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Interest Rates May Be “Lower for Longer”: What’s an Income Investor to Do?

“Lower for longer.” This phrase, dreaded by many fixed income investors, refers to the likelihood that interest rates will stay low over the long term.

If you’re trying to generate income from your investment portfolio without taking a lot of risk, the steep drop in bond yields over the past six months has probably been a big disappointment. And we see no relief in sight: We believe that 10-year Treasury yields peaked for this business cycle at 3.25% last November, and are likely to remain below 3% for the rest of the year and into 2020.

While the prospect of ongoing low interest rates may present some challenges for income investors, it doesn’t represent a big change. Since 2011, there have only been a handful of times when 10-year Treasury yields were above 3%.

Since 2011, 10-year U.S. Treasury yields have rarely been above 3%

Source: Bloomberg, weekly data as of 5/10/2019. US Generic Govt 10 Year Yield (USGG10YR Index). Past performance is no guarantee of future results.

There are several reasons why yields have remained mostly below 3%:

1. Slowing domestic and global growth

U.S. economic growth appears to be edging down toward the longer-term annual trend rate of 2% to 2.5% that has prevailed since 2000. While gross domestic product (GDP) growth has been above that trend in recent quarters, the boost from tax cuts and government spending appears to be waning. Domestic demand, which accounts for about two-thirds of GDP growth, has been edging lower in recent quarters, suggesting a return to a lower growth trend.

U.S. GDP growth has been stronger than expected, while spending has declined

Source: Bloomberg. Gross Domestic Product (GDP CQOQ Index) and Real Final Sales of Domestic Product (A190RL1Q225SBEA), Percent Change from Preceding Period, Quarterly, Seasonally Adjusted Annual Rate. Data as of Q12019.

Leading indicators point to continued softness in growth in other major countries, as well. Europe’s growth rate has fallen to about 1% in the past year, due to a drop in manufacturing activity and trade. China’s growth rate has slowed, along with much of the rest of Asia.

The OECD Composite Leading Indicators Index has shown slowing growth

Note: The Organisation for Economic Co-operation and Development’s (OECD) work is based on continued monitoring of events in member countries as well as outside OECD area, and includes regular projections of short and medium-term economic developments.

Source: OECD as of March 2019.

As a result of slowing growth, central banks have kept interest rates very low or even negative in many major countries. U.S. government bond yields are significantly higher than those in most other major countries. Consequently, investors looking for positive returns are finding U.S. bonds attractive on a relative basis.

U.S. yields are higher than other major countries’ bond yields

Source: Bloomberg. Data as of 5/13/2019. Past performance is no guarantee of future results.

2. Central bank monetary policy is on hold or easier

Central banks in the major developed countries of the world are either easing or leaning toward easier policy as a result of sluggish growth and low inflation. Nonetheless, yield curves in most major countries are flattening despite negative short-term rates, suggesting that investors see even slower growth and lower inflation going forward. Most significant is that 10-year government bond yields are drifting into negative territory in many countries, signaling that investor demand for relatively safe assets is strong while inflation concerns are low. In that kind of environment, central banks have few alternatives to keeping rates low.

Yield curves for Germany and Japan (3 months to 10 years) have flattened

 

Source: Bloomberg. German 10-Year (GTDEM10YR Corp) Minus 3-Month Maturity (GTDEM3MO Corp) and Japan 10-Year (GTJPY10YR Corp) Minus 3-Month (GTJPY3MO Corp) Maturity, Percent, Not Seasonally Adjusted. Weekly data as of 5/13/2019.

3. Demographic forces

One of the underlying forces holding down interest rates is aging in the developed world. Consumption tends to slow as a population ages, which results in slower economic growth. Younger consumers tend to spend more, while older people usually save more, increasing the demand for bonds and keeping inflation pressures in check. Japan is the most extreme example of this trend. Its population is not just aging, but also declining, as deaths outpace births. Consequently, its central bank has been fighting deflation for many years with very easy monetary policies, but bond yields remain near zero.

In the U.S., the aging of the workforce has been correlated with declining inflation. As the ratio of young to middle-aged workers has fallen, so have interest rates. Based on population projections, the trend may have hit its trough, but any increase is expected to be modest over the next few years, suggesting limited upside in bond yields.

As the ratio of young to middle-aged U.S. workers has fallen, 10-year Treasury yields and the Consumer Price Index (CPI) have declined

Source: Bloomberg, USGG10 and CPI XYOY, annual averages through 12/2018. OECD historical population data and projections, annual averages, projections 2015-2025. The ratio of 25-to 34-year olds ("young") to 45- to 54-year olds ("middle-aged"). Past performance is no guarantee of future results.

In light of these trends, we believe that the next move by the Federal Reserve is more likely to be a rate cut than an increase, although it may not happen until later this year or next year. We should have more insight into Fed policy soon. In June, the Fed will convene a meeting in Chicago to review its policies, tools and communications strategy. The impetus for the review is concern that inflation and inflation expectations are not responding to the Fed’s policy moves as they have in the past. This has caused some Fed officials to worry that policy may be out of step with the economy.

What’s an income investor to do?

The good news is that investors looking for income can find yields that outpace inflation without taking extraordinary risks, but it does require careful consideration of the tradeoffs between risk and reward in some asset classes. We continue to believe that investors should favor higher-credit-quality bonds over lower-rated bonds, fixed-rate bonds over floating-rate, and strive for diversification.

Yields on some asset classes are above the Fed’s 2% inflation target

Note: Yield to worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting.

Source: Bloomberg Barclays. Indexes representing the investment types are: Bloomberg Barclays U.S. Corporate High-Yield Bond Index (High Yield), Bloomberg Barclays Emerging Markets Local Currency Government Index (EM Local Currency Government), Bloomberg Barclays U.S. Corporate Bond Index (Investment Grade),  ICE BofAml Fixed Rate Preferred Securities Index  (Preferreds), Bloomberg Barclays U.S. MBS Index (Agency Mortgage-Backed), Bloomberg Barclays Municipal Bond Index (Municipal), Bloomberg Barclays Global Aggregate ex-US Bond Index (International Ex-USD), monthly data as of 5/10/2019.  Past performance is no guarantee of future results.

Within the corporate bond market, we favor maintaining average credit quality above BBB (S&P, Fitch)/Baa (Moody’s) level, due to the risk that a downturn in the economy could cause a wave of credit downgrades. We aren’t suggesting that investors avoid the lowest investment-grade tiers altogether, but rather focus on holding enough higher-rated bonds to reduce their portfolio’s overall risk profile. Corporate bonds rated A currently yield about 91 basis points more than Treasuries of comparable maturity, while BBB-rated bonds yield 147 basis points more than a comparable Treasury security (a basis point is one-hundredth of a percentage point, or 0.01%). For most investors, the difference in yield is worth the reduction in risk to move up in credit quality.

For investors with a longer time horizon and the capacity to take more risk, some allocation to high-yield bonds is reasonable, as the coupon income of roughly 6% can provide some offset to the risk of price declines. However, the caveat is that the yield spread versus Treasuries is below the long-term average.

The upside in high-yield bonds may be limited

Note: Option-adjusted spreads (OAS) are quoted as a fixed spread, or differential, over U.S. Treasury issues. OAS is a method used in calculating the relative value of a fixed income security containing an embedded option, such as a borrower's option to prepay a loan. An excess return is calculated for each security in the index as the difference between the security’s total return and the total return on Treasuries in the corresponding duration cell. These excess returns are aggregated to the index level.

Source: Bloomberg. Bloomberg Barclays U.S. Corporate High-Yield Bond Index, Average OAS using monthly data as of 5/10/2019.

Investors willing to hold longer-term bonds may want to consider municipal bonds and/or preferred securities. Unlike the Treasury bond market, the yield curve in the municipal bond market is positively sloped, meaning that long-term yields are higher than short-term yields. Investors receive some compensation for taking on added duration risk. Moreover, on an after-tax basis, AAA-rated longer-term municipal bonds are offering higher yields than Treasuries. Investors in the 24% or higher federal tax brackets should consider the municipal market for allocations to longer-term bonds.

Preferred securities can also provide more income for investors willing to tolerate more interest rate risk—the average coupon rate of the issues in the ICE BofAML Fixed Rate Preferred Securities Index is 5.75%. Most preferreds either have long-term maturities or are perpetual securities with no set maturity date. They tend to be interest-rate sensitive and their prices can be very volatile, but the higher income payments help to compensate for those risks. For a small slice of a portfolio, preferreds could be a way to add income.

We also suggest investors consider shifting from floating-rate investments to fixed-rate investments. Since we doubt the Fed will raise short-term rates much more, if at all, in this cycle, the benefits of floating-rate investments have diminished. We’re especially concerned about bank loan investments, as they are low in credit quality and less liquid than other markets.

Additionally, we suggest some allocation to Treasuries for diversification from stocks. Although yields are quite low, history suggests that Treasuries tend to perform better than most other asset classes when the stock market declines.

Finally, some investors may want to consider generating income by selling assets, using a total-return approach that harvests some of a portfolio’s gains—including price appreciation—for income as needed.

The prospect for bond yields staying lower for longer means investing for income is likely to remain challenging for the foreseeable future. However, a portfolio of high-quality fixed income investments can still provide positive income and diversification from stocks.

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Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets.  Investing in emerging markets may accentuate these risks.

Currencies are speculative, very volatile and are not suitable for all investors.

Tax-exempt bonds are not necessarily suitable for all investors. Information related to a security's tax-exempt status (federal and in-state) is obtained from third parties, and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the alternative minimum tax. Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

Preferred securities are often callable, meaning the issuing company may redeem the security at a certain price after a certain date. Such call features may affect yield. Preferred securities generally have lower credit ratings and a lower claim to assets than the issuer's individual bonds. Like bonds, prices of preferred securities tend to move inversely with interest rates, so they are subject to increased loss of principal during periods of rising interest rates. Investment value will fluctuate, and preferred securities, when sold before maturity, may be worth more or less than original cost. Preferred securities are subject to various other risks including changes in interest rates and credit quality, default risks, market valuations, liquidity, prepayments, early redemption, deferral risk, corporate events, tax ramifications, and other factors.

The Bloomberg Barclays U.S. Corporate High-Yield Bond Index covers the U.S. dollar-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.

The Bloomberg Barclays Emerging Markets Local Currency Government Index is designed to provide a broad measure of the performance of local currency emerging markets debt. Classification as an emerging market is rules-based and reviewed on an annual basis using World Bank income group and International Monetary Fund country classifications.

The ICE BofAml Fixed Rate Preferred Securities Index tracks the performance of fixed-rate U.S. dollar-denominated preferred securities issued in the U.S. domestic market.

The Bloomberg Barclays U.S. Corporate Bond Index covers the U.S. dollar-denominated investment-grade, fixed-rate, taxable corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P and Fitch ratings services.

The Bloomberg Barclays US Mortgage Backed Securities (MBS) Index tracks agency mortgage pass-through securities guaranteed by Ginnie Mae (GNMA), Mae (FNMA), and Freddie Mac (FHLMC).

The Bloomberg Barclays U.S. Municipal Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed tax exempt bond market. The index includes state and local general obligation, revenue, insured and pre-refunded bonds.

The Bloomberg Barclays Global Aggregate ex USD Index provides a broad-based measure of the global investment-grade fixed-rate debt markets. The two major components of this index are the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices.

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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