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.
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
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