The Challenges of Low Interest Rates
This is the time of year that a lot of conversations are about the upcoming college football season. A lot of hopes and expectations are lunchtime topics, and this year is no different. But there is one big difference. This year the discussions are about hopes FOR a season. Who would have believed this just 6-7 months ago?
Like the sports world, the investment world is talking about situations we thought would never occur. But they have, and similar to the sports world, we are trying to determine the best way to manage through it.
The incredible contradiction between the current economic and job conditions versus the performance of financial markets is talked about almost as often as the outlook for a college football season.
We have talked about this to some degree in our last newsletter. But this time we want to talk more specifically about the challenges of managing diversified portfolios when there are parts of the markets creating real dilemmas.
The basic ingredients of diversified financial portfolios are stocks, bonds and cash. Historically, you have received more income from bonds than stocks. The normal expectations are that bonds provide stability and income, while stocks provide growth and growth of income via dividend increases, but with much more volatility.
Another role bonds have played is during the inevitable periods of time when stocks take a beating, money has normally flowed from stocks to high quality bonds seeking safety. When this money has come out of the stock market into bonds, it has pushed the price of bonds up which has helped offset some of the stock market downside.
But times have changed. What is starkly different now is the much lower expected return of the bond market, with yields at historically low levels. While history may be a guide, there are times when current facts make using historical data much less helpful. Just over a year ago, the ten year Treasury bond was yielding a little over 3%. Today, it is yielding approximately .65%. And many high quality corporate bonds are now yielding around 1% to 2.5%, depending on their quality and maturity date.
So bonds, the less risky portion of your portfolio, which were generating 3%-4% of interest income just 19 months ago, are now generating approximately 50% less. This big drop in yields have pushed the price of bonds up significantly, which provided an extra return for investors who bought bonds before the big rate drop.
But how about going forward? What kind of returns should investors anticipate from the bond portion of their portfolios? That is the problem for diversified portfolios that had been counting on the 3%-4% contribution from their bond exposure.
We can thank a variety of reasons for the currently low level of yields in the bond market, with the primary one being the Federal Reserve Bank (Fed). In response to the COVID-19 crisis, the Fed has embarked on programs that previously would have been unthinkable. They have been buying vast amounts of U.S. Treasury bonds to help finance the huge deficits which we are currently incurring to provide stimulus to the economy. They have even gone so far as buying bonds of corporations, which they have never done before. These moves, along with low interest rates policies of other central banks worldwide, have brought yields to these low levels. In fact, 40% of all the government bonds worldwide are actually priced to generate a “negative yield.”
So what is the net effect for investors? The math is real clear-we must lower expected returns over the intermediate period of time for the portion of your portfolio invested in the bond market. To leave in place the old assumed, historical rates of return for bonds would be a disservice given current rates.
Evaluating modifications that can help investors navigate the challenge of low interest rates is our task now.
Don’t hesitate to call with any questions or thoughts as we go through this very different period of time in many respects.
Disclosure: Any opinions are those of Beach Foster and not necessarily those of Raymond James. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. There is no assurance any of the trends mentioned will continue or forecasts will occur. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Past performance does not guarantee future results. Bond prices and yields are subject to change based upon market conditions and availability. If bonds are sold prior to maturity, you may receive more or less than your initial investment. There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices rise.
If you wish to no longer receive these emails, please reply “unsubscribe.”