When interest rates are low, how can investors focus on total return, growth and diversification, not just yield?
Since 2011–12, investment yields have declined dramatically. Investors have responded by focusing greater attention on various types of income-producing investments.
However, higher-yielding securities, whether they be fixed-income securities, equities that pay high dividends or industry-specific securities, such as REITs or MLPs, are all highly correlated to movements in interest rates.
Knowing this, investors need to consider the impact of rising interest rates if their portfolios are significantly allocated to these asset classes. Alternatively, investors should consider a diversified portfolio that blends both growth and income characteristics. Placing too much emphasis on income-generating securities and minimizing growth and total return investments can be detrimental in three important ways:
1. Focusing solely on income-producing securities can detract from diversification. Income-producing companies are typically mature and are larger businesses that often tilt to the value side of the value-growth spectrum. There will be times when growth is in favor, and there will be times when value is in favor. As a result, focusing solely on yield can decrease a portfolio’s overall diversification, and there is a greater risk that investors will not be able to meet their long-term investment goals in the event of a drawdown.
2. Higher yield, fixed-income securities can increase credit and duration risk. Duration is the sensitivity of the price of a fixed-income investment to a change in interest rates. The longer the duration, the greater the interest-rate risk for bond prices. Since 2011, investors, in their search for yield, have reallocated significant sums from intermediate-duration, core-fixed-income funds into higher credit-risk and longer-term bond funds. While this strategy provides a higher coupon payment, due to additional credit risk and higher-term premium, it’s also increased the price volatility of investors’ bond portfolios.
Investors should consider a diversified portfolio that blends both growth and income characteristics.
3. Investors can end up paying more for higher-yielding securities. High-yield bond funds typically have higher expense ratios than fixed-income funds that invest in core fixed-income strategies. Similarly, market demand for high-dividend stocks may push their valuation to more unreasonable levels than those of lower-yielding stocks. It is important to note that dividends are not guaranteed, and that many companies reduce or eliminate dividends during recessions.
By incorporating total-return investments into a diversified portfolio, investors stand to gain tax efficiencies. Capital gains tax rates are typically lower than income-tax rates. If an investor’s portfolio is designed solely to generate income, the higher taxes that that income produces can negate the benefits of long-term compounding.
Conversely, if a portfolio is more focused on growth and total return, then investors can control what they buy and sell over the course of a year, particularly if they work closely with a financial advisor. Losing investments can be sold to generate income, and selling those losing investments can also be beneficial from a tax standpoint.
Additionally, rather than seeking fixed-income investments with higher yields, investors might look at a less-risky alternative such as municipal bonds. Since the financial crisis, many municipalities have taken steps to repair their balance sheets and have refinanced their financial obligations at extremely low interest rates. These conditions favor prudent, total-return focused investors.
Depending on each person’s investment objectives and goals, income-producing securities can play an important role in an investor’s overall portfolio and financial plan. However, given these securities’ correlation to movements in interest rates, it is always important for investors to remain diversified by including investments with other objectives, such as growth and total return. A properly diversified portfolio is an important tool to get you and your portfolio to your long-term goals.
Information expressed herein is strictly the opinion of Kayne Anderson Rudnick and is provided for discussion purposes only. This report should not be considered a recommendation or solicitation to purchase securities. Pastperformance is no guarantee of future results.
This article was originally published in the December 2016/January 2017 issue of Worth.