With Today’s Low Rates, What About Income?
Historically, the playbook for finding yield in portfolios has been an easy one: buy U.S. Treasuries. For the majority of the 1980s, an investor seeking $100,000 of annual income would have needed to buy $1,000,000 worth of 10-year U.S. Treasuries and clip the coupons. Along with a healthy flow of income, investors benefited from consistent rate declines. Since bonds gain value when rates go down, this provided an almost no-lose scenario for bondholders.
This paradigm no longer exists, unfortunately. With 10-year U.S. Treasury rates between 1.5% and 2.0%, investors must invest $5–$6 million for the same amount of income. Compounding the issue, the current environment does not promote much room for bond values to rise from falling yields. (This is not to say yields cannot go down further in the near term, but the likelihood of a repeat of the stellar capital gains during the last 37 years is relatively low.) The result is a thin margin of safety for any bond allocation. An investor holding a 10-year bond can have three-to-four years of income wiped out if interest rates rise 1%. While this sounds unenviable, the alternative of permanently low rates could be worse.
Investors can move further along the Treasury yield curve and pick up another 0.5%, buy corporate bonds for an additional 1.5%–2.0%, or reach into the high-yield market for 3.0%–4.0%. There are no free lunches, however. Credit spreads trend in line with equity markets, and they have historically risen during times of economic stress. Rising spreads have the same effect as rising rates— bonds lose value.
In addition to providing income, Balentine believes bonds serve as a ballast to equities in today’s environment. As such, we construct portfolios with a blend of bonds, stocks, and in some cases, alternatives, to provide a high level of confidence around a worst-case scenario drawdown. We then tactically allocate to and away from fixed income based on the likelihood of stocks outperforming bonds to create a portfolio minimally allocated to bonds when rates are rising (and values are falling), and with increased exposure to bonds when rates are falling (and values are rising). At today’s lower rates, bonds can provide stability given that a 1% decline in interest rates would equate to a 6%–7% return in bonds.
Balentine believes investors in search of income should move beyond the two traditional levers, credit and maturity, to a third—illiquidity. By introducing illiquid investments (Figure 7), we can add income well above U.S. Treasuries while achieving a new level of diversification.
Illiquid investments can enhance private capital and/or income segments of a portfolio, as the diversified income streams typically begin paying distributions quicker than traditional private equity. An allocation to these assets can shorten the J-curve of a private portfolio, providing early success in a program. Importantly, these assets can produce uncorrelated returns to venture capital, buyout, real estate, or infrastructure.
Dividends are an additional solution to the yield dilemma. For example, as we harvest tax losses on individual securities, we can tilt toward higher-yielding securities within the ACWI index as opposed to investing in riskier assets such as master limited partnerships (MLPs)1 and high-yield bonds. (This is not to imply there is never a time for these securities; rather, they should not be purchased exclusively to generate yield without considering the potential for capital losses.)
If the modern-day purpose of bonds is to diversify equity risk in a portfolio, a mix of private income investments can do one better, providing higher income along the way.
The illiquid asset classes shown in Figure 7 are mostly disconnected from the gyrations of the macroeconomic landscape. While they do not provide the protection of bonds when equities suddenly drop, they offer de facto diversification by providing access to a different risk premium. So, while low inflation and slowing global growth will likely keep bond yields low, investors with a substantial portion of their assets in high-quality bonds can look to the private markets for further diversification and a high level of income.
1 This is a business venture that exists in the form of a publicly traded limited partnership. It combines the tax benefits of a private partnership (i.e., profits are taxed only when investors receive distributions) with the liquidity of a publicly traded company.
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