Get Paid to Wait
Can you manage risk and find yield over the short term without sabotaging your goals for the long term?
Today’s investment environment poses myriad challenges for investors. From heightened geopolitical risks to economic concerns, a lack of political will to address fundamental problems within the developed world and increased volatility across asset classes — it’s no wonder that protecting principal is top priority on many investors’ to-do lists, even at the risk of sacrificing long-term investment objectives. After years of elevated market volatility, investors have fled to safety, primarily by buying U.S. government debt and other relatively safe-haven investments. In the process, though, they’ve bid up Treasury prices and decreased yields to virtually nothing.
For investors — particularly those focused on income — this is clearly not ideal. “But rather than watching the market from the sidelines and trying to time the perfect moment to redeploy capital, we would rather remain invested and attempt to be paid to wait until the market improves,” says Joe Curtin, head of U.S. Trust Portfolio Analytics and Consulting. “To that end, we have devised a yield-oriented investment strategy.”
Cash is safe, but has been producing negative real returns recently. Click to expand
It’s not necessarily a long-term approach, and it’s not right for all investors. In creating their strategy, Curtin and his team had in mind an income-focused investor who has no tolerance for illiquidity but some tolerance for investments that may be less liquid than common equity or fixed-income securities. He says the strategy is probably best suited to investors who want to 1) protect principal while seeking current income in excess of inflation or risk-free assets, and 2) maintain a diversified portfolio that can take advantage of changes in interest rates, geopolitical risks and macroeconomic instability, and thereby improve the likelihood of meeting long-term investment objectives. “Still, seeking yield on an absolute basis — especially in a world where yield is scarce — can lead to unintended consequences,” says Curtin. “So our approach considers total return with a keen eye toward risk management.”
Rather than watching from the sidelines for the perfect moment to redeploy capital we would prefer to be paid to wait until the market improves.
WHERE’S THE YIELD?
“While the long-term global rebalancing trend is intact and, indeed, accelerating,” Curtin says, “short-term cyclical issues are dominating — and roiling — the financial markets.1 Our goal is to help preserve portfolios and earn income over the short term, but we don’t want that income and protection to come at the expense of our clients’ longer-term objectives. We also want to position portfolios to benefit from powerful long-term trends like global rebalancing. So what do we do exactly? Let’s take it asset class by asset class.”2
Cash: Nominal Capital Preservation, Perhaps, but Negative Real Returns In the past, during less extreme market conditions, three-month U.S. Treasury bills have tended to provide returns above the rate of inflation. As a result of the ongoing flight to quality, however, three-month T-bills are not providing any income, and last year they sometimes even produced negative real yields. In short, some investors have been willing to give up real-return potential for principal protection and reduced risk. Exhibit 1 indicates just how far from historical trends today’s money market environment truly is.
“The situation is even worse for investors in taxable accounts, because taxable yield is subject to ordinary income tax rates,” Curtin says. “Accordingly, our strategic allocation calls for a 0% weighting to cash. However, given the recent and expected market volatility, we have adopted a 4% to 7% tactical allocation to cash. As a practical matter, we believe investors could be better served by holding their cash in short-duration fixed-income investments to get some incremental pickup in yield. As volatility settles down, we would look to deploy that cash opportunistically.”
Fixed Income: Better Yield Elsewhere, but Some Opportunities Remain Historically, conservative portfolios have tended to emphasize fixed-income investments. This emphasis is primarily driven by the search for yield, because bonds and other fixed-income securities have typically generated more income than equities do. Where an equity investor shares in the risk of the business, the fixed-income investor — as a lender to the business — is concerned with earning a yield and the return of capital. As a result, fixed-income investments have tended to experience less volatility than equity investments. However, investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments, and yield and share fluctuations because of changes in interest rates. When interest rates go up, bond prices drop, and vice versa.
Equities are cheap on absolute and relative-to-bonds basis on dividend yield. Click to expand
“With paltry yields for U.S. Treasuries, investors should probably consider expanding their risk appetite and looking for yields elsewhere,” says Curtin. “However, if you want to maintain your longer-term investment approach, you could retain your weight to fixed income by investing in high-quality securities that appear attractive on a risk-adjusted basis.” As always, fundamental analysis is key to minimizing exposure to investments that may have undue default risk. Here are a few suggestions:
Corporate bonds. Companies are taking advantage of historically low interest rates to reconfigure their balance sheets. With substantial cash on hand and continued growth in cash flow given their overseas business prospects, many companies today look healthier than government bond issuers do, at least within developed markets. However, because the so-called flight to quality may continue to drive investors away from corporate bonds, investors should look to add corporate debt when spreads widen.
Preferred securities. Preferreds rank higher in the capital structure than common equity. Typically, they have diluted/nonvoting rights. To compensate investors for this, corporations often issue these securities with enticing dividend yields that in many cases are perpetual and cumulative. A note of caution: Most preferred securities have been concentrated in the utilities and financial sectors. The former is considered heavily regulated, while the latter remains in the regulatory crosshairs and is subject to risks from ongoing credit crises, raising concerns about its ability to grow earnings.
Non-U.S. fixed income. “Just because a bond is foreign doesn’t mean it is euro zone debt,” notes Curtin. Indeed, several developed economies continue to display the strong economic fundamentals that validate their investment-grade status. “Commodity-rich developed markets tied to global growth come to mind,” he adds.
Click to expand
High yield. “In our view, global high yield is attractively priced as spreads are very wide over Treasuries. Even if Treasury yields rise, lowering the spread, we believe the high-yield market is likely to produce attractive returns due to their higher yields.”
On the one hand, high-yield debt issuance in the United States has increased substantially since 2008. In large part, this was due to Federal Reserve accommodation to allow companies to “right size” their balance sheets. In other words, today’s higher-quality high-yield bonds could be of better quality than they were before the economic crisis.
On the other hand, even as ratings agencies have been downgrading ratings for several developed countries recently, they’ve increased the ratings on the debt of several developing countries. Because these countries are growing at a faster pace than those in the developed world, several stand to benefit from possible further credit upgrades as well as appreciation against developed market currencies.
Our approach considers total return with a keen eye toward risk management.
“Given the trend toward global rebalancing — where more of global GDP growth should emanate from the developing world — investors would be prudent to consider increasing their allocation to emerging market debt,” says Curtin. “However, they should train their eyes on countries with stable to improving ratings, which continue to adhere to prudent fiscal and monetary policies. In other words, do not stretch for yield while ignoring the potential for a downgrade or adverse foreign exchange fluctuations.”
Comparing yield-oriented and core benchmark portfolios. Click to expand
Equities: For the Yield-Oriented Investor “Considering relative valuations and yields, we would consider investment opportunities in equities as well as fixed income,” says Curtin. However, rather than simply screening for companies with the highest dividend yields, Curtin would focus on solid dividend-growth companies with a global footprint and relatively little exposure to the developed-world consumer. In addition, he would tilt the emphasis to emerging market equities, given their direct exposure to the faster growth in those markets. “Emerging market valuations have also declined relative to developed markets recently, making them a more compelling option,” he adds.
We don’t want income and protection to come at the expense of longer-term objectives.
Curtin also believes that certain types of corporate entities may provide attractive income streams to taxable U.S. investors. Because of their partnership structure, Master Limited Partnership (MLP) earnings are distributed to shareholders/partners with a subsequent adjustment to the cost basis of their original investments. However, Curtin does have a few cautionary words: “MLPs primarily store and transport various forms of energy, using pipelines, power transmission grids, storage facilities, etc., but they should be viewed more as toll operators than as true energy companies — their correlation to the energy sector is relatively low. In addition, given their favorable tax treatment, they could become the target of fiscal policy reform.” That said, he does believe MLPs will continue to prosper as the transportation of energy becomes increasingly important in meeting U.S. and global demand.
Real Estate: REITs: An Additional Source for Yield “While real estate continues to struggle, Real Estate Investment Trusts (REITs) have done quite well and could offer another avenue of opportunity for investors seeking yield,” Curtin says. REITs are publicly traded partnerships that invest in commercial real estate — office buildings, shopping malls, multifamily housing, hotels, storage facilities, warehouses and even commercial mortgages. By law, REITs must return 90% of their taxable income to shareholders, and that return is subject to tax at ordinary rates as opposed to qualified dividend rates. “So many REITs have attractive yields,” says Curtin, “and if that yield can be shielded in a tax-efficient structure, all the better.” However, because of demand, current yields on REITs are lower than their historical trend (meaning they are not cheap). Curtin believes that as the economy continues to improve, REITs should be able to increase their dividends, as they have currently been doing an effective job of lowering their debt-servicing costs by taking advantage of the Federal Reserve’s accommodative interest-rate stance.
Tangible Assets: Diversification Benefits, and Yield Too “Although typically considered for their portfolio diversification benefits, tangible assets can, at times, generate additional yield for a diversified portfolio via the futures contract roll yield and the reinvestment of collateral,” Curtin explains. Typically an asset manager seeks to replicate the return of a particular commodity index by investing in commodity futures contracts. The “rolling” of futures contracts can either add to or detract from the overall return. A positive roll would occur in a normal backwardated market (that is, when the spot price is above the future price for a particular commodity). Since purchasing of futures contracts requires only a minimal investment in the underlying futures contract, the remaining portion of the portfolio is invested in a relatively risk-free asset, such as Treasury bills. Says Curtin: “Some active managers may seek to invest in other fixed-income collateral, which could increase fixed-income risks and detract from the diversification benefits of a commodity allocation. Therefore, investors should be careful in taking on additional risks for which they may not be rewarded.”
Our task is to protect portfolios and continue to earn income now, over the short term.
HOW WELL DOES A YIELD-ORIENTED PORTFOLIO WORK?
“Once we established a framework for constructing a yield-oriented portfolio in the current environment, we tested the entire portfolio’s characteristics and performance,” says Curtin. “To do so, we constructed a simple performance review for 2011. In Exhibit 3, we assumed strategic weights for two portfolios. The Benchmark Portfolio consisted of U.S. Trust’s strategic core weights for a typical investor focused on balanced returns and excluded hedge funds and private equity. The Yield-Oriented Portfolio consisted of dividend-yield-oriented alternatives across the asset classes that embody our current ‘get paid to wait’ mantra.” For 2011, the Yield Portfolio solidly outperformed the Benchmark. Yield, beta (the comparison of a portfolio’s risk with that of a benchmark) and “down capture” (the ability of a manager to perform in down markets) statistics are compelling for the portfolio relative to the benchmark. “In addition, a tracking error of less than 3% demonstrates that the overall yield theme did not overwhelm the portfolio to the point that it could be considered a compromise in long-term investment policy and objectives.”
“In other words, a yield-oriented portfolio has the potential to provide some measure of principal protection and income without negatively impacting long-term goals,” says Curtin. But he is quick to add that before executing any of these ideas, it is important that investors speak with their advisors. “Trying to get defensive or seeking yield can become expensive and end up trading long-term portfolio objectives for short-term capital preservation. What we propose is to maintain a disciplined approach to asset allocation, currently favoring higher-yielding asset classes within a client’s overall strategic investment approach. This is not about opting out of the market. By emphasizing income, investors can be paid to wait. At the same time, we believe that maintaining a diversified portfolio that can dynamically take advantage of changes in the market environment stands a better chance of meeting a client’s long-term investment objectives.”
1See “Investment Outlook” by Chris Hyzy. 2Asset class views expressed in this article are current as of this writing, but as they are intentionally tactical — that is, short-term-oriented — they are subject to change at any time.
Projections made may not come to pass due to market conditions and fluctuations.
Investing involves risk. There is always the potential of losing money when you invest in securities.
Past performance is no guarantee of future results. Asset allocation, diversification and rebalancing do not assure a profit or protect against loss in declining markets.
Always consult with your independent attorney, tax advisor, investment manager, and insurance agent for final recommendations and before changing or implementing any financial, tax, or estate planning strategy.
OTHER IMPORTANT INFORMATION
Fixed Income Investing in fixed income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices generally drop and vice versa.
There may be less information available on the financial condition of issuers of municipal securities than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. Tax-exempt investing offers current tax-exempt income, but it also involves special risks. Income from investing in municipal bonds is generally exempt from Federal and state taxes for residents of the issuing state. Interest income from certain tax-exempt bonds may be subject to certain state and local taxes and, if applicable, the Alternative Minimum Tax (AMT).
Investments in high-yield bonds (sometimes referred to as “junk bonds”) offer the potential for high current income and attractive total return, but involves certain risks. Changes in economic conditions or other circumstances may adversely affect a junk bond issuer’s ability to make principal and interest payments.
Treasury bills are less volatile than longer term fixed-income securities and are guaranteed as to timely payment of principal and interest by the U.S. Government.
Tangible assets can fluctuate with supply and demand, such as commodities, which are liquid investments unlike most other tangible investments.
Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates, and risks related to renting properties, such as rental defaults.