Navigating a low interest rate environment
Typical asset allocation models were created during a time when bond yields averaged 5% and stocks returned roughly 9%. With that data in mind, a 60% stock, 40% bond portfolio would yield an annual average return of 7.4%. Retirees could enjoy 5% cash flow from a fixed portfolio. Fast-forward to the present, and the yield for the 10-year Treasury note is struggling to reach 1%, while the average 10-year Aaa corporate bond yields 2.35%. A retiree with a $300,000 corporate bond portfolio could expect roughly $7,000 in income per year, in contrast with $15,000 annually for a fixed portfolio yielding 5%. This has led investors to question the need for fixed income in a portfolio. Financial advisors offer various asset allocation strategies for a low interest rate environment. Here are seven tips to consider.
The role of bonds remains the same.
In addition to income, investors own bonds to provide stability in a well-diversified portfolio. Martha Post, chief operating officer at Team Hewins, recommends that investors develop a long-term asset allocation plan that fits their return requirements and risk tolerance and stick with it. Post acknowledges investors’ worries about reduced income from bonds. She assuages these fears by reminding investors that when interest rates rise, higher-yielding bonds can replace those with lower coupons. She also suggests that modest exposure to high-yield and emerging-market bonds can increase income, albeit with added risk. Ultimately, investing is a long-term endeavor that requires patience — and short-term decisions may not benefit long-term investors.
Increase exposure to real assets.
Consider transferring money from bonds into real assets, says Sam Solem, portfolio manager, private wealth at Intrepid Capital Management. Real assets include precious metals, commodities, real estate, land, equipment and natural resources. These can diversify a portfolio due to their relatively low correlation with financial assets such as stocks and bonds. Real assets might offer a hedge against rising inflation as well. Many real assets such as gold lack dividends, while others such as real estate can provide attractive yields. The easiest ways to invest in real assets include buying stocks, mutual funds and exchange-traded funds. Investors can choose a broadly diversified real assets fund. For sector exposure, investors can invest in specific categories such as real estate investment trusts (known as REITs), mining stocks or natural resources, and commodity sector funds.
Asset allocation isn’t a “set it and forget it” activity.
Joel Larsen, principal at Navion Financial Advisors, takes a more active approach to asset allocation — although, he reiterates the role of bonds for managing portfolio risk. “In the current setting of an overvalued stock market, looming layoffs and spiking COVID cases, an investor might want to increase bond allocations to lower portfolio risk,” Larsen says. The reason for this strategy is to curtail losses should the stock markets crash. Investing is a trade-off, balancing reward for potential risk. Thus, low yields may be preferred to exposure to excessive losses. Larsen’s strategy is to add risky equity assets to a portfolio when potential for gains is higher and vice versa. His clients prefer to leave potential gains on the table in lieu of extreme losses.
Diversify fixed income and understand risk.
Michael Cocco, managing partner at Beacon Wealth Partners, defines investing risk as the chance that your money won’t be there when you need it. With low interest rates, investors may overlook inflation or purchasing power risk in addition to volatility risk. Diversified fixed-income portfolios are just as important as diversified equities. By owning distinct types of fixed income, investors can temper volatility and increase returns. Cocco advises investors to consider short-term bonds for principal protection and riskier lower-credit-quality bonds for yield. He also reminds investors that for taxable accounts, municipal bonds have a low correlation to equities and provide tax-exempt income in most cases. Preferred stocks, despite having “stocks” in the name, actually perform more in line with fixed assets. These securities typically offer greater income than bonds.
Keep fixed-income durations shorter and seek quality.
Kirsty Peev, portfolio manager at Halpern Financial, recommends a proactive approach to portfolio design by incorporating goals and risk tolerance. In contrast with other financial professionals, Peev encourages investors to focus on quality. She says investors who chased yield with risky, low-quality bonds were badly hurt during the March 2020 market crash. Be aware of the risk of loss when seeking higher yields. When interest rates increase, bond values decline. Longer-term bonds will typically lose more value than shorter-term bonds. Thus, Peev recommends shorter-term bonds and funds when interest rates are low. Peev also prefers actively managed bond funds to index-tracking, fixed-income funds.
Increase equity allocation.
Many financial professionals recommend ramping up equity exposure. This is a riskier response to low interest rates, but for younger investors with time to make up losses, it might be a good strategy. Dividend achievers offer growing cash flow and can replace income lost from a fixed-income portfolio, while faster growing momentum stocks have the potential to grow capital. The risk of this approach is that an investor is trading greater return potential for the possibility of larger losses should the stock market decline. To temper the risk of equity volatility, investors might buy into a low-volatility fund. For example, the Invesco S&P 500 Low Volatility ETF (ticker: SPLV) invests in the 100 stocks from the S&P 500 with the lowest volatility during the prior 12 months.
Take a chance with cryptocurrency.
Bitcoin is gaining ground with traditional financial institutions. Investors might consider adding a drop of cryptocurrency exposure to a well-diversified portfolio in this low interest rate environment. Although digital currency doesn’t pay dividends, it has the potential for capital gains. When investing in cryptocurrency, first perform your due diligence. With many types of digital assets to choose, stick with those that have greater adoption. The most popular cryptocurrencies include Bitcoin, Bitcoin Cash, Litecoin, Ethereum, Binance Coin, Tron and Chainlink. Be aware that these are volatile and speculative investments, so it’s generally recommended to limit purchases to less than 5% of a portfolio.
Seven asset allocation tips in a low interest rate environment:
— The role of bonds remains the same.
— Increase exposure to real assets.
— Asset allocation isn’t a “set it and forget it” activity.
— Diversify fixed income and understand risk.
— Keep fixed-income durations shorter and seek quality.
— Increase equity allocation.
— Take a chance with cryptocurrency.