How to Deal with Lower Interest Rates

Blog post #452

The Covid pandemic has caused already low interest rates to move even lower. 

Throughout much of 2018, the 10-year US Treasury Note yielded around 3%. During 2019, it dropped from the 3% to 2% and since Covid hit, the US 10-year yield has hovered around 0.6% – 0.7%. It is worse overseas, as Germany’s 10-year notes pay 0.09% and Japan’s are at zero or negative.**

The implication of much lower interest rates are important to you as an investor. Going forward, at least for the next few years, it is likely your fixed income allocation will yield even less than it has been. As each fixed income security that you own matures, it will likely be reinvested at a much lower interest rate.

What are the choices that you have, and we face as your investment advisor, regarding very low interest rates? 

We could recommend some of the following, but that is not likely. We could….

  • Extend maturities
  • Invest in lower credit quality fixed income, to reach for higher yields
  • Invest more in stocks and reduce your fixed income allocation
  • Invest more in alternative investments

For most clients, we are not likely to recommend most of the above, at least not without extensive analysis and conversations with you.

Extending maturities means buying individual fixed income investments or bond mutual funds that are beyond what we are buying now, which is generally 5 years or less. The markets are not paying much more interest to hold longer maturities, so it does not make sense to us.

We view fixed income as your foundation, the safe part of your portfolio. When stocks drop, we don’t want your fixed income to crash as well. We don’t buy high yield (or junk bonds) for this reason. Risk and reward are tied together. If an investment grade 5-year corporate bond is yielding 2% today….and another one yields 6% or 10% for the same 5-year maturity, this means that there is much more default risk in the 6% or 10% bond. We want to try and ensure that you will get your principal back.

For some clients, we may review your stock to fixed income allocation, as fixed income is paying so little. For clients who are younger or can emotionally handle the volatility and greater risk in stocks, it may make sense to maintain a greater stock exposure than we would otherwise recommend. For older clients getting close to retirement or in a withdrawal mode, this may be a difficult decision. We will need to evaluate where you are in terms of your need to take risk, and your willingness to handle more risk. If you are comfortable and have adequate assets, the downside of greater stock exposure is probably not worth it.

We have not found any alternative investments that we are comfortable recommending. We have reviewed many, but they must provide benefits to you through performance track records that add value to your portfolio (and not just expected to add benefits), as well as provide liquidity, be understandable to us and have reasonable or low internal costs. As of now, we prefer to stick with our long-term investment philosophy that we are very comfortable with and not try other investment vehicles.

What does this mean for your future?

We focus on meeting your financial goals and the long-term total return of your portfolio.

  • We are not going to reach for additional yield if it means increasing the risk of defaults on fixed income. Although you will receive less interest income for the foreseeable future, we place greater priority on the return of your principal.
  • We will likely use more investment grade bond mutual funds in the near term, due to the very low interest rates, as they may hold higher yielding investments than we can purchase today. This also provides even greater diversification, which reduces your risk further.
  • We may need to work with you regarding Social Security planning, as we discussed in an earlier blog post, Social Security Projections and Impacts for all, dated May 14, 2020. If inflation remains low for many years, then future Social Security benefit increases will be lower or non-existent.
  • If you are in good health and feel you have a longer life expectancy, delaying Social Security benefits until age 70 may be a strategy that is recommended more in the future. There is a huge annual increase in benefits by waiting until age 70, rather than starting to receive Social Security benefits at your normal retirement age of 65-66.
  • We will continue to carefully monitor the credit quality of your current fixed income investments, as we do when we purchase new investments. We avoid low-quality fixed income investments, in both corporate and municipal bonds. We avoid some sectors entirely which have higher historical default risks.
  • Some clients may face difficult decisions, if interest rates remain low for an extended time period. The future is always uncertain, and things can change. Some may have to reduce their spending expectations or work longer, before they retire.
  • You should review your mortgage and see if refinancing makes sense. Rates are around 3% and even lower, depending on where you live and the length of your mortgage. I thought my refinance at 3.50% a few years ago would be my last, but I will likely refinance it again to lock in these lower mortgage rates.
    • For others, we may recommend paying off your mortgage sooner, which is something that we generally do not recommend. Please discuss these mortgage alternatives with us, as the recommendations are very specific to your individual circumstances.

We know the financial world keeps changing. This is what makes our role in your life valuable, as we will continue to provide you advice that is relevant and appropriate. We take this responsibility very seriously.

Talk to us. We want to help you, and your family, deal with change, today and tomorrow.

Source: **WSJ.com, July 9, 2020.

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