn 9.4% over 8 years which is a paltry return – and this is before account­ing for the impact of inflation.

What can we expect going forward?

As you may have guessed, the starting yield for fixed income is the primary deter­mi­nant of future returns. Below, we show the starting yield and 5‑year forward total return. With the starting yield of the Barclays Aggregate Index at 1.18%, the future return prospects are low. While it is possible that interest rates continue to fall, future returns will be signif­i­cantly lower than the past.

But … there’s also more RISK going forward

Due to lower coupons and the fact that corpo­ra­tions are issuing longer bonds to take advan­tage of these low rates, the duration (change in price for a given change in rates) is also now higher. While longer duration is not neces­sar­ily a bad thing (ex: if rates fall, price appre­ci­a­tion would be ampli­fied), many investors may not realize this change in profile.

What’s an investor to do?

By now we’ve estab­lished that invest­ing in fixed income over the past few decades has been a good expe­ri­ence. This was due to higher yields at the begin­ning of the cycle and lower current yields.

However, we also know the future return prospects of invest­ing in fixed income are far lower and the bond index now carries more duration than in the past. Below are five poten­tial options for consid­er­a­tion in this current low rate envi­ron­ment. For purposes of this piece, we assume the equity portion of one’s port­fo­lio is left unchanged and only consider alter­na­tives to fixed income.

Stay invested in similar bonds
It’s impor­tant to note that bonds having a low starting yield does not mean they no longer have utility. Sometimes return OF capital is as impor­tant or more than return ON capital.

U.S. Treasuries are often consid­ered the true risk off” asset. Many will remember that even high-grade munic­i­pal and corpo­rate bonds strug­gled in March. If the stock market has a rough go in the coming years, exposure to tradi­tional fixed income heavy in U.S. Treasuries, Agency Mortgages, and IG corpo­rate bonds (all things heavy in the bond index) will likely hold up well.

At that point in time, an investor could rotate out of bonds which have held up well and into things which have declined.

Interest rates could in fact continue to decline. With a duration of over six years, a 100basis point (1%) decline in interest rates would likely mean a 6% increase in prices to this port­fo­lio. Moreover, the bonds held in the Barclays Index are the types of bonds being bought by the Federal Reserve. This means there will be support in the event of a further liquid­ity event.

Invest in other types of higher yielding bonds
The Federal Reserve is buying U.S. Treasuries, Agency MBS, and Corporate bonds which has provided a strong bid due to the Fed backstop. Certain types of bonds are not being purchased by The Fed includ­ing non-govern­ment backed resi­den­tial mort­gages, commer­cial mort­gages, asset backed secu­ri­ties, and munic­i­pal bonds.

There are caveats to each of those listed, but many of these are asset classes sporting more attrac­tive yields and total return profiles due to the lack of Fed buying. It might mean an annual total return poten­tial of a few hundred basis points higher than high grade corpo­rates and agency mort­gages. On the flip side, the lack of Fed buying exposes these segments to volatil­ity if we have another big economic disruption.

For indi­vid­ual investors, this will mean access­ing these segments of the fixed income markets through actively managed funds. FMC clients, or prospec­tive clients, can reach out to me for more specifics on funds are currently tracking and invested in.

Cash flowing real estate
For indi­vid­ual investors who are invest­ing taxable dollars and are in a high- income tax bracket, invest­ing in cash flowing real estate could be an attrac­tive option. However, this is depen­dent on your specific circumstances.

In exchange for taking on illiq­uid­ity and real estate specific risks, investors can earn high current yields and favor­able tax treat­ment by invest­ing in various real estate vehicles. These can spread across the multi-family, single-family, indus­trial, single-tenant net lease, and other segments of the real estate markets. All else equal, we prefer real estate in second and third tier cities with positive demo­graphic changes and favor­able tax climates. Low cost fixed long term funding is part of the allure. For example, a distri­b­u­tion facility or class B multi-family complex with a cap rate of 6% may be financ­ing with 10-year fixed rate debt at 3% at 50% loan-to-value. This equates to a high single digit return on equity, which over time can provide a large margin of error versus bonds.

These type of invest­ments are not equiv­a­lent to fixed income however, but the total return profile on an after tax basis over a 5 – 10 year period could be superior to taxable and tax-exempt bonds. The illiq­uid­ity of real estate can often be a positive feature, not a bug. Investors owning real estate do not need to be concerned with day-to-day volatil­ity which might be the case when owning a stock or bond. To be clear, this does NOT mean there’s less risk, but it may be an added psycho­log­i­cal benefit.

As Cliff Asness wrote so eloquently, What if illiquid, very infre­quently and inac­cu­rately priced invest­ments made them better investors as essen­tially it allows them to ignore such invest­ments given low measured volatil­ity and very modest paper draw­downs? Ignore” in this case equals stick with through harrow­ing times when you might sell if you had to face up to the full losses.” What if investors are simply smart enough to know that they can take on a lot more risk (true long-term risk) if it’s simply not shoved in their face every day (or multi-year period!)?

Adding uncor­re­lated return streams
Adding uncor­re­lated return streams to a tradi­tional port­fo­lio of stocks and bonds could be another poten­tial avenue to increase risk adjusted returns. Replacing a portion of a portfolio’s allo­ca­tion to low yielding bonds with an uncor­re­lated return vehicle such as a multi-strategy hedge fund could both reduce volatil­ity and increase expected returns.

In aggre­gate, hedge funds have not deliv­ered on this promise but there are certain multi-strategy funds with decades long track records which have deliv­ered strong returns relative to bonds with very low volatil­ity. Unlike equity long/​short funds, the multi-manager plat­forms do not take direc­tional market risk and target absolute returns in any envi­ron­ment. True alpha has never been worth more. If one believes excess returns can be had in an uncor­re­lated manner, it can be an appeal­ing substi­tute for a portion of low yielding fixed income.

This type of strategy is not devoid of risks and would require an investor to take on the illiq­uid­ity and idio­syn­cratic risks of each fund. In addition to higher poten­tial returns, this type of strategy has proved not only to be a buffer during volatile markets, but also produced positive returns during corrections.

Dividend stocks
It’s become very common for investors to ask them­selves why they would invest in 1% yielding bonds when they can buy blue chip dividend stocks yielding 3%+”. I will not argue the merits of invest­ing in dividend stocks on their own, I will say that the compar­i­son between stocks and bonds is completely differ­ent. Fixed income secu­ri­ties are contrac­tual claims which are typi­cally senior in the capital struc­ture. Not to mention they have a maturity date. An equity is a residual claim on the cash flows of a company, and

the issuance of a dividend is a discre­tionary decision made by the board which may or may not be continued.

Even if a stock has a high dividend yield, the total return of a stock will typi­cally be dictated by the change in price. Meaning you won’t be happy with a 6% yield if the stock drops by 20%. Dividend stocks are not a fixed income replace­ment, as looking at the yield is just one piece of the overall return profile. Adding dividend stocks as a bond replace­ment is merely doubling up on equity exposure that’s held in other areas of your portfolio.

So what should you do?

Should you stick with bonds in your invest­ment allo­ca­tion despite likely meager returns going forward? In short, it depends on your ability and will­ing­ness to take on risk in addition to other specific factors to your situ­a­tion. However, there are numerous alter­na­tives to low yielding bonds, which I list above. One or more (or none) of them could make sense in your overall asset allo­ca­tion. At the end of the day, investors must decide if they are content with lower returns going forward or if they are willing to enter­tain other options in pursuit of higher returns. If nothing else, investors’ expec­ta­tions must be adjusted for the current régime of low rates.

We are thinking about these deci­sions when review­ing your port­fo­lio, but if you would like to discuss this sooner, please feel free to reach out to a member of your Family Management Team.

David Schawel, CFA

This material contains the current opinions of Family Management Corporation and its affil­i­ates (collec­tively, FMC”), which may change without notice. This material is distrib­uted for infor­ma­tional purposes only. It is not a recom­men­da­tion or offer of any invest­ment or strategy. Nothing herein shall be consid­ered a solic­i­ta­tion to buy or sell, or an offer to buy or sell, to or from any persons in any juris­dic­tion where such solic­i­ta­tion, offer, purchase, or sale would be unlawful. Information contained herein has been obtained from sources believed to be reliable but are not guar­an­teed. FMC provides no guar­an­tees regard­ing the perfor­mance of any invest­ment or strategy. Investing entails risks, includ­ing possible loss of prin­ci­pal. Past perfor­mance is no guar­an­tee of future perfor­mance and indi­vid­ual client results will vary. No part of this material may be repro­duced in any form, or referred to in any publi­ca­tion, without the express written permis­sion of FMC.