Fixed income has been the hottest investment for so long, it’s hard to even remember that stocks were once considered a sexy investment.
The Federal Reserve said Wednesday that it “will provide additional accommodation” as needed for a slowing economy, meaning interest rates are likely to stay low for a long time.
[See 8 Top-Rated Income Funds.]
Even as yields remain paltry, investors keep coming back for more. The bond market is like the joke in Woody Allen’s movie Annie Hall: One woman says to another at a Catskills resort, “The food’s horrible here,” and the other answers, “Yes, I know, and the portions are so small.”
Yes, treasury prices are high, and the rates are pathetically low. But there are reasons investors keep loading up on the safety of high-rated, low-yield debt. Other investing options carry risks that will become even more worrisome if the economy continues to falter.
“Investors ask, ‘What should I do to generate yield, given the current low interest-rate environment?’ I would advise investors not to chase yield,” says wealth manager Andy Schwartz, chief executive of Bleakley, Schwartz, Cooney & Finney LLC. “The bond market is very efficient. A greater yield is therefore equivalent to greater risk.”
Here are the main options for fixed income—and how the risk factor complicates the choice:
1. Municipal bonds. Tax-free munis are now yielding more than U.S. debt, which is unusual. Normally, muni yields are lower because their after-tax yield adds a percentage point in total return. On that basis, munis pay over 4 per cent, versus barely 3 per cent and less for U.S. bonds.
Risk: Many municipal and state governments are in tough financial straits. They are still relatively low-risk investments, but investors should be selective, or rely on a diverse bond fund that can spread the risk.
2. Sovereign debt. Returns are very attractive, to be sure, and you don’t need to go to an emerging country that you could not locate on a map to find good yields. The Power Shares DB Italian Treasury Bond Futures ETF (ITLY) gained 15 per cent in the first half of the year. Italy is stressed financially, but has been paying on its debt.
Risk: Europe’s monetary union is in tatters, and a China slowdown is hitting Asia’s other economies. The failure of India’s energy grid this week casts a spotlight on the kinds of unpredictable things that can happen in emerging economies.
3. Corporate bonds: High-yields are still paying 7 per cent, and it’s possible to find 4 per cent and 5 per cent rates from relatively safe B-rated debt issuers. The top A-rated corporate bonds pay only slightly more than the government bonds.
Risk: Standard & Poor’s figures show that about 3.5 per cent of speculative bonds default. A flood of new high-yield bonds have hit the market this year, and some credit analysts are forecasting a rise in defaults. In the latest downturn, the rate of failure was 1 in 10. For A-rated corporate bonds, the default rate is close to zero.
4. REITs: Real Estate Investment Trusts have been strong for the past three years, with returns far into the double digits, and they have been one of the strongest-performing investment sectors.
Risk: The income payments for REITs are definitely not fixed. The funds pay out 90 per cent of their net income each year. In 2007-2009, the real estate collapse caused their value to fall sharply and payouts plunged. Since then, they have benefited from low borrowing costs and a unusually high demand for rentals (chosen by many over home purchases). Few expect those fundamentals to stay in place.
5. Stock dividends. Some see it as a golden era for dividend yields. The average for S&P stocks is over 2.5 per cent. And it’s not hard to find blue chips paying in the 3 per cent to 4 per cent range.
Risk: Corporate earnings are seen peaking right now and dividend payments could suffer. There is also the risk that if profits fall, so will share prices. The 2008 and 2009 period saw the most cuts in history.
6. Floating-rate funds: The opposite of high-quality, fixed-rate investing, these funds are growing in popularity as an income solution. In part, this is because they differ from traditional bonds and bond funds in that their value does not fall as interest rates decline. Floating-rate fund managers invest in a wide variety of short-duration notes and floating-rate securities to limit the risk of a default. It also limits principal risk and provides stable value. They have paid yields in the 3.5 per cent to 4.5 per cent range over the past couple of years.
Risk: In an all-out credit crunch like the one that hit in 2008, the corporate-debt market came to a virtual standstill. In an all-out financial meltdown, you don’t want to be here. So if you fear a repeat of that crisis, don’t go there.
Schwartz explains that for floating rates, “If the coupon payments of the bonds [in the floating-note fund] rise with prevailing interest rates, the net asset value of the fund is presumably stable.”
Floating rate, however, is not a panacea for income investors. “This is just another sector of the bond market. There are many multisector bond funds that have the ability to increase and decrease exposure to this sector as the manager sees fit,” he adds.
Investors have been seeking out the stability of fixed income in response to stock market volatility. Fund investors have overwhelmingly favoured income funds over equity in recent years.
It sparked a big debate in recent days as Bill Gross, the famed PIMCO bond manager, said the “cult of equity” is dead, and took issue with Jeremy Siegel, a Pennsylvania professor who has long advocated the merits of long-term stock investing and continues to do so.
That debate is as old as the Buttonwood Agreement (the Manhattan meeting in 1792 that set up the New York Stock Exchange). But few would debate Gross’s argument from a recent tweet that “Boomers can’t take risk.” And they have more money, so financial services are offering more income products. Collateralized debt obligations, government-sponsored entity debt, master limited partnerships, and annuities are others.
Each of the investments has its own set of risks, though, requiring more planning about how to create a diversified portfolio. One solution may be to look for multisector bond funds that change their holdings to reflect changes in the economy, market sentiment, and corporate earnings.
Regardless of investing preferences, Schwartz said, “Investors should continue to maintain a well-balanced fixed-income portfolio.”