Viewpoints: Where is the Income?May 2013
Navigating Low Rates Through 2013 and Beyond
Many investors are anxious about the dwindling income from their portfolios. They rightfully wonder if their portfolio assets will ever again provide enough income to comfortably meet expenses. We provide our perspective on why portfolio income has been shrinking and share our views on what can be done to potentially offset the effects of today’s low income environment.
Nearing the End of an Epic Bond Rally
A 30-Year Bond Rally Triggered by Government Actions
Interest rates are the thermometer of economic health. When they are high, it is a signal that inflation is untamed. Investors with long memories will remember the trendless, volatile financial markets of the 1970s—a period when inflation was steeply accelerating. Fortunately at that time, a new Fed Chairman, Paul Volker, arrived and was able to reverse inflation’s insidious path by sharply raising interest rates. These actions triggered back-to-back recessions that began to bring rates down, starting a 30-year rally in bonds.
The Downward Trend in Rates Continued
Step forward from 1979 to 2006. Low interest rates, a lack of regulatory vigilance, the rise of China and the requirement to place its massive newfound wealth somewhere safe—which could only be in US Treasury bonds—worked together to keep rates at lower levels.
The result was a vulnerable bubble in housing, as low rates made mortgages affordable. Ingenious structures to sell these mortgages to the uninformed, undisciplined or just unwary—and then package them as securities for investors—kept pumping the hot air, further inflating the bubble.
The bubble-bursting events of 2008 and 2009 leading to the “Great Recession” are well known. Lehman, AIG and Citi’s travails hinted of the widespread affliction that only a deep and prolonged recession could cleanse. The cleansing manifested itself in the massive liquidation of personal debt, including mortgage foreclosures, and the contraction in spending as consumers scrambled to balance their budgets as they faced uncertain incomes.
Central Banks Drove Rates to Near Zero—And Have Kept them There
The only financial players powerful enough to stop the ensuing economic free-fall were central banks—the Federal Reserve, the European Central Bank, the Bank of England and the People’s Bank of China. These banks implemented a long series of monetary policies to drive interest rates down in an effort to reignite investing, borrowing and consumption, and ultimately to reverse high unemployment. The Fed’s actions are working and US employment is rising. For investors, however, the byproduct has been a dramatic reduction in income from bonds; income from the 10-year Treasury dropped by nearly 64% (CHART 1).
Borrowers Benefited at the Expense of Savers
By forcing low interest rates through ongoing quantitative easing programs, the Federal Reserve and central banks around the world by design significantly altered the balance between savers and borrowers. This dynamic, referred to as “financial repression,” means that investors have essentially been subsidizing borrowing by providing low-cost funding (CHART 2).
The ultimate beneficiaries have been the borrowers who have been in a position to capitalize on low-cost financing. The public sector, led by the US government and local municipalities, has been one of the greatest beneficiaries, but in some cases the private sector has also benefited. The access to capital has been abundant not only for large multinational corporations, but also for speculative-grade issuing companies.
Some individual borrowers also benefited from the government’s efforts to lower mortgage rates. Given tighter lending standards, however, many individuals with outstanding loan balances in excess of their home’s market value have been hampered by their inability to lower their mortgage payments through refinancing.
Savers, on the other hand, endured a sharp reduction in their investment income. Discouraged by low absolute yields, many have—possibly inadvertently—begun to increase their risk exposure. In reaching for higher yield, they are shifting their focus to bonds with longer-dated maturities or to lower-quality bonds, increasing market risk or credit risk, or in some cases, both. Ironically, these very same investors who sought bonds for their safety may no longer be achieving their original objectives with respect to outright risk reduction.
Risk Aversion Drove Investors to Bonds, Despite Low Yields
Investors have demonstrated an unprecedented demand for fixed income assets, which further contributed to lower yields. Despite the prolonged period of relatively low interest rates, demand for bonds remained staggeringly strong, suggesting that we are living in a perpetual climate of extreme risk aversion. Surprisingly, even many corporate pension plan managers repositioned assets dramatically in favor of fixed income, attempting to reduce risk in favor of perceived safety and liquidity.
Bond Valuations Reached Unprecedented Levels
Over the past five decades, the price-to-earnings ratios of stocks and bonds have generally tracked each other, reflecting the ebb and flow of their relative attractiveness and prospects. The scramble to avoid risk during the Great Recession, however, has pushed bond prices, and their relative value, to unheard of levels, while leaving stocks undervalued compared to the past two decades (CHARTS 3 and 4).
Higher Income Is Available from Stocks Than from Many Areas of the Bond Market
Unlike the bond markets whose strong performance was, by and large, a result of Fed policy and unprecedented demand, stocks have benefited from fundamental improvements. Corporate America appears to be in a strong position for recovery as moderate growth, high productivity, low financing costs and an emphasis on expenses have contributed to strong cash flows and wider profit margins. Many companies have been able to buy back their own stock or return capital through cash dividends.
It is therefore no surprise that dividend yields today are relatively high, and as overall earnings continue to rise, we believe that the likelihood of further dividend increases is strong. This shift has presented investors with the unusual opportunity to earn higher income from the stock market than from many areas of the bond market (CHART 5).
Not only are dividend yields generally outpacing Treasuries, investors may also find instances when stock dividend yields exceed yields on corporate bonds. More than 25% of S&P 500 companies now offer a higher dividend yield than the average 10-year corporate bond yield (CHART 6).
Companies’ Dividend Payout Potential Appears Strong
The average dividend payout ratio (the dividend per share divided by the earnings per share) of the S&P 500 is well below its historical long-term average (CHART 7). In our view, this low ratio indicates that companies may have the potential for dividend increases in the future.
Our Outlook: A Bias Toward Equities
We believe we are coming to the end of what has been a generation-long period of total returns from bonds that rivaled, and at times, were superior to equities. After years of dramatically declining interest rates, our view is that interest rates have bottomed, and we are experiencing a period of relative stability before they begin to rise. At the same time, we feel that financial markets are approaching an inflection point where investor bias will begin turning from fixed income back to equities, potentially slowing the pace of demand for bonds.
Consistent with this view, we are positioning portfolios with an underweight asset allocation toward fixed income and an overweight allocation bias toward equities.
FIXED INCOME. While the general fixed income market has returned about 6% over the past five years, we believe returns for the next several years will be closer to the coupon, which is now generally yielding less than 2%.
We are structuring fixed income portfolios with the goal of holding their value by maintaining above-average credit quality and liquidity and below market risk. Our focus will remain on principal preservation as we move through this low-rate period. Today, corporate bonds do not appear as vulnerable as their Treasury counterparts, and we believe their more generous yield and relatively lower risk profile gives them a place in portfolios to generate income while offsetting the inevitable volatility of equities. We are seeking selective opportunities in this area to add incremental yield.
EQUITIES. Our optimism toward equities is increasing, especially in the US, as many macro-uncertainties have been resolved in our view. We have tilted portfolios toward stocks, especially those with higher dividend yields or with what we view as the strong potential to raise their dividend, to help supplement income during this persistent low-rate environment.
While stocks traditionally present higher risks than bonds, we believe that the lower risk demonstrated by stocks with a history of increasing their dividends makes them a viable income-producing alternative. We expect these stocks to earn 2% to 3% in income for portfolios.
A Reversion to the Traditional Risk/Reward Balance Will Take Place as the Recovery Proceeds
We believe that the trends in the economy and the markets are positive and more progress will likely reestablish the long-term balance of risk and reward between bonds and equities. The excesses that brought on the Great Recession of December 2007 through June 2009 were huge, and the collapse of the housing market and slow recovery in employment are their legacy. Little more can be done by the Fed that has not already been tried to speed up the recovery.
History has continually reinforced the wisdom of a balanced investment approach, and today is no exception, despite the effects of financial repression, now in its fifth year, being so hard on investors searching for income. While we expect bond yields to be meager in the near term, we also maintain our belief that bonds play an important role in diversifying portfolios and offsetting the generally greater volatility among equities. We believe that as interest rates and bond yields inevitably increase over the next several years as central banks’ repressive policies are relaxed, investors will again enjoy a more generous and lower-risk income stream that fixed income investments have historically provided.
We encourage you to contact us about this important topic. We welcome the opportunity to review your income needs and provide more information about the specific actions being taken in your own portfolio.
This communication is intended solely to provide general information. The information and opinions stated are as of March 31, 2013, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.
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