THE QUEST FOR YIELD

With bank interest rates expected to hover at a meager 1% or less for the foreseeable future, individuals with sizable accounts have become exasperated. After adjusting for taxes and inflation, they understand that these accounts are registering negative real returns. The effect of these paltry interest rates can be devastating for those who rely on this interest for living expenses.

In my 34 years in practice, I have never been approached by so many clients, friends, colleagues and relatives for possible alternatives to these abysmally low interest rates. “Bank alternatives” or fixed income options to savings accounts and CDs have become a top priority for investors in search of yield.

When comprising any portfolio, the biggest factor to be analyzed is risk. In this current climate, the two largest risks for a fixed income portfolio are rising interest rates and credit. As a result, I avoid bonds that are at historic low interest rates even if they are deemed to be credit worthy. I also eliminate low credit risk bonds that could possibly default in the event the economy deteriorates or if an outside or “black swan” event such as a European sovereign debt default roils the bond market.

Short term investment grade bonds represent the first asset class I consider for any fixed income portfolio. With yields in the 3-4% range and little or no interest rate or credit risk, the benefits of deploying funds to this asset class are evident.

Another potential opportunity in fixed income is US government guaranteed mortgages. As the housing market slowly improves, many short duration mortgages that remained solvent and continue to be paid punctually can deliver consistent yields of 3-4%. The bigger risk in these mortgages is the possibility of homeowners refinancing at lower rates, but this risk is largely mitigated if allocations are largely to mortgages with limited maturities.

Municipal bonds provide another outlet for astute investors. Historically, longer term municipals have generally produced yields approximately 80% of comparable Treasury bonds. Currently these yields are between 110-120%. Even if interest rates rise, there is enough of a cushion to, at least temporarily, offset a decline. And with a dwindling supply of municipals and the real possibility that interest tax rates will increase as early as next year, supply and demand factors should sustain municipals as a viable option.

Fixed income alternatives in emerging markets bonds are also attractive. In credit quality countries such as Brazil, interest rates are much higher than comparable bonds in the US. Investors might also receive a boost from appreciating currencies since many of these nations post much higher GDP growth rates with significantly lower debt. However, currency swings are a double edged sword and values could decline despite a rosier economic outlook.

For those investors willing to edge out beyond the comfort of banks, there continues to be lower risk and potential higher yielding fixed income options. But investors beware! A deft tactical strategy is required to avoid potential pitfalls in this uncertain global economy.

Sincerely,

Clifford L. Caplan, CFP®, AIF®

In The News: On June 26th, I was quoted in a Thomson Reuters article about investment companies that were fallen angels but are on the comeback trail.