In July the three-month Treasury Bill yield climbed to over 2 percent, a level it hasn’t seen in more than 10 years! The rise is primarily the result of the U.S. Federal Reserve’s efforts to bring its benchmark lending rate up from historical lows coming out of the Great Recession. By December 2008, rates had been lowered to a target of 0-0.25 percent as part of the recovery efforts and they have remained low for nearly a decade. Rising rates bring new opportunities and it may be time to rethink your investment portfolio.
The low rates following the Great Recession have been both a blessing and a curse. Low interest rates mean “cheap” capital, which, for example, is great for businesses looking to grow through debt and consumers who are in the market for a new home. However, low rates are challenging for retirees who are looking to their investments for retirement income. The rate-of-return on various money market and fixed-income investments has been horrible for the better part of the last decade. As I’m sure you’ve noticed, until recently, you have not been receiving much interest in your bank account. In fact, bank account interest rates hovered near zero for most of 2009-2016. The same can be said for bank certificates-of-deposit (CDs), treasury bills and money market mutual funds. Even individual bonds have been unappealing as most short- to medium-term corporate and municipal bonds, as well as treasury notes, have all yielded something less than 4 percent.
For investment advisers like me, the classic approach would be to allocate a large portion of a client’s investment portfolio to stocks when they are younger and continually transition toward fixed-income investments (e.g., bonds, CDs) as they approach retirement. The historically low rates have made this challenging. Many advisers, in fact, have eschewed the bond market in favor of stocks and this supply/demand effect contributed to the stock market’s impressive run over the last 10 years.
While the stock market has proven to be a solid long-term investment, we need to remember that the performance of the last 10 years is not normal. The sell-off from the Great Recession, along with the low interest rate environment and other stimulus, created a nearly relentless stock market climb. With rates now on the rise and other stimulus reversing, it’s likely that tougher days are ahead for the stock market. It’s time to take a hard look at our portfolios and dust-off some of those fixed-income investment tools.
Looking at the fixed-income market overall, the longer-term bond market continues to look like a bad risk/return trade-off. Let’s take a quick look at the current “yield curve” for U.S. Treasury Bonds. The yield curve shows the annualized yield that can be earned on bonds with varying maturities. As expected, long-term bonds yield more than short-term bonds as investors require a premium for locking up capital. However, this yield curve is noticeably “flat,” meaning the time-premium is abnormally low.
So, the flat yield curve and rising rate environment leads us to the conclusion that the most compelling options today are those with the shortest time to maturity. I also like the options with the lowest risk—i.e., Treasury Bills, bank certificates-of-deposit and certain money market funds that focus on investments with maturities of less than one year.
Sounds easy enough; is that it? Not exactly. Here are a few key considerations when implementing this strategy to maximize yield.
In a rising interest rate environment—with all signs suggesting that more increases are coming—it’s important to “ladder” your investments. Meaning, you should purchase securities of different maturities so that you can roll into new higher-yielding investments as rates climb. The exact length of the ladder and how to weight each investment is generally based on your expectations for future rate increases and the perceived risk/return trade-off of the various options. You’ll want to revisit the analysis as each investment matures.
It’s also worth noting that purchasing individual bonds is generally going to yield better results in a rising rate environment than purchasing a bond mutual fund or bond exchange-traded fund (“ETF”). Why? If you hold a bond to maturity, it may fluctuate in value, but you will receive your capital back at maturity (along with all the interest payments along the way). However, with a bond fund or ETF, the investment manager may need to sell bonds to accommodate liquidations from the fund, and thus may be forced to realize losses that could otherwise be avoided.
Next, look for opportunities for diversification. Many of these investments are low risk, but they are not riskless. Treasury securities are, of course, backed by the “full faith and credit” of the U.S. government, which is generally deemed to be the lowest risk option. Moreover, bank accounts and CDs are insured for up-to $250,000 per account per bank (see FDIC.gov for details). So it would be wise to limit exposure to any one bank to $250,000. Many brokerages (e.g., Charles Schwab and Fidelity) make this type of diversification easy by allowing one to invest in multiple banks through the same platform.
Enjoy your long-lost interest payments! Hopefully, they’re here to stay for a while.