Finding income and managing risk in a near-zero interest-rate environment

William Martin, Head of Fixed-Income Portfolio Management TIAA-CREF


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Executive Summary

  • Yields in traditional fixed-income strategies are near rock-bottom, causing many investors to seek other opportunities to meet income requirements.
  • The current low-yield landscape raises important issues, including where to find adequate income, how to address the risk of rising rates and how to protect against the potential for higher inflation.
  • Some non-traditional sources of yield include emerging-market debt, U.S. high-yield debt, dividend-paying stocks, real assets and commodities.
  • A well-diversified fixed-income portfolio may provide income and generate positive returns even in a rising-rate environment.
  • We expect to see modestly higher rates into year-end, and we remain constructive on the potential for fixed-income returns in 2013.

Led by waves of retiring Baby Boomers, investors have allocated more than $1 trillion to bond funds and pulled more than a half trillion from stock funds since 2008 — at a time when interest rates have fallen to historically-low levels. Bonds can produce regular “coupon” (interest) payments and are often less volatile than stocks, especially during market downturns. These are big pluses for investors seeking capital preservation and an income stream. Yields in the traditional high-quality havens favored by income seekers are near rock-bottom, however, causing many to look for other opportunities to satisfy their income requirements.

Figure 1: Cumulative flows into stock and bond funds since 2008

Figure 1

Source: Investment Company Institute, cumulative monthly net flows into retail equity and taxable fixed-income mutual funds, as of March 2013

The current low-yield landscape raises important issues for all investors, including where to find adequate income, how to address the risk of rising rates and how to protect against the potential for higher inflation. Interest rates could remain low for at least the next two to three years as the Federal Reserve has committed to keeping them there until 2015 to stimulate job creation and economic growth. As the economy continues to improve, however, rates could begin to increase as investors seek to move out of bonds and into riskier investments such as stocks. In this article, we will look at some non-traditional options for sourcing yield and for managing risk in the current low-yield environment.

Figure 2: Difficult to find yield in investment-grade domestic bonds

Figure 2

Source: Bank of America Merrill Lynch, yield-to-maturity, end of period as of February 28, 2013

Thinking beyond the “Agg”

For retirement-plan participants, an increased exposure to fixed income often means adding more holdings based on the Barclays U.S. Aggregate Bond Index, a benchmark widely used by the industry for managing fixed-income strategies. Known as the “Agg,” the index covers more than 8,000 bonds, mostly domestic investment-grade issues, including corporate, U.S. government, and mortgage-backed securities. Approximately $4 trillion in investor assets are managed against the Agg, as it provides access to a deep, broad and liquid universe. The index has posted only two years of negative returns (1994, -2.9% and 1999, -0.8%) since 1976, which is a testament to the endurance and sturdiness of the U.S. investment-grade bond market over the last several decades. In recent years the index composition has changed, however, reflecting the evolving nature of debt issuance. For example, as U.S. government debt issuance has increased to record levels, so has its presence in the index, which is capitalization-weighted. As of the end of March, 37% of the index was comprised of U.S. Treasuries, versus about 21% a decade ago, though this figure has fluctuated over the years. Corporate bonds, which are higher-yielding, are a much lower component of the index today versus a decade ago.

There are many options outside of the Agg to consider, including some that offer income-generating opportunities. As with all investments, there is no such thing as a “silver bullet,” as all approaches involve risk.

Emerging-market debt

International fixed-income markets have matured over the last two decades and far surpass the U.S. market in terms of total issuance size. The non-U.S. debt market is roughly $74 trillion, nine times what it was in 1989 and almost triple the size of the U.S. debt market.1 One fast-growing segment of the international market is emerging-market debt. The credit quality of emerging market issuers has also improved, as the percentage of investment-grade EM countries has increased from 39% in 2007 to 62% in 2012.2 The advantage of having an allocation to EM debt has been evident in recent years, including in 2012, when returns for these markets led the way (see Figure 3). As of early April 2013, EM government debt was yielding 5.2%, compared to 1.86% for the broad U.S. bond market.3

Figure 3: Fixed-income market returns in 2012

Figure 3

Source: FactSet, as of April 2013. The performance discussion above concerns various market indices. It is not possible to invest in an index. Performance for indices does not reflect investment fees or transactions costs.

By making an international allocation, investors may improve risk-adjusted returns versus a fixed-income strategy focused solely on the domestic U.S. market. Despite these returns, EM investing involves many risks, including the potential for currency risk, however, which investors should consider carefully.

U.S. high-yield debt

U.S. high-yield debt offers another way to help build a diversified portfolio. High-yield debt has low correlations to investment-grade fixed income and may offer lower sensitivity to rising interest rates than Treasuries. Yields in the high-yield segment are also currently near record lows (6.14% as of early April), which could make an allocation challenging now, though spreads remain above pre-crisis levels, providing cushion to our current forecast for high-yield defaults.4 As economic activity continues to pick up, the risk of issuer default—one of the primary risks of investing in high yield debt—should remain steady or even decline, as measured by the credit default rate.5

High-yield bonds have historically outperformed investment-grade corporate bonds and have exhibited performance characteristics that are similar to stocks, but with less volatility. This may make high-yield bonds an attractive "middle ground" for investors looking for a mix of risk/reward options plus attractive yields.

Dividend-paying stocks

Historically, yields on bonds exceed those of stocks—and usually by a wide margin. The yields of these two asset classes converged during the financial crisis as investors piled into bonds, bidding up prices and causing yields to dip. Nowadays, the yield on the S&P 500 Index is competitive with the yield on 10-year Treasury notes. (Of course, despite offering competitive yield, stocks have risk characteristics that are far different from those for bonds.) While these relative yields are an interesting market anomaly, we expect the historical relationship between equities and fixed income to eventually normalize as the economy stabilizes and the Federal Reserve shifts away from quantitative easing. An income-seeker with a longer-time horizon may consider stocks as part of an overall strategy.

Figure 4: Equity yields edged higher than bonds

Figure 4

Source: Haver Analytics, as of April 2013.

Real assets

Real assets refer to investments such as precious metals, commodities and property. Many real assets have highly favorable economics—that is, the end products are in demand by a growing world population and there is only so much supply. The assets also have the advantage of not being highly correlated with traditional fixed-income securities. Real assets often offer hybrid investment characteristics—equity-like upside along with relatively stable bond-like income. TIAA-CREF, for instance, invests in timberland in North and South America, Australia and New Zealand. These strategies provide diversification and income, in addition to inflation-hedging benefits. Investment strategies like these are becoming more common and available to more investors as they provide another income-generating option.6

Fixed annuities

In an era of low interest rates, annuities may have an increasing role to play in retirement planning as they can offer steady income. With fixed or guaranteed annuities, the issuer, not the contract owner, assumes all investment risk. Fixed annuities offer a guaranteed payment, with the payout amount calculated in part based on the assumed future returns of the investments in the underlying portfolio that supports the annuity’s guarantees, and on the annuitant’s life expectancy. All guarantees are based upon the claims-paying ability of the issuing insurance company. The payment can be fixed for life or can allow for future increases. Fixed annuity payments are not negatively impacted by changing interest rates, though bond values may fluctuate. This characteristic of annuities may provide enhanced diversification and offer greater ability to control risk in a broader portfolio.

The risk of rising rates and inflation

There are two major risks in bond investing: credit risk (risk of issuer default) and interest-rate risk. Many investors are concerned with interest-rate risk, as rates are expected by many to increase in the months and possibly years to come. While the Federal Reserve has committed to keeping its short-term policy rates low until 2015, market effects could trigger rate increases before then. As the economy improves, investors may move from safe havens such as Treasuries and other U.S. government securities into riskier asset classes such as stocks and high-yield debt. With less demand for conservative bonds, interest rates may rise.

Some bonds are more sensitive to rising rates than others, which is why duration is a critical concept to understand in fixed-income investing. Duration is a measurement of a bond or bond fund’s sensitivity to a change in interest rates, expressed in a number of years. Bond values fluctuate with rising and falling interest rates. Bonds and bond funds with longer duration tend to be more sensitive to rising and falling rates. Longer duration has helped some bonds outperform during a declining rate environment, but that same attribute could cause underperformance versus shorter-duration bonds in a rising rate environment. Duration of the Barclays U.S. Aggregate Bond Index, for example, was 5.26 years compared to 4.34 years on the Barclays High Yield Very Liquid Index in early April, which would indicate that the Agg is more sensitive to rate changes than the high yield index, though the high-yield index may exhibit greater spread volatility.7 High-yield bonds also typically appreciate in value when the economy improves, as default rates tend to fall, and investors seek opportunities for achieving greater returns. High-yield spreads, or the difference in yield between high-yield bonds and similar Treasury bonds, tend to narrow when an economy improves, which indicates investor demand for the asset class.

Inflation is also problematic for bonds, since it erodes the value of the fixed payments that they generate. As the real value of those fixed payments declines, there is generally a fall in the price of the underlying security.

There are a number of ways to invest in fixed income while seeking to minimize exposure to rising rates and inflation, including investing in bonds and funds with shorter duration. Treasury Inflation-Protected Securities (TIPS), floating-rate loans and other inflation-sensitive assets, such as commodities and real estate, also offer opportunities to manage risk in, and add return to, a fixed-income strategy.

At TIAA-CREF, we believe it is possible to mitigate rising rates and maintain high levels of liquidity while generating attractive returns. We look for opportunities to invest in high-yield, emerging-market debt, leveraged loans — which are sectors that tend to offer portfolio protection and yield opportunities when interest rates rise, while other sectors, such as U.S. Treasuries, generally underperform during these periods. When we see increased potential for rising rates, we look for opportunities in these sectors, and for opportunities to maintain the flexibility to move in or out of a position, or hold onto bonds that will continue to provide income and stability during uncertain times.

Expanding diversification in a fixed-income portfolio

Retirees not long ago could park capital in low-risk forms of debt and be confident about preserving the value of their investment. In the year 2000, for instance, $100,000 invested in U.S. Treasury bills would have produced close to $5,700 over the course of the year — a 5.7% rate of interest, and more than enough to compensate for that year’s 3.4% inflation rate.

Those days are a memory. Today, $100,000 invested in Treasury bills would produce an anemic $110 over the course of a year,8 which is not nearly enough to keep pace with inflation, which averaged 2.1% in 2012.

A well-diversified fixed-income portfolio that includes exposure to a range of income-producing asset classes has the potential to provide income and generate positive returns even in a rising-rate environment. Barring a large, unexpected rate spike, we expect to see modestly higher rates into year-end, and we remain constructive on the potential for fixed-income returns in 2013.

Investors should consider their views on inflation, their risk tolerance and their specific investment goals when making an allocation to any asset class. Knowing and understanding the composition of a bond portfolio can help investors understand how their investments may perform under different scenarios, including under low-rate and rising-rate conditions.