Taking a Strategic Approach in a Low-Rate Environment

Rick Spencer, CFA, Fixed Income Trader
August 18, 2016

The search for income from investments has only become more challenging in recent years.

For years, investors have been told that interest rates can only increase from here. The 10-year Treasury yielded in excess of 5 percent in 2006, and over the last 10 years, rates have moved lower and recently settled to a 1.58-percent yield. Periodically, rates have moved higher, but the longer-term downtrend remains intact.

As rates have continued to move lower over the last 10 years, investors have employed different strategies to replace lost interest income. Some of these strategies include dividend-paying stocks, high-yield bonds and REITs. In many cases, investors have assumed much greater risk to their capital than they have taken on in the past.

While some individuals have taken the high-risk route, others have gone the opposite direction into money markets and short-term CDs. By doing so, these investors are essentially pushing the investment decision into the future. Unfortunately, this strategy does not often work to their advantages.

The Cost of Market Timing

The effectiveness of market timing has long been debated in investment circles. Studies have generally shown that attempting to time the markets substantially reduces long-term investor returns relative to market returns. Hulbert Financial Digest ranks market timers on an ongoing basis in comparison to those who use a buy-and-hold approach. A 2014 Hulbert study showed that only 11 of the 81 stock market timers actually made money during the bear market that began in March 2000 and ended in October 2002. Even the few market timers who successfully predicted the bear market were too slow to re-enter the markets, hurting future returns.1

Hulbert Financial Digest found that bond market timing newsletters cost their clients 3.32 percent per year over a five-year period. On average, the recommendations generated returns of 4.18 percent annually, but this fell well short of the Treasury index’s return of 7.5 percent annually for the same period.2

A study of today’s rate structure sheds some light on why timing is so difficult. In a market in which corporate bonds pay 2–3 percent for a five-year time frame or 3.5–4 percent for 10 years, money-market rates still hover just north of zero. Though those bond rates don’t seem like much compared to 10 or 15 years ago, they still allow the investor to compound income at a much faster rate than they would in cash. In fact, even if short-term rates increase in the future, it will be difficult for the market timer to make up for lost ground.

The scenario below illustrates the difficulty of timing the market. In a scenario in which short-term rates increase by 0.5 percent per year, the market timer never catches up with the investor holding the 10-year bond at 3.5 percent. If rates stay low for another year or two, the gap becomes even more difficult to close. In our second scenario, rates stay low for the next two years and then increase by 1 percent per year before topping out at 6 percent in year eight. Even in this scenario, the market timer would not catch up until year 11.

Obviously we cannot predict the course of future interest rates, and it’s possible that they could rise sharply enough to reward market timers. However, this illustration should make clear how difficult it is to select a profitable entry point into the market.

With the 10-year Treasury currently yielding approximately 1.56 percent, BBB-rated corporate bonds earn a spread of 1.71 percent over that, resulting in a yield of 3.27 percent. For investors who are willing to invest in the lower levels of the investment-grade universe, which includes many energy and commodity companies, yields approaching or even exceeding 4 percent can be achieved.

Laddering of maturities, a strategy used to evenly spread cash flows using bonds reaching maturity in multiple time frames, is an excellent method to manage interest rate risk. A three-to-seven-year maturity range for a ladder is a solid starting point for investors who don’t want exposure to significant interest-rate risk. This portfolio structure allows for increasing future income if the economy enters a period of increasing interest rates.

In addition, diversification by industry and sector helps to protect overall portfolio performance from industry-specific issues. We’ve seen a couple of good examples of this so far in 2016. In January and February, many energy bonds reached distressed conditions as oil prices dropped below $30 per barrel. A more recent example of this is the effect of the surprise Brexit referendum on the bonds of the British banks. In both cases, the bonds traded lower in response to market conditions, though the energy bonds have regained value as oil prices have recovered.

In our challenging economic environment, it is important not to give up on the opportunity to earn a decent level of return at an acceptable level of risk. We are constantly on the lookout for value in the short to intermediate segment of the bond market, which, for you, means sensible investment opportunities that provide the opportunity to generate higher risk-adjusted returns. Working with your advisor, you can determine what role fixed income should play in your overall portfolio structure.

1 “Timing this market is guaranteed to make you a loser,” MarketWatch. Aug. 8, 2014.
2 “Timing and Selection Within the Bond Market: A Look at the Record,” Mark Hulbert. AAII Journal.

 

Disclosures:

All opinions expressed and data provided are subject to change without notice.

Some of these opinions may not be appropriate to every investor.

Investing in fixed-income securities involves special risks not typically associated with equity securities. These risks include credit risk, which is the risk of potential loss due to the inability of the issuer to meet contractual debt obligations, and interest rate risk, which is the risk that an investment’s value will change due to a change in the level of interest rates. Additionally, there is an inverse relationship between bond prices and interest rates specific to fixed-income securities. As interest rates rise, bond prices fall, and conversely, as interest rates fall, bond prices rise. You may have a gain or loss if you sell a bond prior to its maturity date.

Asset allocation/diversification of your overall investment portfolio does not assure a profit or protect against a loss in declining markets.

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