Stubbornly low yields have made income tough to come by in recent years, and they have sent investors searching for yield and income wherever they can find it.
A key question on investors’ minds remains how long low rates, and the accompanying search for yield, are likely to continue. As I write in my new Market Perspectives paper, “Stuck in the Low Yield Environment,” the search for yield is likely to remain in place throughout the remainder of this year and into 2015.
Why? The reality is that while the U.S. economy continues to recover, short-term interest rates are likely to remain anchored at zero throughout 2014. The Federal Reserve (Fed) is facing few inflationary pressures and structural challenges are keeping employment low.
Meanwhile, there are several factors—both cyclical and secular—that are conspiring to hold down long-term rates. These factors include the tail end of the consumer deleveraging, lower supply of debt, a strong institutional need for high quality bonds, and demographic trends.
While I still expect that the yield on the U.S. 10-year Treasury note will rise modestly throughout the course of the year to 3% to 3.25%, the backup in yields is likely to be a slow, modest climb characterized by volatility and back and forth movement. In addition, even at 3% or 3.5%, the 10-year yield would be well below its 20-year average (and only about half of the 60-year average).
In this environment, many investors are still determined to wait out the bond market, believing that rates will eventually normalize and provide investors with a risk-free 5% yield, though this isn’t likely to happen anytime soon. At the same time, others are overreaching for yield by entering ever more speculative fixed income asset classes, such as Greek bonds and leveraged loans, where the risks may not be worth the potential returns.
In my opinion, investors should be wary of both of these strategies. As many of the traditional income plays have become expensive, I continue to advocate that investors instead adopt a flexible and opportunistic approach within fixed income and consider bond market substitutes – such as dividend-paying stocks – as an alternative way to generate income. In addition, I continue to see relative value in select areas of the fixed income market such as tax-exempt bonds, commercial mortgaged-backed securities (CMBS) and U.S. high yield.
The bottom line: investors should consider strategies that allow for the premise that yield may continue to be hard to obtain for a while longer, while also balancing out their desire for income with their risk tolerance.
Sources: BlackRock research, Stuck in the Low Yield Environment Market Perspectives paper
Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.
There may be less information on the financial condition of municipal issuers than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. Some investors may be subject to federal or state income taxes or the Alternative Minimum Tax (AMT). Capital gains distributions, if any, are taxable.
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