Note from our CIO: Increasing Current Income

With interest rates so low, the Abacus Investment Committee has been devoting a lot of thought to how we can increase the current yield on our portfolios. Unfortunately, each move we can make to increase yields would also increase one or more risks. Here’s some detail on bonds, and alternatives we’re considering.

Medium-term Treasury Bonds

Before 2011, US Treasury bonds generally provided pretty good overall returns, as declining interest rates helped boost their prices (and boosted returns to investors). And Treasury bonds didn’t suffer defaults, unlike some corporate bonds. Currently, the 10-year US Treasury bond is yielding about 2.25%. There’s not much room for interest rates to decline from here. If rates stay stable for the next ten years, you’ll earn 2.25% on your ten-year bonds. If rates increase, which seems more likely to most observers, your return will be even less, or perhaps even negative. After inflation and taxes, ten-year Treasury bonds seem unlikely to preserve purchasing power. Hence the search for other sources of income. Here is a summary of various income-oriented asset categories, some of which our clients are currently invested in, and some to which we’re contemplating increasing our allocation.

Short-term Treasury Bonds

We are invested in institutional mutual funds that own short-term Treasury bonds, along with carefully selected high-grade short-term corporate bonds. These provide some current income and have the great virtue of being more stable in value as interest rates change. As rates rise, and these bonds mature in the next 1-3 years, the proceeds can be reinvested at the new, higher rates…unlike medium-term bonds, where you’re stuck holding the old, low-yielding bond, or selling it at a loss to reinvest.

Corporate bonds

Corporate bonds can yield much more than Treasuries (as high as 8% for high-yield “junk” bonds), but they come with a higher potential risk of default. And if repayment risk becomes significant, the prices of these bonds may move more in tandem with the company’s stock. That’s not a good thing if we want our income portfolio to be independent of stock market moves. We’re currently using a few of the highest-rated, shortest-term corporate bonds through the mutual funds we’ve approved.

Varying duration and credit exposure

There is some evidence that higher total return can be attained by modifying the average duration of the bonds to always be near the “steepest” part of the yield curve, i.e., where you get the most increase in yield for a small increase in duration. The same is true with regard to credit spreads; one can benefit most from the steepest part of the credit curve. We are currently evaluating various managers who purport to do this, to see if this approach is practical for our clients.

Municipal bonds

After-tax yields on municipal bonds are fairly attractive. One needs to carefully diversify, and be aware that if state and municipal finances worsen, the prices of these bonds could decline. Higher tax rates, however, could help muni prices. The same cautions about avoiding longer-term bonds apply here.

Mortgage bonds

The very complicated securities created by packaging up mortgages have been shunned by investors, partly because they’re hard to evaluate, and partly (in the case of certain institutional investors) because tighter regulatory requirements prevent them from holding them any more. This has created an opportunity for the last few years, which still exists, to identify particular tranches of securities which are priced very cheaply compared to expected repayment. Total return can be 6% to 8% or higher. But if housing prices decline another 20% from here, or recent job gains turn into another large wave of job losses, defaults could increase, reducing total return.

Dividend-paying stocks

While the average dividend yield in the US is about 2.5%, some solid firms pay closer to 5% per year in dividends. The problem is, focusing more of your investments in the highest-yielding stocks makes your portfolio value more vulnerable to downturns in a smaller handful of stocks. We are considering whether the extra yield is worth the risk.

Master Limited Partnerships

This structure is commonly used to own pipelines, through which oil or natural gas is shipped for a fee (some call it “underground real estate”). The yield is often in the 6% to 7% range. However, the volume of oil and gas shipped is linked to overall economic activity, so the yield can vary, and prices dropped as much as the stock market in 2008.

Real Estate

Here the income is derived from rents, and properties have the potential to appreciate. Yields are generally in the 3% to 5% range, or higher on new construction or if mortgage debt is used to increase leverage. With potential appreciation, total returns can approach 10-12% per year, especially if the particular property could benefit from refurbishing, bringing rents up to market, or other management changes. However, real estate is illiquid, requires a significant investment in each property, and needs ongoing hands-on management. While clients with large portfolios can afford to diversify across several properties, the majority of our clients use REITs (Real Estate Investment Trusts) to access real estate. These are more highly correlated with stocks than privately owned real estate, but provide liquid access to an illiquid asset, an acceptable trade-off for most clients.

As you can see from this brief list, there are a number of investments providing higher yields than the 2% to 3% we’ve had to accept from Treasury bonds. Yet each has its own unique set of risks and advantages. We’re actively seeking ways to increase the current yield on our clients’ investments, and will let you know as we make changes to the portfolio.

Tom O’Connor, CFP, CFA
Chief Investment Officer