By: Steve Lowe, Senior Portfolio Manager, Thrivent Asset Management October 03, 2016
If you’re wondering why you may be earning essentially no return on your bank savings or money market accounts, it may not surprise you to learn that we are currently living in what appears to be the lowest government bond interest rate environment in recorded history.
To illustrate the depths of the current interest rate market, you need look no further than the following two graphs – the 500-year history of the Dutch bond market and the 226-year history of the U.S. 10-year Treasury bond market. In both graphs, you’ll see that yields have never been this low before.
The following graph of the Dutch bond market dates back to 1517. As you can see, bond yields are at the lowest level in the history of the world’s oldest bond market:
The next graph of the U.S. Treasury market shows that the yield – which has ranged from 1.36% to about 1.6% in recent months – is the lowest it’s ever been, dating back to 1790 when Alexander Hamilton, the nation’s first Treasury Secretary, consolidated the individual states’ revolutionary war debts and issued the first U.S. federal bonds. You’ll also see that the yield has trended steadily downward for the past 36 years – from about 16% in 1980 to the sub-2% rates of today.
But rates are actually higher in the U.S. than they are in most of the world’s other major bond markets.
In fact, a dozen European nations, as well as Japan, all currently have government bonds on the market that trade at a negative yield (see chart below). In other words, the bonds pay no interest and are actually issued at a cost higher than their redemption value.
In all, as of September 2016, there were about $10.9 trillion in government bonds with negative yields on the market, according to Fitch Ratings. That accounts for about one-third of the entire global government bond market. Negative bonds were first issued in Europe in 2014.1 Prior to that, there is no record of any government issuing bonds with a negative yield.
Why so Low?
What’s the reason for these historically low-to-negative rates? They are a product of governmental monetary policies intended to stimulate economic growth. The rationale is that by making money available to businesses and consumers at an extremely low rate, more businesses would invest in capital improvements and expansion. Policy makers also hoped the cheap money encourages consumers to spend more on goods and services. The ultimate goal of low rates is to generate stronger economic growth and prevent harmful deflation by boosting inflation to around 2% percent.
Unfortunately, there’s mixed evidence to date that the strategy is working. Perhaps the most positive example has been a recovery in the U.S. housing market. More Americans are buying homes these days thanks, in part, to historically low mortgage rates.
But the low interest rates here and abroad appear to have had limited impact on capital investment by businesses. Consumers have also been slow to take the bait. In fact, in Europe we’ve noticed that consumers seem to be saving more to compensate for the lack of return that they can earn on their savings.
Retired individuals living on a fixed income may also find themselves in a pinch. Instead of living on the returns from their savings, they may be forced to tap into their principal and to cut back on their spending.
Additionally, there is some concern that low rates could fuel asset bubbles as investors drive up valuations in search of higher yields and returns. For instance, there is some concern that income-oriented investors have already driven up prices of the better dividend-paying stocks to historically high levels.
Where to Find Income
While income investment opportunities are certainly less attractive than we’ve seen in the past due to the low interest rate environment, there are some areas that may offer a reasonable return if you are willing to assume the risks associated with them.
In the bond market, there are two avenues to better yields, and they both involve some risk – “duration risk” and “credit risk.” “Duration risk” entails buying bonds with longer terms and greater interest-rate risk to get a higher yield, while “credit risk” means buying bonds with a lower credit rating and greater default risk to get a higher yield.
Investment grade corporate bonds (the highest rated bonds) are currently paying about 3%, although if you’re willing to invest in bonds with longer terms – around 30 years – you may be able to get a yield of 4% to 5%. Bonds with longer terms, however, carry greater duration risk, which increases sensitivity to changes in interest rates. If market interest rates rise, the market value and price of bonds tends to drop.
High yield corporate bonds (those with a lower credit rating) are paying in the range of 6% to 7%. But these lower rated bonds have a greater risk of default, so we believe that it’s important to be diversified, which can help reduce risk, although it won’t eliminate it. Bond mutual funds, which invest in a large group of different bonds, provide better diversification for individual investors. Although the yields on bond funds are typically somewhat lower than the yields on the individual bonds, the return still far exceeds the yield on Treasuries and most bank accounts and certificates of deposit (CD). However, that higher yield does come with more credit risk than you would face with CDs or government bonds.
Leveraged bank loans have been paying yields of about 6%. The higher yields are possible because the loans tend to be for businesses with higher debt or lower creditworthiness. As a result, these loans carry a higher credit risk than most bank loans. However, they are not as affected as most other fixed income investments by duration risk. While many bonds tend to lose value when market interest rates rise, interest payments received from leveraged loans are based on floating rates such as LIBOR2 which would increase if rates rise.
Mortgage-backed bonds generate income primarily from home mortgages. Agency mortgage-backed bonds currently pay in the range of 2% to 3%, and “non-agency” mortgages pay around 5%, but carry greater credit risk. However, mortgage-backed bonds are institutional type investments which are typically not suitable or available as investments for individuals, but are geared more to mutual funds and managed portfolios.
Dividend-paying stocks are also an option for income seekers. Utility stocks are currently paying dividends in the range of 3% to 4%, which is somewhat lower than the historic average, but still a much better yield than government bonds. You would face equity market risk – the risk of a drop in stock market prices –with dividend-paying stocks, just as you would with all stocks. This year, investors have flocked to dividend stocks, driving the S&P 500 Utility sector3 up nearly 20% – and driving down the average dividend yield. The utility sector rally has also pushed up the price-earnings ratio (PE) of the sector to about 18, which is high by historic standards. The higher stock prices and PE’s mean that these utility stocks carry an increased level of market valuation risk, (which is the risk that an asset is overvalued and prices may correct lower as valuation normalizes).
Real estate investment trusts (REITs), which also trade on the equities exchanges, are currently paying dividends in the range of 4% to 5%, but they are also trading at a relatively high level, with an average PE of about 20 (according to Goldman Sachs). Because of the relatively high prices and PE’s, we believe that REITs also have a higher than usual level of market valuation risk.
Income Oriented Mutual Funds
While many of the investments mentioned above offer above-average yields, they may not be suitable for individual investors.
But individuals may invest indirectly in many of those investments through Income-oriented mutual funds, which are professionally managed and provide broader diversification.
Government bond funds, as their name implies, invest in U.S. Treasuries and other government issued bonds. While the bonds these funds invest in are considered the least risky, they still carry duration risk, and their yields have been very low – currently around 1% to 2%.
Corporate bond funds that invest in the higher-rated investment grade bonds have been offering a higher yield – currently in the range of 2% to 4% -- but are considered to have a higher level of credit risk than government bond funds.
High yield corporate bond funds are currently paying in the range of 4% to 6%, but are considered to have a higher level of risk than government bond funds and investment grade corporate bond funds.
Municipal bond funds invest in bonds issued by state and local governments and government agencies. They are currently paying yields in the range of 1% to 3%. The yields are generally federally tax-exempt and, in certain cases, also exempt from state taxes.
Income funds invest in a variety of income-oriented investments, including many of the investments mentioned above, such as corporate bonds, mortgage-backed securities, and leveraged bank loans. These funds currently paying yields in the range of 3% to 6%.
Asset allocation funds typically invest in a wide range of stocks, bonds and other debt instruments. The returns of these types of funds may vary widely depending on the mix of assets and the movements of the markets. Asset allocation funds tend to range from aggressive, with most assets invested in stocks, to conservative, with some assets in stocks, but most in bonds and other debt instruments.’ While you may have to take on greater risks to obtain yield today than we’ve seen in the past, if you’re willing to take the risk, you may be able to earn current yields that are better than you would earn on government bonds or at your bank.
Thrivent Mutual Funds offers a variety actively managed no-load mutual funds with the goal of helping investors generate income, including Thrivent Income and High Yield Funds, as well as the Thrivent Asset Allocation Funds and the Thrivent Income Plus Funds, which are diversified with a mix of bonds and stocks to seek to achieve both income and longer-term growth.
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