INSIDE THIS EDITION:
Why Fixed Income Still Has a Role in Portfolios
It is no secret that interest rates are near historic lows. It is less of a secret that as yields remain depressed, it becomes increasingly difficult for investors, especially those in retirement, to generate income from their fixed income portfolios. Take for example the data in the chart below which shows the wide income gap relative to retirement savings that exist across wide swaths of the population.
As you might imagine, this situation creates significant challenges for advisors and their clients as they try to adapt to this reality.
To better understand the predicament, it is important to understand the reasons income generated by investments is so hard to come by today.
One of the primary drivers is that we have a large part of the population, the baby boomers, hitting retirement. This wave of retirees started leaving the workforce several years ago and has only accelerated over the last few years. In fact, some projections show that this trend will continue on the upswing for several more years ahead. For a sense of how big this wave is, just consider that about 10,800 people reach retirement age every day. That amounts to approximately 4 million retirees per year. This has generated tremendous demand for fixed income securities and helped push yields lower.
Second, we have central bank policy further suppressing yields and creating a perfect storm for yields to remain at, or near, historically low levels.
As you can imagine this causes major issues at the personal level because while yields are low, the retirement assumptions that many retirees used in designing their financial plans have turned out to be far off course and in many cases leaving income shortfalls. Additionally, we are presently in an environment that has seen the complexity of income-producing asset classes increase thus keeping some retirees from participating in potential investments that could help their situation. Not only are these things driving the challenges for income investors, but they should also provide a reason to work with an advisor that can help navigate this environment with considerable foresight.
Perhaps it is helpful to put some numbers to the income problem retirees face today to really drive home the point of how different this environment is compared to ones in the past.
For that, we use the example of a balanced portfolio consisting of 60% stocks and 40% bonds. This allocation would have generated about 9% per year dating back to 1926. This same portfolio would have also kicked off a 4% yield. Compare that to today where the same portfolio allocation generates only about 1%.
Of course, citing problems isn’t enough. We also must think about solutions. And for this, we believe investors should be doing several things.
First, they should be considering their portfolio construction framework. Having a well-developed methodology can help determine appropriate allocations for generating sufficient returns while keeping volatility within an intended range. This is exactly what we do at STA Wealth Management by using fully optimized portfolios that target both expected return objectives within given risk tolerances. This generally means mixing stocks and real assets with a diversified fixed income allocation. After all, fixed income securities can both diversify risk and allow an investor to hold their portfolio through the ups and downs of an entire market cycle.
Second, investors should look outside of traditional income investments. This means looking for opportunities in areas of the market that can boost portfolio yield while not taking on much incremental risk. Some areas that could offer opportunities include preferred stocks, emerging market debt, real estate, or even private investments for accredited or qualified investors where appropriate. As a quick example of what is possible, we can look at preferred stocks. As the chart below shows, over 5- and 10-year periods up to 2019 preferred stocks delivered returns slightly ahead of long-term bonds while having a lower volatility profile. All while generating yields that were well ahead of what traditional fixed income delivered.
Third, investors should be discussing financial plans with their advisors on a regular basis. This is exactly what we do with clients on a yearly basis. This regular review helps not only calibrate portfolio allocations but also allows for periodic updates to financial plans that account for any new developments or goals clients may have. Part of the review process also includes revisiting plan assumptions to ensure they are in line with what the market is likely to provide and with expected withdrawal rates. For example, there has long been a rule of thumb that a retiree should think about withdrawing 4% from their accounts every year in retirement. Investors should be discussing with their advisors whether this assumption is appropriate and whether any adjustments are needed. Getting this wrong can drastically take a retiree off course.
Before we close, we do want to emphasize that despite the lower yields, traditional fixed income should still play a role in portfolios. Traditional fixed income securities can provide diversification benefits to equity portfolios and can keep the credit quality of the portfolio at acceptable levels.
Weekly Global Asset Class Performance Table