Interest rates have been at rock-bottom lows for years, and there is no sign that rates will rise substantially enough to satisfy a fixed income investor’s hunger for yield. To feed that appetite, investors need to find alternatives.

But there are risks. Staying in traditional debt markets means accepting lower-to-negative returns for stability while seeking income in stocks or credit brings different risks. It comes down to what type of risk investors and investors can accept, market watchers note.

How did we get here?

Interest rates peaked in 1981, with the US 10-year Treasury note yielding 15.8% that September and have sloped downward since. As recently as November 2018, benchmark yields topped 3%, and a year later, they were at 1.8%. When the global pandemic happened, rates dropped sub-1% for the first time, falling as low as 0.55% in July. Rates are creeping up but remain below pre-COVID-19 levels.

Pat O’Hare, chief market analyst at Briefing.com, said the pandemic caused a confluence of factors to weigh on rates as buyers snapped up US Treasuries, spooked by global recession worries, and the Federal Reserve bought government and corporate debt to stabilise markets.

Foreign buyers have long sought US debt, appreciating meagre yields here versus negative interest rates offered in some of their home markets, he adds. Finally, short-covering – buying back previously sold positions – may be suppressing rates.

O’Hare noted there is a mindset that rates are artificially low, which enticed fixed income short-sellers, particularly in Treasuries. Yet yields continue to fall, triggering short-covering, which further pressures those yields.

All three factors are why rates can be so low, even with an economy showing 6%-plus gross domestic product growth. “That is how we got here,” O’Hare observed.

How investors approach the fixed income market depends on their view on interest rates, O’Hare said. Inflation expectations play a big factor in this, especially with the Consumer Price Index at 5.3% as of August 2021.

Fed Chairman Jay Powell and US Treasury Secretary Janet Yellen have both said inflation is temporary and should run its course once the U.S. gets through the supply chain bottleneck. If deflation occurs, US Treasuries should still be fine to hold, O’Hare argued.

But he noted some people think rates should rise for a variety of reasons, including the Fed tapering its extraordinary monetary policy, and that inflation may not completely retreat. Even if inflation cools to a 3% annual rate or even meets the Fed’s stated 2% target, US 10-year Treasury yields should be higher than the current 1.5% yield, O’Hare posited.

Solutions

A standard approach for principal protection while addressing inflation concerns is to buy Treasury inflation-protected securities, such as the iShares $ TIPS UCITS ETF (ITPS), O’Hare said.

Chris Shea, chief investment officer of WealthSource, still uses some Treasuries, and reminds clients that fixed income is a ballast against equities in a portfolio, at least from a principal-protection perspective, and advocated investors should consider total return, not just yield. He is also selective about credit and duration, but he admits fixed income is not easy.

“I wish there was a really good answer,” he said. “When you are thinking long-only, liquid solutions, it is challenging.”

Extra credit

With a relatively good economy and the outlook for rates cloudy, some investors are taking higher credit risk for their clients who seek income. Senior loans are one way to wade into this part of the market.

John Ingram, chief investment officer at Crestwood Advisors, recommended the SPDR Blackstone Senior Loan ETF (SRLN), noting in December 2020 and in January, his firm increased exposure to floating-rate notes. Historically the firm was wary of credit-risk vehicles such as high yield bonds since they act like stocks in troubled times, but the pandemic changed that.

“We have taken on a little bit more credit risk just to get some yield, and also shortened duration. Floating-rate notes have been great in that area,” he said, noting this is more of a tactical view because of the higher risk.

Briefing.com’s O’Hare said firms that issue bank loans may not be in the best financial shape however those loans are also at the top of the capital structure, and typically they are collateralised loans. Bank loan ETFs might also benefit from inflation because they are floating-rate structures.

“It is another type of inflation hedge that could work well for investors,” he noted.

Lori Van Dusen, founder and CEO of LVW Advisors, suggested preferred stocks could be an alternative for fixed income investors, and ETF investors should seek an actively managed fund such as the First Trust Preferred Securities & Income ETF (FPE): “Preferred ETFs are not created equal.”

Because FPE invests in preferred securities, its dividends are “qualified,” and therefore taxed at the long-term capital gains rate. These tax savings boost its current 12-month yield to 4.5%, with an average duration of four years.

“That is a tool for someone who is looking to get higher income, and not extend a lot of risk,” she said.

This story was originally published on ETF.com

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