The problem: low yields
In today’s painfully low-yield environment, investors are starved for income. But with interest rates near generational lows across many traditional income markets, the usual sources aren’t bearing much fruit these days. Historically, high-quality bonds — those in the government and investment-grade corporate sectors of the market — have accounted for the core of an investor’s income portfolio.
The problem is that bond prices across these core sectors are extremely high today, offering only meager yield opportunities for investors. That’s because interest rates have been driven to basement levels by a combination of powerful forces, including low economic growth expectations and a historically unprecedented easy monetary policy by the central bank. For many income investors, today’s environment presents a massive conundrum. Income needs are as high as they’ve ever been, particularly considering the battering account values have experienced during the two recessions of the past decade, while income generation from many traditional investment classes has all but vanished.
The risk: price losses if rates rise
Today’s low rates pose another threat: What happens when rates start to rise? While the Fed’s current policy of holding short-term rates near zero may spur economic growth, it is also likely to be inflationary over time. As inflation rises, it becomes more difficult to preserve the value of one’s investments while also maintaining purchasing power.
Even with inflation below the 2% annual target, much of the core fixed-income market is priced for negative real returns. In other words, after accounting for inflation, they yield less than zero. For example, with annual inflation at 1.5% and most bond benchmarks currently generating negative total returns or positive earnings of less than 1.0%1, even a 1.0% return would fail to protect your investment from inflation’s eroding impact. Historically when inflation remained higher than yields for an extended period, bond investors experienced devastating consequences.
Considering these risks, we believe investors should beware of running blindly into the fixed-income markets in search of yield. Yields in all of these areas are historically low, with significant interest-rate risk embedded as part of their risk/return proposition. The seesaw of bond math is simple — prices fall as interest rates rise — so ignoring the price paid for an investment is a risky endeavor.
The challenge: investors adhering to conventional approach
Many investors seem to be ignoring those price considerations by still allocating significant portions of their assets in high-priced, low-yielding core bond strategies. Some may not recognize that if interest rates revert toward their mean, bond prices and account values will take a hit.
At Eaton Vance, we believe that investors need to apply creativity in building income portfolios that are relevant to today’s markets and hedge against key risks found in the income markets, including duration risk, credit quality and concentrated dollar exposure. The good news is that there are many options available to help build a less conventional income plan, albeit in areas of the market often easily overlooked.
Strategies to address these needs
At Eaton Vance, we believe owning a diversified set of income strategies may be a smarter approach than betting the farm on traditional bond sectors alone. That is why we suggest financial advisors and investors also consider the following strategies:
1. Floating-rate loans as a hedge against interest-rate risk
Accessible to investors through mutual funds, floating-rate loans offer sufficient income generation potential to be on any short list of investment options for a creative income strategy. Among their many features, floating-rate loans:
- Currently offer compelling yields and have historically performed well when interest rates rise.
- May provide a hedge against rising interest rates.
- Have their interest rates reset regularly, typically every three months, which makes their duration very short.
- Occupy a senior position in an issuer’s capital structure.
- Have low correlation to traditional equity and fixed-income sectors, which may help diversify2 a portfolio.
2. Multisector bond strategies as a diversified source of income
An allocation solely to traditional core fixed-income strategies may carry surprisingly high risk with the threat of bond price depreciation once interest rates start to rise. We believe investors should consider a multisector strategy for a more tactical positioning in their fixed-income portfolio allocation. A flexible approach may benefit investors by:
- Emphasizing bottom-up research, focusing on security selection across the entire income investment spectrum.
- Seeking bonds that can appreciate in price regardless of the current interest-rate environment.
- Introducing uncorrelated risks across such varied sectors as bank loans, unsecured debt, preferred stocks and convertible bonds, all of which have historically had low or negative correlations with U.S. Treasurys.
- Increasing portfolio diversification2 while potentially protecting against interest-rate risk.
3. Foreign currency as a hedge against US-dollar exposure
While most investors know the importance of portfolio diversity, they often overlook one component of diversification — currency exposure. Concentration in one or two currencies such as the U.S. dollar or the euro can create risk just like excessive concentration in a single stock or bond. Today, there are a number of compelling reasons for U.S. investors to consider exposure to foreign currency:
- Foreign investments have frequently offered higher yields than developed markets.
- Emerging-market economic fundamentals are generally strong, with economies growing at a much faster pace than more slow-growing developed-market Western countries.
- Emerging-market countries tend to have different economic cycles and interest-rate trends than the U.S.
- Currencies have particularly low correlations with the Barclays U.S. Aggregate Index.3
- A basket of foreign currencies may reduce the volatility of an overall portfolio.
4. High-yield bonds for equity-like returns with less volatility
High-yield bonds offer attractive yields relative to other income sectors. The trade-off can be higher levels of credit risk for these below-investment-grade corporate bonds. But at a time when corporations have relatively healthy balance sheets and are generally financially sound, their risk/return characteristics can be quite favorable. High-yield bonds have numerous features that may make them well-suited within a mix of income-generating bonds:
- Equity-like returns with traditionally less volatility than equities.
- Lower interest-rate sensitivity than high-quality bonds.
- A low correlation with other asset classes, thereby potentially adding to portfolio diversification.
- Historically solid relative performance with only four years of negative returns since 1980.4
5. Short-duration bonds for protection in a rising-rate environment
A tactical move to shorten the duration of bonds can be central to efforts to seek protection from interest-rate risk. The shorter a bond’s duration, the less sensitive its price is to interest-rate changes. Short-duration bonds generally have durations of three years or less and can contribute to a well-rounded income strategy in these ways:
- Short-duration bond strategies can be flexible, giving a portfolio manager the latitude to invest in what they see as the most promising parts of the market, which can include high-income short-duration bonds.
- As part of a diversified2 income-generating fixed-income portfolio, a short-duration bond strategy could include below-investment-grade bonds and convertible securities as well as other high-yielding alternatives, such as absolute return and floating-rate strategies.
- Short-duration bonds can be an attractive sector to rotate into tactically from longer-duration bonds.
Put all the pieces together
Today’s fixed-income investors face a particular challenge in generating sufficient income without undue risk exposure. As investors struggle to find a reliable income stream, we advocate they go beyond the traditional core fixed-income sectors. Although areas such as floating-rate loans and currencies may be unfamiliar territory to many investors, they are readily accessible through professional fund managers who bring years of experience in these niche sectors of the fixed-income market. Adopting a creative, diversified strategy now may spare investors future pain when interest rates start to rise, and provide a greater source of income across market cycles.
1CPI as of 4/15/14 per BLS website; bond data from Morningstar as of 4/21/14.
2Diversification does not eliminate risk nor protect against loss.
3Barclays Capital U.S. Aggregate Index is an unmanaged index of domestic investment-grade bonds, including corporate, government and mortgage-backed securities.
4Source: JPMorgan Domestic High Yield Index.
About Asset Class Comparisons
Elements of this report include comparisons of different asset classes, each of which has distinct risk and return characteristics. Every investment carries risk, and principal values and performance will fluctuate with all asset classes shown, sometimes substantially. Asset classes shown are not insured by the FDIC and are not deposits or other obligations of, or guaranteed by, any depository institution. All asset classes shown are subject to risks, including possible loss of principal invested.
The principal risks involved with investing in the asset classes shown are interest-rate risk, credit risk and liquidity risk, with each asset class shown offering a distinct combination of these risks. Generally, considered along a spectrum of risks and return potential, U.S. Treasury securities (which are guaranteed as to the payment of principal and interest by the U.S. government) offer lower credit risk, higher levels of liquidity, higher interest-rate risk and lower return potential, whereas asset classes such as high-yield corporate bonds and emerging-market bonds offer higher credit risk, lower levels of liquidity, lower interest-rate risk and higher return potential. Other asset classes shown carry different levels of each of these risk and return characteristics, and as a result generally fall varying degrees along the risk/return spectrum.
Costs and expenses associated with investing in asset classes shown will vary, sometimes substantially, depending upon specific investment vehicles chosen. No investment in the asset classes shown is insured or guaranteed, unless explicitly stated for a specific investment vehicle. Interest income earned on asset classes shown is subject to ordinary federal, state and local income taxes. In addition, federal and/or state capital gains taxes may apply to investments that are sold at a profit. Eaton Vance does not provide tax or legal advice. Prospective investors should consult with a tax or legal advisor before making any investment decision.
Investments in foreign instruments or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical or other conditions. In emerging countries, these risks may be more significant. An imbalance in supply and demand in the income market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. Investments in income securities may be affected by changes in the creditworthiness of the issuer and are subject to the risk of nonpayment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer’s ability to make principal and interest payments. As interest rates rise, the value of certain income investments is likely to decline. Investments rated below investment grade (typically referred to as “junk”) are generally subject to greater price volatility and illiquidity than higher-rated investments. Bank loans are subject to prepayment risk. Securities with longer durations tend to be more sensitive to interest rate changes than securities with shorter durations. There can be no assurance that the liquidation of collateral securing an investment will satisfy the issuer’s obligation in the event of non-payment or that collateral can be readily liquidated. The ability to realize the benefits of any collateral may be delayed or limited.
About Eaton Vance
Eaton Vance Corp. (NYSE: EV) is one of the oldest investment management firms in the United States, with a history dating to 1924. Eaton Vance and its affiliates offer individuals and institutions a broad array of investment strategies and wealth management solutions. The Company’s long record of exemplary service, timely innovation and attractive returns through a variety of market conditions has made Eaton Vance the investment manager of choice for many of today’s most discerning investors. For more information, visit eatonvance.com.
The views expressed in this Insight are those of Kathleen Gaffney and are current only through the date stated at the top of this page. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund.
This Insight may contain statements that are not historical facts, referred to as forward-looking statements. Future results may differ significantly from those stated in forward-looking statements, depending on factors such as changes in securities or financial markets or general economic conditions.
Before investing, investors should consider carefully the investment objectives, risks, charges and expenses of a mutual fund. This and other important information is contained in the prospectus and summary prospectus, which can be obtained from a financial advisor. Prospective investors should read the prospectus carefully before investing.
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Christopher Remington is Director of the Product & Portfolio Strategy Group at Eaton Vance
Michael A. Cirami, CFA, is Co-Director of the Global Income Group at Eaton Vance
Kathleen Gaffney, CFA, is Co-Director of the Investment Grade Fixed Income Group at Eaton Vance
Scott Page, CFA, is Director of the Floating-Rate Loan Group at Eaton Vance