What can investors do about low interest rates?
It’s no surprise that interest rates are at record low levels. Over the past decade, 10-year government bonds in the US, Germany, and England have fallen from 6% to 2%. The drop in yields has provided great opportunities for capital appreciation from long-term bonds, but investors now are faced with a dilemma: continue to invest in long-term bonds and run the risk of a price decline, or go with short-term instruments that don’t even earn the rate of inflation.
Clearly, one reason for the decline in yields is that the pool of safe assets has shrunk. Mortgages are no longer considered risk-free; swaths of government debt have been downgraded due to economic and political troubles; even staid and sleepy municipal bonds are having problems, from Stockton, California to Detroit, Michigan.
But the demand for safe assets has not gone down. While the stock market has not seen a return to the heart-stopping volatility of 2008, every minor drop brings fears of “the big one” back to investors. Real-estate is no longer a safe-haven, and commodities are almost as volatile as stocks, while forgoing the dividend income that many blue-chip stocks generate. So demand for the stability of the bond market is strong.
Many income-oriented investors have turned to dividend-paying stocks as proxies for the bond market. Some large companies pay dividends in excess of 6%, and many companies with an historic commitment to dividend growth pay more than 3%. With 10-year Treasury Notes yielding 2%, these levels are attractive. But equities carry more risks than bonds, and they hold a junior position in the capital structure. As owners of Fannie Mae stock learned, insolvency can wipe out stockholders.
For good or ill, the only thing investors who need income can do is take more risk: equity risk with stocks, property risk with REITs, and commodity risk with Master Limited Partnerships and some ETFs. The world has changed; it’s not “different this time,” but long-term challenges will keep rates low. Investors should get used to this.