Investing in 2013: Thriving in a Low-Yield Environment
By Peter McDougall
In December, the Federal Reserve announced that it would keep interest rates low until the unemployment rate drops to 6.5 percent-likely not until sometime in 2015. So investors must face the reality that the current low-yield environment for fixed income is here to stay-at least for the next few years.
Consider the current situation: In the U.S., all fixed income assets are, to some extent, priced off U.S. Treasury yields. And while the 30-year average yield for 10-year Treasuries is 3.71 percent, 10-year Treasuries yielded a mere 1.95 percent as of February 7.
“We've seen absolute yields on the Treasury curve come down, and the spreads on other products priced off of Treasuries have narrowed as well,” says John Sawyer, chief investment officer at BBVA Compass. “To a great degree, all fixed income products tend to move in lockstep.”
But while fixed income investors may not find the income they need in the securities they typically prefer, higher yields are available-if they know where to look and how to assess the various risks involved.
More risk, same reward
Low yields are forcing investors to rethink how they manage risk in their portfolios. Sawyer points out that investors continue to use bonds to offset the market risk of equities, but they do so by discounting the risks associated with inflation. "To buy into a 10-year security at current levels, you would have to say there will be no inflation for the next decade,” he says. “And that's hard to predict.”
Sawyer's advice: Fixed income should play the same role in a portfolio as it always has, but investors must revisit their assumptions about how much risk they can tolerate in order to achieve the returns they need. “Investors have to consider whether their risk objectives are still realistic, given their income needs and the current markets,” he says.
Fixed income investors have two primary options for playing with risk: term and credit. If you believe the Federal Reserve will keep rates in check in the near term, then the higher yields offered by longer-term debt are attractive. Likewise, if you believe that the economy is finally finding its feet, you may expect the risk of default to decline, making A-rated municipal bonds, for example, more appropriate for your portfolio than AAA-rated munis. Alternatively, you might shift your corporate bond allocation toward high-yield bonds.
Other fixed income alternatives, such as emerging market sovereign debt, are also available. However, Sawyer notes these types of issuers represent a big jump for most investors who are used to investing in Treasuries or munis. “While such investment may be appropriate in a diversified portfolio, they will possibly add new elements of risk to a client's holdings, such as currency risk or foreign market inflation.” Further, Sawyer adds that investors need to understand how new investments will behave by themselves as well as the impact they will have on their overall portfolio. “It's advisable for investors to take incremental steps moving along the continuum of risk until they achieve the yield they need.”
For investors willing to stray further from their current allocations, there are alternative income-generating securities to consider. For instance, investors can generate relatively robust income streams from high-quality dividend-paying stocks with track records of raising their dividends over time. The S&P 500 currently averages a dividend yield of 2.2 percent-a yield greater than 10-year Treasuries. But dividend-paying stocks are subject to the same day-to-day price volatility as other equities, which may represent an emotional challenge for traditional fixed income investors. Adding some amount of equities to a fixed income portfolio “can actually lower the overall portfolio risk,” according to Sawyer.
Another option is domestic real estate income trusts, or REITs, which generate an income stream based on internal cash flows. As noted earlier, Sawyer explains that such investment adds yet another risk exposure to one's holdings. But while such securities can be volatile, they can serve to decrease the overall volatility of the portfolio.
While acknowledging that such investments increase one's risk exposures, Sawyer stresses that all of these alternatives are appropriate when integrated into a well-balanced portfolio that is aligned with a client's goals and objectives. “Nothing is that exotic if it is held in its proper place in a portfolio,” he says.
'Investors must understand the exposures that they have from specific asset classes and ensure that not all of their exposures will behave in the same way at the same time.”
The current low-yield environment is hardly a death knell for fixed income investors. It just means investors may have to stray from their comfort zone to generate the income they need.
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