It’s week four of the investing year. This week the government reopened. The president and eight cabinet members are in Davos. The news for stocks has been all positive so far this year, but what about bonds? What kind of cash flow can investors expect from fixed-income investments in 2018?
There are many reasons to hold bonds. High on the list, especially for retirees, are safety, preservation of capital and a steady income stream. Generating cash flow from bond interest payments can be a central pillar of a modern portfolio.
Watch these metrics
- The risk-free rate is up to 2.65%. This is the interest rate you earn when the U.S. government borrows money from you for 10 years. We started the year at 2.40% on the benchmark 10 year Treasury. The move to 2.65 is a big jump when rates are this low. There is upward pressure on these rates. First of all, the majority of experts are saying it will happen. In the short-term, the prophecy can be self-fulfilling. Next, the domestic economy is stronger. We will see evidence on Friday the 26th when fourth-quarter GDP is reported. Lastly, the Fed and its new chairman, Jay Powell, will make a call on raising short-term rates in March. The odds favor a .25% increase.
- The 10-year TIPS rate is .58%. Subtract this number from the 10-year treasury above (2.65% – 0.58%) and you get 2.07% – that’s the implied inflation rate. The Fed has been targeting a 2% inflation rate for years and we finally just hit it last week. Keep in mind that investments with fixed cash flows (bonds, CDs, etc) are punished when inflation picks up.
- The high yield spread is 3.59%, indicating how much more you can earn by lending money to a bond issuer that can’t guarantee payments like the U.S. government. There are only two ways to increase your yield on fixed income investments: increase duration (the time the bond issuer has to pay you back in full) or increase credit risk (the risk of not getting paid back). 3.59% is a relatively low bonus for taking added credit risk. Add in the treasury rate (3.59 + 2.65) and you get 6.24% – an indication of the cash flow you can earn on high yield (aka junk) bonds. For the last few years, we’ve focused on keeping the duration short (1-5 years) on high yield investments. I can’t mention specific funds in this article but we target cash flows of 5% on our short-term high yield.
Fixed payments are alluring because they seem like a perfect solution for generating income in retirement. But with rates low, the allure has its limits. Investing only in bonds worked better 10 or 20 years ago when rates were much more generous. Today it’s less than optimal. Bonds should be a part of most portfolios, but generally, a more diversified portfolio makes sense.
We encourage investors to look at the full picture, both cash flows and prices. Going further, we recommend a global portfolio approach, investing in U.S. and non-U.S. stocks, bonds and alternatives. Global investors can expect a minimum 2% cash flow rate on a diversified portfolio. 3% is achievable, too. Keep costs in an efficient range and make sure the investments are carefully selected to capture what they advertise. Combine cash flow, price changes and tax efficiency and you are in even better shape.
If you’d like to see how investors buy into the examples listed above, just let me know.