Market Update: Investing in a Low-Yield Environment: Unusual Strategies for Unusual Times
In this report you will learn:
- How a balanced portfolio is expected to perform in coming years
- Whether or not bonds still provide safety and income
- What the Federal Reserve’s stance is in this environment
- Alternative investment strategies to consider
The markets have robustly rebounded from their March bottom, but interest rates remain historically low. Traditional stock and bond portfolios are expected to have muted returns over the next several years due to the low interest rates and high stock valuations. Fixed income instruments, such as bonds, have long provided stability and cash flows to investors. Now, they may offer neither, as low yields generate little income and small protection against rising interest rates. Below, we discuss the portfolio implications of the current environment.
Source: Federal Reserve
First, allow us to provide a brief historical recap. From 2011 to 2018, the yield on 10-year Treasury bonds was rangebound between 1.50% and 3.25%. Repeated and almost consensus predictions of rising interest rates and negative bond returns (bond prices move inversely to interest rates) proved erroneous during these years. Then, from November 2018 to March of 2020, the yield plummeted unexpectedly from 3.25% to 0.50% resulting in strong bond returns. A new yield range of 0.5 to 1.0% has since developed over the past nine months and provides a poor starting point for future returns.
The Federal Reserve has stated that they are willing to tolerate higher inflation until the economy fully recovers. With so much government debt outstanding, the Fed will be very keen on keeping interest rates low. Inflation and interest rates often are highly correlated, but perhaps the two could decouple if the Fed continues to buy bonds, thus keeping downward pressure on interest rates.
While no one knows when interest rates will go up, or by how much, we do know that the current yields will make funding a retirement challenging and possibly volatile. With that in mind, what can we do to navigate the environment more profitably and comfortably?
From the non-portfolio perspective, lifestyle changes such as delaying retirement dates or reducing discretionary spending will have direct effects. Also, replenishing your cash reserves will allow one to better straddle future bear markets without excessively burdening the portfolio.
Within the bond portfolio, we advise sticking with a high-quality bonds with slightly below-average to average duration. Don’t chase higher yields by investing in longer term or lower quality bonds. The pandemic has taken a financial toll on many companies, so now is not the time to delve into lower quality bonds. Also, the present yield spread on these bonds does not adequately compensate us for the risk. When this changes, one can marginally add risk in this area.
Some other parts of the bond market are worth considering. For example, the housing market remains strong, so mortgage-backed or other securitized bonds may make sense. Also, emerging market countries have weathered the pandemic better than anticipated and can offer some higher yields. Having a quality bond manager to sort through these less traditional sectors is especially important at this time.
Stable fixed income investments remain an attractive asset class in this environment. Holdings like TIAA Traditional provide double the yields of the bond market and are immune to interest rate risk.
Another option is to maintain equity allocations a little higher for a little longer. While large technology-oriented stocks have become overpriced, other stock sectors such as small cap, value, and international have become relatively inexpensive. This would add some volatility to the portfolio, but eventually one could reduce exposure at higher levels, if patient enough.
Moving further outside of the box, one can consider areas such as precious metals and cryptocurrencies. If a high inflationary environment does arrive, traditional fiat currencies will be a poor protector of value. A small dose of bitcoin, say 1-2% of your portfolio, could serve as an insurance policy. This type of investing brings with it some hard-to-define risks, but it might be beneficial to remain open to new strategies in these unprecedented times.
Obtaining higher returns inevitably requires accepting more risk. Assessing how much risk one is taking is complicated when less traditional investments are utilized. The risks are continually changing, however, and sometimes one needs to incrementally change with them. Either that or sit tight and accept lower returns for several years. The correct answer is likely somewhere in the middle. With that in mind, 2021 might just be as active as 2020 in terms of portfolio adjustments.