While economists and pundits continue to debate the risks and merits of the unconventional monetary policy implemented by the Federal Reserve and other central banks since the financial crisis, there is little to argue about when it comes to assessing the impact these policies have had on the ability of income-oriented investors to earn attractive yields on their savings.
Investors in most kinds of long-term income-generating investments, whether investment-grade bonds or dividend stock funds, have generally benefited from the reduction of long-term interest rates as these moves have tended to drive up the capital value of their holdings. But the low levels of both short- and long-term interest rates that now prevail have made the search for yield more challenging than ever.
In this environment, investors may be tempted to reach for yield by either extending the duration of their fixed-income investments or by investing in inherently riskier securities. Moving capital toward riskier, longer-duration assets may in fact be exactly what central bankers want investors to do, on the premise that it will help drive growth in the overall economy. But is this the wisest course of action?
Interest rates may not stay low in the future, and were they to rise, an investor could be faced with a meaningful decline in the market value of his long-term bonds. Also, even with moderate inflation, the principal that the investor receives when the bonds mature might suffer a significant erosion of purchasing power.
It isn’t just long-term bonds that are at risk. Stocks with interest rate-sensitive business models and capital structures can exhibit bond-like behaviors. On the surface, these investments may seem attractive to income-seeking investors, especially compared to the paltry yields of Treasurys. However, these higher yields are often achieved through the use of financial leverage at the company level, which could make these securities even more vulnerable in a rising interest rate environment.
After the Federal Reserve’s comments that it was contemplating “tapering” its purchases of long-dated Treasurys and mortgage-backed securities, investors had an opportunity to witness how their portfolios might respond should interest rates increase to more normalized levels. After bottoming in early May near 1.6 percent, 10-year Treasury rates nearly doubled over the next four months before peaking just below 3.0 percent on September 5, Bloomberg said.
This sharp move primarily represented a response, we believe, to the signal from the Fed that extraordinary stimulus measures would, at some point in the foreseeable future, come to an end. While financial markets are always affected by multiple factors, the magnitude of the rise in interest rates allows us to review a period when rising yields were perhaps the most significant factor driving asset price fluctuations.
Between May 1 and September 5, 10-year Treasury bonds returned a negative 10 percent measured by the Barclay's U.S. Aggregate Government Treasury 10- to 20-year index, reported Factset. While the S&P 500 Index delivered a total return greater than 5 percent in this time frame, interest rate-sensitive investments such as REITs, utilities and emerging market bonds returned between -10 percent and -15 percent, Factset says. The returns were based on the S&P GICS Industry REITS Index, S&P GICS Sector Utilities Index and the JPMorgan GBI Emerging Markets Broad Composite, respectively.
Since September 5, bond yields have reversed some of their increases, allowing many interest rate-sensitive assets to recover some of their losses. The recovery affords investors the opportunity to review the performance of their income portfolios during this “summer stress test” and, if necessary, reposition their investments in anticipation of what may be a resumption of the upward trend in rates.
In today’s environment we believe it is particularly important to take a broad approach to income generation. Rather than narrowly focusing on typical interest rate sensitive equities, we believe that investors should focus first and foremost on finding attractive risk/reward opportunities in stocks with undemanding valuations, solid balance sheets, and prudent management teams, as well as a strong commitment to dividend payments. Currently, this has led us to invest in industries that may not immediately be associated with equity income, including energy, construction and technology.