Rising Rates And Low Yields: What’s The Strategy For Income Investors?
Insight The solution for income investors is to diversify their portfolio while maintaining their desired risk.
Canadians who invest for income may feel like they are stuck between a rock and a hard place. Bond yields are low, which makes it challenging to find income with new investments in traditional government and corporate bonds. Also, low yields on fixed-income investments provide little cushion against the effects of rising interest rates. When interest rates increase, bond prices decrease. And interest rates in the United States are rising, which has implications for income investors around the world. Low yields represent the rock for income investors; rising rates are the hard place.
Risk of rising rates
The U.S. central bank has moved to tighten interest rates and it announced its third hike of this cycle in March. Other downward pressure on bond prices came in late 2016 as bond yields increased in many countries amid positive economic growth and inflation data while central banks started shifting away from some extreme policy measures like negative interest rates.
To many investors this looks like the end of a long period of declining interest rates, an environment that benefitted investors in high-quality government and corporate bonds. For years, fixed income investors could earn the coupon on their bonds along with the price appreciation of those bond portfolios.
“The reality now is that the upside/downside profile of these investments is more asymmetrical,” says Kristi Ashcroft, Senior Investment Director of Fixed Income, at Mackenzie Investments.
“Fixed income investments with low yields provide little protection against price declines if rates go up. So the seemingly safe part of a portfolio, core bonds, may at some point deliver an unpleasant surprise if there is sustained upward pressure on bond yields.”
Instead of bond portfolios offering safe havens for income investors, they now present changing risks.
A strategy for income investors
One option available to income investors is to expand the range of their investments beyond traditional core bonds while staying within their risk profile. Creating a more diversified portfolio with the desired risk characteristics can be done by integrating asset classes like high yield bonds, floating rate loans and emerging markets debt, says Ms. Ashcroft.
“These asset classes have a lower correlation to traditional fixed-income securities, so this diversifying effect helps to mitigate the overall volatility of a portfolio,” she adds. “The strategy of expanding into non-investment grade securities helps reduce a portfolio’s exposure to any single economic development or risk and also tends to boost the portfolio’s yield.”
Avoiding undesirable risks is the first pillar in Mackenzie’s strategy to protect the capital of investors, says Ashcroft.
“The Mackenzie Fixed Income Team applies rigorous fundamental credit research while building portfolios. Every security is reviewed by our credit analysts and portfolio managers, which is one big source of value from active management.”
Mackenzie also manages risk through portfolio monitoring and tactical positioning for prevailing economic and market conditions. When appropriate, portfolio managers may also use downside hedging strategies.
Today’s environment of low yields and rising interest rates creates an opportunity for financial advisors to talk with clients about what they should really expect from their bond portfolios. Conservative investors can still count on fixed-income assets to generate income, preserve capital and mitigate equity volatility but different assets may be needed to help with the heavy lifting. That’s one strategy to avoid getting stuck between a rock and a hard place.