Investing in a Low-Interest-Rate Environment

This post is from John Reimer, CFA, of Stellar Capital Management, LLC. John is my financial adviser.

For the past few years low interest rates have made it challenging for anyone looking to generate income. At present, the yield on the 10-year Treasury bond is below 2 percent, the 5-year Treasury bond yields below 1 percent, high-quality short-term corporate bonds yield very little, and bank deposits and money markets offer next to nothing. The Federal Reserve has said it plans to keep interest rates low until at least 2014 and that it could extend the time frame even further depending upon economic conditions. What is an investor to do? Here are a few alternatives that can help an investor create income in what is a very challenging environment.

Variable-rate Preferred Stocks. Although technically a stock, the structure of these issues resembles a bond more than a common stock. Key features of variable rate preferred stocks:

1) They are issued at par value, normally $25.
2) They have a specified dividend rate, and many have a floor on the dollar amount paid.
3) They are structured to permit increases in the dividend paid.

An example of such a structure is a preferred stock with a minimum dividend rate of 4 percent based on a $25 issue price, equating to a $1.00 minimum dividend per share annually. If that issue is purchased at $20, the investor would receive a 5 percent yield ($1.00/$24). Should economic conditions change (rising inflation or rising interest rates), the base rate of the dividend will increase; should rates drop, the floor yield keeps income levels intact. These issues carry call and maturity features that are important to understand when considering the price per share one is willing to pay.

Step-up Bonds. These bonds pay a set dividend or interest payment for a fixed period of time, then, at specified intervals, increase the payment to a higher level. This structure helps mitigate the risk of rising interest rates in the future, as the coupon rates increase on a set schedule. Government agencies such as Fannie Mae, Freddie Mac, and the Federal Home Loan Bank, are the most frequent issuers of step-up bonds, but corporations, understanding investors’ hesitations with buying long-term, fixed rate bonds at low interest rates, are increasingly getting into the act. Again, the call and maturity features are important to understand when considering the price per share one is willing to pay.

Floating Rate Funds. These funds invest in floating rate notes or direct loans backed by companies considered to be at the lower end of investment grade or below. The notes are short-term in nature; the interest payment floats up and down, based on widely used benchmark rates such as LIBOR (London Interbank Offered Rate), or the Federal Funds Rate; and they are often secured by assets of the borrowing company. These notes/loans typically have lower levels of defaults versus pure high yield bonds because of the shorter nature of the loans and also tend to perform better in a rising rate environment due to the floating rate feature. The average default rate on the floating rate loans from 1997-2010 was 3.8 percent while the average default rate on high yield bonds was 4.9 percent. Because floating rate bonds are often secured by assets of the issuing company, the recovery rate on defaults is much higher than other forms of unsecured debt. They offer a good source of current income and typically pay out monthly interest.

High-yield Debt Funds/ETFs. High-yield bonds are issued by companies that are normally not as financially strong as companies that qualify to offer bonds at lower rates. A term used in conjunction with the high-yield market is “spread to Treasuries,” which means how much more a high-yield bond pays compared to a U.S. Treasury bond (typically the 10-year bond). Currently, that spread is wide. Of course, much of that spread is due to the recent flight to quality, which has pushed U.S. Treasury rates to near historic lows leaving the multiple of high-yield rates over Treasury rates far above average. The combination of the absolute level of interest income and the size of the spread to Treasuries serves to offset some of the risk associated with rising interest rates. To help reduce credit risk, mutual funds or exchange-traded funds diversify their portfolio into many individual bonds, so a single default does not have a big impact on the overall value of the investment.

Emerging Market Debt. Emerging and developing economies issue bonds to fund infrastructure development, just like the U.S. or any other developed country. An allocation to this type of debt security is another method to achieve diversification and higher income than domestic bonds. The easiest way to participate in emerging market debt is through mutual funds. Many emerging market funds hedge the currency risk, meaning investors are not directly affected by swings in the exchange rates. While emerging market credit qualities have been steadily improving, their currencies can be quite volatile so the hedging employed by some of the funds helps to alleviate some of the risks. Some firms offer unhedged funds, which are more volatile, but allow investors to participate in any currency appreciation of the underlying fund holdings vs. the U.S. dollar.

Although there is more risk in other income-producing securities, they do have a place in a diversified portfolio. Some investment vehicles, such as real estate investment trusts (REITs), pay quarterly dividends which can yield 5 percent or more. While most of these do not qualify for the reduced tax rate on dividends, they can still add cash flow to one’s portfolio. Some common stocks also have big dividend payouts. These are often in the range of 3-6 percent and you also get the benefit of the current tax law, which only taxes the dividends at 15 percent at the federal level. With equity investments, an investor should always look at the total return (capital gains and dividends), especially in an environment when stocks are not moving up rapidly. In addition, high dividends are great, but understanding the payout ratio (the amount of earnings paid out in dividends), is one of the ways to avoid the things that look too good to be true.

As you can see, while interest rates are low, there are many ways to secure decent levels of income and protect yourself and benefit from rising interest rates. In this environment, it is wise not to lock yourself into a long-term fixed-rate investment, as you don’t want to be stuck in a low yielding investment that will lose value if rates move higher.