With rates near zero and the Fed (and most other global central banks) likely holding rates flat for the next three to five years, generating portfolio yield is increasingly difficult. As the use of lower-quality, higher yielding fixed income and non-traditional assets increases, its important to understand how these investments can impact portfolio risk.
A balanced portfolio yields 30% less today than 15 years ago
Prior to the 2008 financial crisis a balanced portfolio of 60% equities and 40% fixed income generated an annual yield near 2.8%. Following the financial crisis the Fed started a policy of (continuous) monetary stimulus, quantitative easing, and near-zero rates. Lower interest rates have lowered consumer borrowing costs, but also led to lower yields on debt instruments. As a result, investor portfolio yields have declined given the lower the on fixed income securities. Today, the same portfolio that yield 2.8% in 2005 yields just over 2%.
As noted above the decline in yield has been driven by falling rates on fixed income. Prior to 2008 the Barclays Agg (a diversified index of debt securities) yielded nearly double that of the S&P 500 (4% vs. 2%, respectively). Today, the yield differential hovers near just 1%.
Hunting for high(er) yield
Investors seeking higher yields have turned to new segments of fixed income markets, including increasing allocations to high yield debt securities. While high yield and other parts of the fixed income market can provide higher yield and boost portfolio income, the cost of the yield typically comes from lower credit quality.
The lower credit quality can result in two things: 1) a higher risk of default, and 2) increased correlations to equity markets. From a risk standpoint its important to understand the macro environment when “moving down” in credit quality. Specifically, debt levels on S&P 500 companies have increased today and are near all-time highs, increasing the risk associated with debt defaults. Furthermore, companies issuing high yield debt (i.e. junk debt) are often more sensitive to the economic environment, with slowdowns impacting their business (and ability to pay back debt) more than peers with stronger balance sheets.
Secondly, lower quality (and higher yielding) debt tend to track equity index performance more closely. While this is not inherently a problem, it’s important to analyze the implications of this increased exposure on a holistic portfolio. As allocations to lower quality debt are increased, so too does the overall risk profile of the portfolio. Daily volatility of the portfolio increases, as well as the potential for drawdowns.
Understanding holistic portfolio risk
Amid economic uncertainty and market volatility it’s even more important for proper portfolio construction. Not only do investors need to fully understand the composition of their portfolios, but they need to understand the potential risk. Risk should be added strategically, with the reward (i.e. performance) for that risk justifying the investment.
ENDNOTES
Disclosures
This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy, sell or hold a security or an investment strategy, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor’s objectives and circumstances and in consultation with his or her advisors.
The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
A word on risk
All investments carry a certain degree of risk, including possible loss of principal, and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, tax risk, political and economic risk, and income risk. As interest rates rise, bond prices fall. Non-U.S. investments involve risks such as currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks are magnified in emerging markets. This report should not be regarded by the recipients as a substitute for the exercise of their own judgment. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.