On March 29, Fed Chair Janet Yellen gave a speech to the Economic Club of New York. Before you fall asleep, as is usually justified when it comes to mind-numbingly boring economic talk, let’s discuss how her comments will directly affect your investments. Yellen advocated for letting the economy run hot before continuing to raise interest rates. She basically admitted that the small increase administered by the Fed in December was a mistake, and that global and market events have significant influence on policy. (You don’t say …)
So now that the expectation of “lower for longer” interest rates is all but set in stone, how will this affect your investments?
First and foremost, the yields offered on savings and money market-type accounts will remain paltry. It will be hard to find and earn a safe return. Simply put: If you want a return, you’re going to have to take on more risk. Taking on more risk exposes one to a higher degree of losses and volatility. (Ironically, this is exactly what investors looking for a “safe” return want to avoid.) The search for anything with yield has caused the prices of bonds and other income-yielding assets to rise dramatically in price.
Many investors seeking yield have turned to alternative assets such as junk bonds, MLPs, utility, telecom and other dividend stocks. Whereas these can be valid long-term investments, many are treating these assets as “bond proxies” while ignoring their stock-like risks. These alternatives do have better yields than many safe assets, but they are exposed to the gyrations of the stock market. It doesn’t take much of a drop in the equity market to wipe out the small yields these alternatives offer. Plus, they’re expensive, and these assets are sensitive to changes in rates. At today’s low rates, this risk has become even greater.
Because bond yields move inversely to bond prices, it is getting harder to squeeze price returns out of bonds as interest rates get lower. The closer rates get to zero, the more sensitive bond prices become to changes in rates. As bonds increase in price, their future returns are lowered. This is true even if rates go sideways from current levels.
To understand the current situation for a conservative asset and what it implies about future returns, refer to the displayed chart. This chart presents the historical interest rate (black line) and the total return (red line) for the 10-year U.S. Treasury bond since 1928. Interests rates peaked in 1981 as the Fed finally hiked rates dramatically to kill inflation that had hobbled the economy for an extended period. Notice the sharp increase in the total return line that corresponds with the long drop in interest rates since the peak in 1981. During this period, shaded in blue, bonds performed very well. Now review the area shaded in green, which displays a period of rising interest rates. The red total return line barely rises during this period, illustrating the poor performance of bonds during this 41-year period. The point of the chart is to compare where interest rates are now and what happened to future returns the last time they were at this level. At a current yield of around 1.75% for 10-year Treasury bonds, the future return of bonds does not look good.
The Fed and other central banks are putting on a full court press to get higher inflation. But what happens if they actually get what they want? Inflation is the No. 1 enemy of bonds because it erodes the future value of bonds’ interest payments and return of principal. Central banks must raise interest rates to offset the negative effect of inflation. As interest rates rise, the prices of bonds go down. The lower rates go, the less cushion (in the form of interest earned) there is to offset decline in bond prices that come with increases in interest rates. Not predicting rampant inflation, but even a return to “normal” inflation can significantly affect bonds at their current prices. That is at the heart of what makes the current environment so risky.
So, in this low-return environment, how will we generate returns in Managed Income? Fierce flexibility and continued commitment. We look at the risk first, and then compare it to the potential return. We are more opportunistic. We expertly use a combination of strategies to offset risks — and work endlessly for your best interests. One thing is certain: Our flexible strategy will be the best approach to this uncertain future. Here are some current investment choices that we feel offer better return for the risk versus the average alternatives that many investors chasing high yield are opting for:
High Yield/Higher Risk
- Long Maturity Bonds
- High Yield (Junk) Bonds
- High Dividend Stocks
- Short to Intermediate Corporate Bonds
- Preferred Stocks
- Some REITs and Closed-End Funds
- Dividend Growth Stocks
Disclaimer Paragon Wealth Management is a provider of managed portfolios for individuals and institutions. Although the information included in this report has been obtained from sources Paragon believes to be reliable, we do not guarantee its accuracy. All opinions and estimates included in this report constitute the judgment as of the dates indicated and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Past performance is not a guarantee of future results.