How to Invest in a Low Interest Rate World


 

For the last decade, the fed has been openly committed to a low interest rate policy, which has generally made sense given the weak economic growth following the financial crisis of 2008.  Along came the Coronavirus earlier this year, which led to a stalled economy and liquidity crunch in the bond market. With rates already extremely low, the Fed did the only thing they could do…drop them even further.  Fed Chairman Powell has since announced he plans to keep rates essentially at zero for the foreseeable future.  Now it is certainly up for debate whether this is the correct economic policy, but what is not debatable is the impact this has on investors – specifically those in our near retirement.  Before we jump ahead to what this means for investors and what actions they can take, it’s good to understand the purpose of fixed income investing.

For those who may be a novice, the typical way of investing in this space is through the purchase of government or corporate bonds.  This is when I as an investor basically provide a “loan” to the government or a corporation, and they agree to pay me interest in regular intervals (coupon payments), and then repay my initial investment back at the end of the agreed upon time period (maturity).  Historically people have invested in bonds because they are generally safe and provide liquidity and income along the way.  Contrast this with investing in stocks, which can have pretty extreme volatility and an unknown rate of return.  So why would anyone invest in stocks when bonds are so much more predictable and less volatile?  They have historically provided a much higher rate of return.  Over the last 95 years, stocks have outperformed One-Month T-Bills by 6-7% annualized, and Five-Year T-Notes by about 5% annualized. This highlights an important concept that is extremely relevant to this conversation:  Risk and reward are related…There is no free lunch.  Nothing out there is going to provide higher returns and lower risk than what is generally available in the market.  Based on this data, one can conclude that the investment vehicle with the highest expected returns is going to be stocks.  The purpose of bonds is very simple – to lessen the volatility of the stocks in ones portfolio, and to provide a buffer and source of liquidity when stocks are down.  This principle has been tried and true for as long as financial planning has been around, and has led investors to a couple general rules of a thumb:

  • Investing in a balanced portfolio, something close to a 50/50 split of stocks/bonds,  is an efficient way to provide a steady growth rate with not too much volatility.
  • Investing in this type of efficient portfolio will allow for a 4% “safe” withdrawal rate to provide for lasting income throughout retirement.

However, these assumptions were both predicated on historical “normal” interest rates, where one could expect to get a 3-5% return.  This is no longer the case.

You can see from the above chart that rates have been steadily declining for years, and basically bottomed out in March of this year, with the 10-year treasury rate currently sitting at 0.71%.  We are now in a scenario where roughly half of this type of portfolio went from generating about 4% historically to now close to zero.

If we assume stock returns still have an expected return of 8-10% (which may be high), then this 50/50 portfolio went from providing ~ 7% annualized historically to now having an expected return of closer to 5%.  Considering that inflation is probably coming, allocating half of your portfolio to bonds that are paying very little may result in difficulty either  A.) growing the portfolio during accumulation years or B.) maintaining an inflation-adjusted 4% withdrawal rate if drawing down the portfolio.

So as an investor, what do you do?  Unfortunately, there is no magic bullet here.  Pretty much all financial assets have some connection to either interest rates or stock market risk, and as I mentioned earlier, risk and return are related; if something sounds too good to be true, it almost definitely is.  Outside of some products that are being horribly misrepresented (ex. structured notes or annuities paying 8% with no downside), a couple options sometimes discussed is to allocate more to preferred stocks or high-dividend paying stocks, and treating the dividend payment as a “fixed” payment similar to a bond.  Both of these strategies come with their own issues.  The chart below shows the performance of stocks, high dividend stocks, preferred stocks, and bonds from 2004-present.  High dividend stocks (green line) have almost an identical risk profile to regular stocks (purple), so don’t achieve the diversification benefit of reducing volatility or providing a buffer in down markets. Preferred stocks (orange) tend have a very similar profile to bonds (blue), with the added element of similar downside risk characteristics as stocks.  Neither of these options will do much to improve the overall portfolio.

Although there are some challenges facing investors right now, there are some practical steps that can be taken to improve your odds of a successful investing experience in this low rate environment.

  • Maximize Stocks – Any money that you are not going to spend in the next 10 years can be invested in stocks.  The market is volatile in the short run, but the longer the time period, the less the volatility.  The graph below shows the rolling 10 year periods of a diversified portfolio of US stocks.  Investing at the beginning of any month from 1926 thru 10 years ago in this portfolio NEVER resulted in a negative return over 10 years.1
  • Be Flexible – If possible, allow for flexibility of withdrawals.  This can either mean spending less or finding an additional source of income (working longer, part-time job).  If you are able to reduce or turn off withdrawals at times when stocks are down, it will allow you to be much more aggressive with your stock allocation and thus reduce your exposure to low-yielding bonds.
  • Diversify – This might seem unrelated to investing in fixed income, but if the goal of bonds is to reduce volatility and buffer dramatic or prolonged down periods, properly diversifying the equity side of your portfolio can go a long way toward accomplishing this.  If your portfolio is concentrated in any one stock, sector, or asset class, it is exposed to significantly more risk than a diversified portfolio.  This necessitates a greater allocation of bonds to achieve the same level of downside protection.
  • Own the right bonds – No matter how low the yields, it is necessary to have some allocation to bonds for the purposes outlined above.  Short-term, high quality bonds are optimal for providing liquidity and minimizing volatility, and have the enviable quality of being negatively correlated to stocks, meaning they generally go up when stocks go down.  Inflation-Protected (TIPS) are great for hedging against inflation.  Straying from bonds with these characteristics can introduce unnecessary risks.
  • Pay off high interest loans – This doesn’t just mean credit card debt anymore.  Any loan for which the interest rate is higher than the prevailing bond rates is a good target to be paid off.  The important caveat is that this only applies to money that would have otherwise been invested in bonds.
  • Sacrifice liquidity when appropriate – For monies allocated for use between 5-10 years, or for those investors that just can’t stomach volatility and need to have more safety than they need liquidity, sacrificing immediate liquidity can garner a little extra return.  In these scenarios, using (good) fixed indexed annuities can provide total downside protection while providing an expected return greater than that of bonds, at the cost of giving up some liquidity.
  • Work with a professional –  Devising a plan to optimize these strategies, properly rebalance, and most importantly controlling behavior is something that is very difficult to do on your own.  Find someone qualified that you trust, and don’t get in your own way.

1. Source: DFA Returns Web.  Allocation: 25% S&P 500, 25% CRSP 6-10, 25% FF Lg Value, 25% FF Small Value

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