Blog post #462
Interest rates have been quite low for over a decade and are not likely to increase in the next few years. This has important implications for all investors.
The 10-year US Treasury bond yield has been below 4% since 2008, in the 2-3% range for most of 2009-2019, and has been well below 1% since the Covid pandemic hit in March of this year. (see the chart below).
The Federal Reserve on Wednesday provided forward guidance that they project short-term interest rates to remain near zero well into 2023. Eventually they predict short-term rates of around 2.5%, but they do not provide any guidance as to when that may occur. While their forward guidance (projections) have generally not been accurate, they are basing these predictions on the impact of Covid on the economy and the lack of current and expected future inflation.
What is the impact of continued low interest rates mean to you?
When we do investment planning for you, one of the most important decisions is how much to allocate to stocks and how much to allocate to fixed income (bonds, CDs, bond mutual funds, cash, etc.).
This high level asset allocation decision is based on several factors, which include your need and willingness to take risk, how much growth you need from your investments to meet your financial goals and your investment timeframe.
As we review these items with you, that will guide our recommendation of how much of your portfolio should be in stocks and how much should be in fixed income.
The key concept that we want to stress is that even though interest rates are very low, and may remain that way for a while, this should not significantly change how much you should allocate to fixed income.
Why? Shouldn’t the prospect of continued lower interest rates make someone want to increase their stock allocation, as the fixed income returns will be very low? Let’s look at some examples and discuss this further.
If you are in your 20s or 30s and have decades of work and savings ahead of you, we may recommend a stock allocation of 80% or even more.
If you are in your 40s or 50s and need growth from your portfolio to provide for the retirement you desire, your asset allocation may be 60-70% in stocks, with the remainder in fixed income.
If you are in your 70s or 80s and have saved enough so that you can live comfortably, your stock allocation may be well below 50%.
We don’t think the prospect of continued very low interest rates should materially change your overall asset allocation plan because most people don’t want to significantly increase their stock market risk more than they need to.
If you feel that because of expected continued low interest rates you should decrease your fixed income allocation and increase your stock exposure, you must be prepared for the increased volatility (short term risk) that comes with owning more stocks.
Fixed income provides you with some income, but we view the fixed income allocation primarily to provide stability to your portfolio. Thus, you don’t have as much temporary volatility that comes with owning stocks. If you have the stomach to own more stocks, and can handle the swings and volatility, then your expected returns could be much greater over the long-term, say 10 or more years. But for most investors, they need the ballast of fixed income in their portfolio.
As we remind clients, it is normal for stock markets to decline at least 20-30% every 3-5 years. That is the type of temporary volatility that is to be expected in order to earn the long-term rewards of owning stocks.
- If someone had a $2 million portfolio with a 50% stock / 50% fixed income portfolio, they would have $1 million invested in stocks. If that portfolio incurs a 35% decline, as happened in the S&P 500 earlier this year, the stocks would decline by $350,000.
- But if the stock allocation had been increased to 75% because of lower expected interest rates on the fixed income allocation, they would have had $1.5 million invested in stocks. If a 35% stock market decline occurred, the temporary decline would be $525,000, which is far greater than the $350,000 temporary drop of a 50/50 portfolio.
The question you must ask yourself: Is the additional volatility of the stock market worth the increased exposure to stocks? Will you be able to maintain a higher stock market exposure through the down periods? This is so important, because the worst result would be to increase your stock market exposure now, then panic when a major stock market decline occurs.
We plan to remain consistent with our long-term principles regarding fixed income.
- We will only invest in high quality fixed income, as the return of your principal is most important.
- We will not reach for yield by buying junk bonds. If a bond fund says high yield, that means it is holding less than investment grade securities, which have a much greater chance of defaulting. We don’t recommend junk or high yield bond funds for our clients.
- Diversification is vital in fixed income. For those who invest in municipal bonds, we recommend holding bonds of many states, not just your home state.
- We regularly monitor your fixed income holdings of corporate and municipal bonds for any downgrades or credit risk exposure. We would rather sell today than take the chance on a default in the future.
The financial world is continuously changing. We are here for you, if you have any questions about this or other financial matter.
We would be pleased to assist you, your family members and friends.