2021 couldn’t come fast enough as the dawn of a new decade ushered in a renewed sense of hope and optimism. Although it was a difficult year, 2020 witnessed exceptional efforts by the Federal Reserve in the depths of the March market decline to ward off a more perilous outcome. Their efforts, combined with increased investor confidence, brought the prices of many financial instruments back to, or above, their pre-pandemic levels. The fixed income market was no exception. Bond yields in both investment-grade and riskier, high-yield markets have recovered. Investment-grade bond yields are near all-time lows, and high-yield bond spreads, the incremental return investors demand in excess of Treasuries, returned to pre-COVID levels despite increasing defaults.
Fixed income, which primarily serves the functions of providing stable income and hedging against equity market downturns, has less to offer investors today than ever before. The chart below shows the decline in yields for the 10-year Treasury bond, which began in the early 1980s. Currently, the 10-year Treasury yield is near its lowest level dating back to 1958. As of December 31, 2020, the real yield, which is derived by taking the yield and subtracting inflation, is negative 0.72%. This trend implies that bond holders are losing purchasing power as the interest payments are worth less each year after inflation is considered. Historically, bond investors have received an average real yield of 2.27%.
Low yields, combined with the prospect of higher inflation, have many investors struggling to navigate a market where bonds offer little, if any, return potential for the next few years. Although there is no easy solution, investors may want to consider modifying their portfolios to better navigate this low and potentially rising rate environment. The following are some options that may improve portfolio returns during this low-rate period.
Decrease interest rate risk
The U.S. 10-year Treasury yield is approximately 1% today. At a paltry 1% yield, it’s difficult to suggest investors are adequately compensated for lending to the U.S. government for that length of time. Although the yield on shorter maturing bonds is lower, the bonds mature sooner, and if rates rise, the proceeds can be reinvested at a higher rate. During periods of rising interest rates, investors typically benefit from owning bonds that mature over a shorter time period as the principal can be reinvested at higher rates. However, in the short term, income will be limited since shorter maturity bonds are offering lower yields than bonds maturing further in the future.
Less inflation-sensitive asset classes
Low interest rates tend to punish fixed income investors if inflation increases. Today, many investors are preparing for higher inflation following the vast amounts of government and Fed stimulus resulting from a coordinated response to the pandemic. Should inflation return as anticipated, investors should consider including assets that tend to perform better during periods of rising inflation. Several bond categories, such as convertible bonds, emerging market bonds, and high-yield and floating-rate bonds, tend to have a higher correlation with stocks and perform better when inflation and/or economic growth increases. These asset classes introduce increased default risk compared to more traditional investment-grade bonds and generally provide little protection if stocks fall.
Less liquid asset classes
If higher income is desired, investors can look to investments that generate a relatively attractive yield but do not offer daily liquidity. Interval funds typically invest in less liquid assets, such as commercial real estate and private loans. Unlike traditional funds, they only allow quarterly liquidity on redemptions and, at times, can restrict the percentage an investor can redeem. The limited liquidity is a better match for the type of less liquid assets held in these vehicles and is only suitable for investors with a longer time horizon that have other sources of liquidity if needed.
Increase allocation to equities
Investors may also consider another avenue outside of fixed income. Low interest rates are typically beneficial to stocks as investors are typically willing to pay more for earnings when rates are low. Low rates also encourage higher leverage and more spending, which can boost economic growth. Rather than simply accept low interest rates, a portion of the portfolio normally reserved for bonds could be moved into equities. This clearly increases the risk of the portfolio, but given the current environment of lower rates, massive stimulus, and global economic recovery, this may be a palatable solution until rates begin moving higher.
We should all get used to the concept of low rates for the next few years. Investors should adjust their return expectations for bonds downward. We have provided a few options for potentially improving portfolio returns in this low rate environment, but they all come with additional risks. If you hold bonds purely to protect capital and are not concerned about return, you may maintain your current allocation and wait for rates to rise eventually. However, if you hold bonds as a source of income, you will likely want to consider some of the options presented and determine if you want to adjust your portfolio.
Above all else, seek counsel from your advisor on what opportunities are both suitable and appropriate for your long-term needs and objectives.
Meet the Expert
Director of Investments
Chris Van Dyke, CFA®, CAIA
Chris Van Dyke has over twenty years of experience in the financial industry. Since joining Aldrich in 2020, he works primarily with high-net-worth individuals, endowments and foundations, and corporate retirement plans. His role supports the firm’s investment research efforts across both traditional and alternative investments. Chris finds tremendous fulfillment in working with individuals and organizations…
- Wealth Management
- Chartered Financial Analyst (CFA®)