Interest rates have been low for quite some time, and if Federal Reserve projections hold true, they’ll continue to be low for a while. How might you get a yield bump in such an environment? Here are a few ideas—but remember the risks.
It’s hard out there for fixed-income investors, with the 10-year U.S. Treasury yield hovering below 1% through most of 2020, and the front end of the yield curve near zero.
It’s not likely to get better anytime soon, considering Federal Reserve Chair Jerome Powell said at the June 2020 Federal Open Market Committee (FOMC) meeting that the Fed is “not even thinking about thinking about raising rates.”
Viraj Desai, senior portfolio manager at TD Ameritrade, said some investors are taking solace in strong total bond return, and he pointed out bonds have “put up exceptional numbers.” Even in conservative portfolios investors have experienced above-average performance due to strong returns across bonds.
But that’s not likely to last, especially with interest rates as low as they are, Desai explained. If the Fed decides to embrace negative rates, these bonds might do well from a total return standpoint. However, Powell hasn’t shown much appetite to take interest rates negative, unlike in Europe or Japan.
Are you a fixed-income investor looking for the best investments for a low-rate environment? You might need to rethink how to generate income and construct a portfolio to get a return that modestly outpaces inflation. That might mean taking on a little more risk. There are several ways to approach reassessing a fixed-income portfolio, and it may take using a few of these alternatives to construct the type of income you seek.
And remember: In general, the higher the yield, the more risk a security has. Higher yield often acts as a sort of “compensation” for taking on more risk. Keep that in mind as you consider these six ideas to increase yield.
Investors who want to stay with U.S. Treasury bonds can extend duration to get higher yields, so instead of owning 10-year bonds, you might buy 30-year bonds. Longer duration means higher sensitivity to interest rate risk.
“If the Fed changes their mind and decides to turn really hawkish, those bonds are going to underperform versus where you were originally,” Desai pointed out. “The flip side of that is true. If things get worse, then bonds are going to do very well.”
Why invest in bonds when interest rates are so low? There are places to grab some additional yield—or more, depending on your risk tolerance.
U.S. Treasury bonds are seen as the gold standard, but some investment-grade corporate bonds are also highly rated. Credit-rating agencies will rate investment grade corporate bonds from AAA to BBB. The lower in the alphabet you go, the higher chance for a default. Anything rated below BBB (BB+ down through the Cs) is considered high-yield, or “junk,” bonds and runs a very high default risk. Investors who go this route need to make sure they’re being compensated well for the risk they’re taking. (Learn more about junk bonds and bond ratings.)
Investors who have time to dig in and research non-rated companies can sometimes be rewarded by finding diamonds in the rough. Desai noted that non-rated bonds are popular with active managers. Some companies forgo paying a rating agency (such as Moody’s, Fitch, or Standard & Poor’s) to issue a rating, and instead give that money in the form of a higher yield to investors. But doing it on your own takes some legwork, and there may be hidden risks that a typical investor might not consider.
The United States isn’t the only place with low yields for sovereign bonds—much of the developed world is in the same predicament. Some countries like Germany and Japan have bonds with negative yields. You could look at emerging markets, because these countries are still issuing higher-yielding government debt. Investors considering emerging-market sovereign bonds should treat them like high-yield bonds. Many emerging-market bond indices have below-investment-grade holdings. For example, the J.P. Morgan Emerging Market Bond Index has close to 40% of its bonds rated BB or lower. And there’s another risk with investing abroad: foreign exchange risk. Currency fluctuations can sometimes eat into returns. Again, that higher yield might be a form of compensation for taking on excess risk.
If foreign exchange risk is something you don’t want to add to your portfolio, these bonds also come in the dollar denominated variety.
The dividend yield on the S&P 500 Index (SPX) is around 1.8% as of late 2020, according to S&P Dow Jones Indices. This is a quite a bit more than what U.S. Treasuries are paying, so some income investors are turning to divided-paying stocks. Many dividend-paying stocks are less volatile than the broader market, but these are still equities and are at risk of a sell-off if there is a broad-market break. Some dividend-paying choices include value stocks, blue chips, and real-estate investment trusts.
Conservative investors who are less concerned about total return and more concerned about income can seek out preferred stock. In the seniority hierarchy (meaning the order of who gets paid in the event of a default or bankruptcy), preferred stockholders are right between debtholders and common equity. But unlike common shares, preferred shares typically have no voting rights. Preferred stocks tend to have less price appreciation and less volatility but often carry higher dividends.
These six types of income-targeting investments may take some reshaping of your investment portfolio. Desai suggested investors make a thorough examination of portfolio goals and objectives.
“Is the goal income? Is it growth and income? Is it growth with some income? Weighing those two things often allows you to find the right mix of yield-producing assets that you can look to based on your risk tolerance,” he said.
It’s not just about finding the best investments for a low-rate world. It’s about finding the right portfolio mix for you.