How can I earn 4% from my fixed-income portfolio in a 0% risk-free environment?
Indeed, for the first time in our 30-plus years as financial advisors our clients and friends are considering the possibility that the United States could face a low interest rate environment for many years, as has Japan since the early 1990s. This change in capital market assumptions may have wide-ranging implications for retirement plans. The challenge will be to find attractive investments that permit maintenance of a standard of living while balancing the dual possibilities of deflation and inflation. Surely, this is the pressing question on the minds of pension fund managers who must consider the prospect of lower investment returns in the context of increasing life expectancies.
Coastal Bridge Advisors has addressed this problem by looking at several portfolio mixes. We tested various allocations from the time period of 2000 to 2010. Our research focused on the volatility of the portfolio, performance over differ- ent periods of time, and the relative performance of the portfolio against relevant benchmarks. We were concerned with risk mitigation; as a result, we focused on the portfolio’s sensitivity to a rising interest rate sce- nario. Although we would typically like our sample to include a longer time period, we felt this decade gave us good data on how our allocations would react to different cycles. After all, it was a period that included two stock market declines of more than 50 percent and a Fed funds rate that ranged from 0.0 to 6.5 percent, as well as several recessions.
The portfolio providing the best return with the least amount of risk (no down years, lowest volatility, highest alpha and Sharpe ratio) consisted of short-, intermediate- and longer-term municipal bonds, inflation-adjusted securities (taxable and tax free), publicly traded master limited partnerships, real estate investment trusts, and international sovereign and corporate debt.
We found it most beneficial to overweight the municipal bond sector while under-weighting the MLPs, REITs and international debt. Importantly, this portfolio generated more than 4 percent in after-tax yield with enough maturity and call protection to ensure continuous cash flow for a considerable period of time. Additionally, it generated positive returns in the 2004– 2006 time frame when the Fed funds rate increased from 1.25 to 5.5 percent. Moreover, the standard deviation (measurement of volatility) was approximately equal to a short-term bond or roughly one/fifth of the S&P 500, with a worst quarterly performance of just over 2.5 percent.
Investors sitting on cash may have to reorient their thinking. Waiting for interest rates to rise to acceptable levels to invest may be an exercise in futility. Investors should consider placing a couple of years of spending in money markets or Treasury bills and investing the balance in a well-diversified portfolio, like the one above. The portfolio should have some balance between instruments, such as MLPs, REITs and inflation adjusted securities, that do well in periods of inflation, and those, such as intermediate- to long-term municipals and international debt, that will do well in periods of low or no inflation. For the baby boomer generation, the real risk may be earning power over the balance of their life, not short-term market moves.