As we all are aware, interest rates are at historic lows. In fact, rates have been coming down rather consistently for the last thirty-five years. In the mid-1980’s, one could invest in a 30-year U.S. Treasury bond and receive a rate of over 14% for the next three decades. Now, that same 30-year bond yields a meager 1.95%. The 10-year Treasury note is now yielding 1.45%.¹ For a person who retired in 1984, generating income for the rest of their life may have only been a matter of investing in a laddered portfolio of U.S. Treasuries. Nowadays, the income solution is more challenging.
Some investors are of the belief that this is a temporary situation, and that rates “have to go up.” Well, maybe, but maybe not in the near future. A quick look at a chart of rates shows that they move in very long cycles. The last time rates bottomed near this level was at the end of World War II, and the subsequent move up unfolded over nearly four decades. The prior peak was twenty-five years earlier.
We know that interest rates are driven by a combination of expectations for inflation and economic growth. Given this, the bond market appears to be predicting a long period of low growth and low inflation.
So, if rates aren’t going to help us generate income, we might ask two questions:
- Why hold bonds at all?
- How do we generate income?
The first question seems simple enough. If rates are going to stay low, then it would seem obvious to abandon the asset class. But it’s not that simple. As we’ve seen in other developed countries that are now experiencing negative interest rate environments, total return may still be available. As most investors know, when rates go down, bond values go up. So, if the projection is for lower rates, we would want to consider adding to bond holdings to take advantage of that change. But perhaps more important than speculating on a return, we may also be wise to consider holding onto bonds as a hedge to the rest of the portfolio. Bonds have historically been considered a hedge against stock market volatility, and they continue to be despite low rates. The importance of this cannot be overstated. To abandon bonds in hopes of higher returns in equities or other alternatives could be a very risky approach.
The second question is more difficult. But as we consider this issue, always keep in mind that in investing, there’s no such thing as a free lunch. Any time an investor reaches for a higher return, they also increase the potential for negative volatility.
Our observation is that at the moment, the S&P 500 stock index has an average dividend yield that is nearly equivalent to the yield on a 30-year Treasury bond, about 1.95%. This yield, spread between the two, is very small – effectively 0.00%. If we look at the dividend rate for some of the higher dividend paying stocks, we will see that those dividend rates are rather attractive. So, one might think it simple enough to lean in the direction of those stocks, pick some high-dividend payers, and hope for the best. But remember the “free lunch” issue. Without meaningful analysis of the income statements and balance sheets of these companies, an investment may hold hidden risks.
Another way to generate income may be to investigate “alternative” asset classes such as hedge funds, private equity, master limited partnerships, or real estate. We see some of these opportunities as interesting for the right investor, but they typically come with significant investment minimums and tie-up periods, as well as complex tax reporting requirements. But, while these things may complicate the investment, they may provide a supplement to a larger portfolio of stocks and bonds. Ask your Atlas Wealth Management Advisor if these may be right for you.
Ultimately, our view is that the solution lays in a prudent, considered combination of approaches. We think that dividends will become a much more meaningful component of yield for a portfolio, and that with a prudent allocation to dividend paying stocks, we can offset some of the negative impact of low rates. That said, we also believe the need for total return (as opposed to simple interest income) will have to be considered for the investor nearing retirement in the next decade. There is no single approach to this issue, and it is dependent on the needs, risk tolerance, and time horizon of the investor.
At Atlas, we are actively adjusting portfolios to protect principal and to generate total return. If you have questions regarding any changes being made, or the right approach for you, please feel free to contact your Atlas Wealth Management Advisor to discuss your options.