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April 15, 2021 Article 8 min read
Interest rates are at historically low levels, presenting fixed income investors with challenges for forward-looking returns. Investors may benefit from considering alternative investments to supplement their fixed income portfolios in this environment.

Introduction

Fixed income investors are facing historic challenges with forward-looking returns in a yield-starved world. At the beginning of 2021, 10-year U.S. Treasury Bond rates were just above 1%, investment-grade corporate debt had generated negative real-yields (inflation-adjusted income) for the first time in history, and 30-year mortgage rates were at historic levels as low as 2.65%. Although interest rates have seen a notable uptick since early February as investors digest expectations for the economy picking up with higher growth and inflation, absolute rates remain low.Woman checking her phone

The starting yield is an important determinant of prospective future performance. For long-term buy-and-hold investors, return is capped at the yield that comes from the promised interest payments and payoff at par upon maturity (assuming no losses or defaults and the bond is held until that time). With lower returns expected from traditional fixed income sources, investors are asking, “are there other bond replacements or income sources that I can use to supplement my fixed income portfolio?” In this article, we will explore some of these alternative investment options and highlight relevant considerations and trade-offs. First, let’s look at the path that led to the current low-rate environment and the role that fixed income plays in a portfolio.

A long road to the bottom

On a global basis, interest rates have been trending lower for decades. There are several structural factors contributing to this move, including slowing economic growth, low inflation, growing global savings, and the expanding share of debt capital from less capital-intensive businesses lowering the cost of capital. As larger generations reach retirement age and advancements in healthcare have improved life expectancy, labor force participation in developed economies has declined, GDP growth has waned, and savings rates have risen. Like much of the developed world, observed inflation in the United States has consistently undershot Federal Reserve (the Fed) targets over much of the past decade because of aging demographics, the economy’s transition to less capital-intensive industries like technology, and globalization, among other factors. As these trends continue, the consensus expectation is that interest rates can remain relatively low for the foreseeable future. Still, a cyclical increase in rates should be expected as the economy continues to recover and inflation edges back to or through the Fed’s 2% target.

The long-term decline in rates chart

Over the past decade, the Fed’s target rates have been well below their historical levels. After a short period of rate hikes, the central bank trimmed its benchmark rate in 2019, a preemptive move aimed at extending the economic expansion against rising trade tensions and a slowdown in global growth. The Fed’s next step came last March as the COVID-19 pandemic threatened the economy and financial markets. One of the central bank’s first actions taken to combat the economic effects of COVID-19 was the slashing of the Federal Funds rate by approximately 1.5% to a range of 0–0.25% within a two-week span. In June 2020, the Fed announced its expectation to keep rates near zero through 2023, and recently reiterated this guidance following its March 2021 meeting. Thus, the economy's need for support, in combination with the structural factors already pressuring rates downward, makes it unlikely that the central bank will raise its policy rate in the near term. Of course, a faster economic rebound or surging inflation could accelerate that plan and cause the Fed to act more quickly, although policymakers have clearly signaled their intent to let inflation exceed their 2% target for some time.

Purpose of fixed income in the portfolio

A fixed income allocation generally serves multiple purposes in a diversified portfolio: acting as source of income, a hedge during periods of volatility, a source of liquidity, and a means of diversifying portfolio returns away from equity market risk. The income aspect of fixed income investments provides investors with a consistent cash flow.Alternative investment benefits Additionally, returns will be influenced by changes in the pricing of fixed income securities. Consistently falling interest rates over the past 30 years have provided bond investors with meaningful price appreciation on their investments, while at the same time reducing the effective yield of portfolios over time.

In a low interest-rate environment, duration risk — the risk of rising interest rates reducing the market value of the fixed income portfolio — is often noted as the greatest risk to future returns of a fixed income portfolio. Looking back at periods when broad-market interest rates rose materially, defined as a greater than 1.5% increase for the U.S. Aggregate Bond Index in under 36 months, we see a notable short-term impact on portfolio returns. However, over longer time frames, this negative performance has historically reversed as the benefit of higher rates (more income) helped to offset reductions in principal valuations that occurred as rates were rising. For example, for a bond portfolio with a constant duration of six years and a yield to maturity of 2.5% to lose money over a five-year period, the average yield would need to rise to 5%, assuming no defaults. This concept — and practical experience — strongly reinforces the benefit of continuing to hold fixed income investments within a broadly diversified portfolio, even in a low interest-rate or rising interest rate environment.Returns Chart

Alternative strategies to traditional fixed income

While historical trends are important to understand, investors in today’s low interest-rate environment can’t avoid the fact that finding a balance between yield and risk has once again become difficult. Despite the recent surge in long-term yields, they remain near historical lows. As such, fixed-income investors could consider alternative yield-generating strategies to earn rates of return more closely resembling historical averages.

Outside of traditional bonds, investors have a variety of options to consider as supplements to fixed income that offer higher yields and/or uncorrelated returns. However, these return opportunities require trade-offs, such as moving out on the risk spectrum, sacrificing liquidity, or accepting reduced transparency, higher leverage, and/or additional portfolio complexity. Investors should carefully consider each of these risks prior to investment. These alternative strategies may include:

  • High-yield opportunistic credit: Noninvestment-grade corporate and municipal debt, defined as bonds rated below BBB- or Baa3 by established credit agencies, can offer investors a higher yield than government bonds or high-grade corporate and municipal credit. These markets can also provide opportunities for active managers to add value through credit selection and downside risk management. Skilled management in this space is critical to reduce the risk of defaults or restructurings that could be costly to the investor.
  •  Private credit: Investors are increasingly extending loans directly to firms seeking to bypass financial institutions, a trend that has been rapidly growing since the 2008-2009 financial crisis. Private credit is typically offered to smaller businesses with earnings below $100 million. A majority of this capital is allocated to private credit funds specializing in direct lending and mezzanine debt, which focus almost exclusively on lending to private equity buyouts. Investors have been attracted to private debt due to its higher yields, which range from mid-to-high single digits. Some funds may further enhance these yields through the use of leverage. These investments are highly illiquid and may present further credit risk. To illustrate, the leveraged loan index, a common public market proxy for middle market loans, has historically averaged a default rate of approximately 2.2% with a peak annual default reaching nearly 10% in 2009.1 By comparison, investment-grade corporate bond defaults have averaged 0.12% since 2001 with a peak annual rate of 0.75% in 2008.2 Manager selection is beneficial in the high-yield market, but it’s absolutely critical here.
  •  Real estate strategies: Real estate can offer a stable, growing source of income from the cash flow generated by the property assets. Investors can consider equity or debt exposure to real estate investments across various risk levels. Core or core-plus private real estate funds invest in stabilized real estate with moderate leverage across various subsectors and geographies. Returns are principally driven by income, which has generally delivered mid-single digits annually, with the potential for modest property appreciation, especially in an inflationary environment. Real estate debt strategies can vary across capital structures and lending solutions, but generally involve the purchase of structured real estate-related assets such as residential and commercial mortgage-backed securities.
  • Insurance products: A number of insurance-related products held within life insurance and annuity vehicles may offer a higher rate of return than the current yields offered by the bond market, while also providing some level of principal protection. Life insurance death benefit as an investment, cash value life insurance and annuity products that are based on a collared return of the stock market, and other equity market hedged products within an annuity are a few areas that are interesting to consider in today’s interest rate environment. Of course, the caveats to these vehicles, including illiquidity/surrender penalties, fees, investment time frame, and other considerations are critical to understand prior to making an investment.
  • Hedge fund strategies: Hedge funds vary broadly in terms of their risk-and-return targets, but many reputable managers employ diversified, uncorrelated strategies with exposure to equity, credit, commodity, and derivative markets through idiosyncratic opportunities. Additionally, some hedge funds employ trading-oriented strategies with less reliance on market direction, which may further add diversification to a portfolio. Credit-oriented hedge funds often specialize in complex debt arrangements and structures that are less dependent on the direction of interest rates or credit markets. However, investors in hedge funds will typically be subject to stricter liquidity terms than in traditional investments.

Clearly, alternative solutions can enhance income generation and return potential relative to core bonds, but may introduce additional risks, cost, or complexity to a portfolio. Investors who consider such strategies should recognize that the increased yield comes at a price. Whether that price is worth paying depends on the goals, objectives, and risk tolerance of the individual investor. Assuming those hurdles can be overcome, these options can be attractive additions to a diversified portfolio seeking to enhance their portfolio yield and potential return.

Yield comparison across asset classes chart

Conclusion

The low interest-rate environment has created unique considerations across the entire investment landscape, which may last for years to come. Rates in developed economies have been low for an extended period and investors seeking higher yields may want to consider various alternatives to their traditional fixed income holdings to enhance return potential. While we believe that traditional fixed income assets are still a critical building block in a diversified portfolio, investors who are comfortable with the additional risks associated with various alternative strategies may find viable solutions to meet future goals and return targets.

Sources:
1 Default rate of the S&P/LSTA Leveraged Loan Index, measured by principal amount. The S&P/LSTA Leveraged Loan Index is a market value-weighted index designed to measure the performance of the U.S. broadly syndicated loan market based upon market weightings, spreads, and interest payments.
2 S&P Global Ratings Research

Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.

Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other sources believed to be reliable. However, some or all information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis non-factual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree.

Plante Moran Financial Advisors (PMFA) publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the companies or sectors mentioned herein may not be appropriate for you. You should consult a representative from PMFA for investment advice regarding your own situation.