As part of Research on Wealth’s theme for the October 2016 issue of how to guide clients in a low-yield environment in areas as diverse as retirement planning to investment management, we gathered the thoughtful words of a number of advisors.-Ed.
View from a UBS Advisor
Years of historically low interest rates, I believe, have left our clients searching for income. In July 2015, the 10-year yield stood at 2.45%; one year later, it reached the historical low of 1.32% according to an August 2016 UBS report.
We are constantly searching for the appropriate investments that align with our clients’ financial objectives and risk tolerance. Our clients continue to ask us to find opportunities to help achieve income with the least amount of risk. While it appears that CDs and Treasury bonds could continue to yield lower than historic rates, we find that a diversified approach is a prudent way to help invest during these unprecedented times. Here are two investment themes that investors should consider.
First, we favor stocks with a preference for U.S. dividend-producing companies. We have been using high-quality blue chips stocks with solid dividends for diversification and potential growth. We always look for companies with a strong balance sheet, solid free cash flow generation and low dividend payout ratios to support their ability to fund dividend growth.
Although government bonds can still act as a portfolio diversifier, there may be better opportunities with corporate credit. Investment grade corporate bonds contain both credit and interest rate components, and we think corporate bonds would be beneficial if global uncertainty continues.
Using high-quality corporate bonds coupled with diversified fixed-income ETFs has allowed us to help lower the volatility in our portfolios while seeking to generate returns. We use extensive search criteria to identify an ideal ETF that is based on cost efficiency and a proven performance history. The use of preferred stocks as an instrument for income has also increased, as it has become a critical component of our fixed income concentration.
We take a step beyond the normal premise of investment return and risk by developing a comprehensive financial plan for all of our clients. Our main objective is to help clients pursue what is important to them. No matter what a client’s retirement goal may be, a financial plan can help them feel more prepared to meet life’s challenges. Working together with our clients, we identify their financial goals and model alternative strategies to help improve the likelihood of reaching these goals.
Our team conducts risk assessment to help address a number of critical issues, analyze various wealth transfer strategies when applicable, and finally, tailor the investment portfolios based on their specific financial objectives. A financial plan provides us with a better understanding of client’s expectations for retirement and lays out a path for achieving their retirement goals, while taking into consideration the current state of the financial markets.
This has been effective in helping to realize a solid cash flow in retirement, while attaining less market risk. We are strong advocates of having a stable cash flow and are firm believers that this is an important time to have a detailed financial plan.
Overall, investors should accept that the economy will be in a low interest rate environment for some time. However, we still have confidence that opportunities exist and help investors accomplish their desired outcome. We understand that managing a portfolio in this market environment requires more time and effort than ever.
It is important to always perform detailed investment research and stay up-to-date on all market events. In addition, planning is also a great way to help mitigate market uncertainty and ensure financial goals and objectives. Our team recognizes that having a sound plan in place which addresses specific goals can help allow investors to accomplish a steady cash flow and seek returns through a prolonged low yield environment.
—Stefan J. Contorno, financial advisor & portfolio manager, UBS Financial Services, Bonita Springs, Florida
Raymond James FAs’ Analysis
The lower for longer interest rate environment is affecting the way we manage our practice in myriad ways. While we never claim to be interest rate experts, we’ve been managing to an eventual rate hike that, essentially, hasn’t materialized.
For context, we are what some would call industry dinosaurs. We are plain vanilla money managers: we buy individual stocks and individual bonds. On the equity side, we run a multi-cap, concentrated yet diversified portfolio of somewhere between 20 and 30 companies, depending on the client. On the bond side, we buy mostly tax-free municipal bonds and investment grade corporates, venturing into the high yield realm opportunistically.
Of our $1 billion-plus in assets under management, about half is invested in traditional fixed-income instruments (individual bonds). We have had to make thoughtful changes in order to keep cash flows intact for many clients without taking much more risk.
Over the past three years, we have used the following tactics to augment income and create new streams of income for our clients: rotation back into MLPs and REITs; managing client goals to total return from income goals; selecting private equity deals with cash flow components; dividend equities with the capacity and propensity to grow dividends; other LP units like public/private equity; adjustable rate bonds and preferred stock; selective high yield bonds; and taking long-term capital gains for distributions, because they are taxed at the same rate as qualified dividends, for now.
To complicate things further, we have reached the point where we are reevaluating many holdings we’ve had for years based on stretched valuations. Some of the best performing sectors of the past 12 months are sitting at valuation highs we are monitoring very closely.
In the past, consumer staples, utilities and some REITs have been our “go to” bond substitutes, but now are trading at 20-plus times earnings and growing earnings at less than 3%. This is not the formula for future positive returns. We must be prudent, not piggish.
The underlying threads of consistency we need to be comfortable with are simple: strong balance sheets, defensible businesses and good management. Following those tenets, we must then apply reasonable valuations and try to buy growth or income at a reasonable price. We can’t get caught up in chasing the hot sector. As always, we aim to be prudent stewards of our clients’ capital as well as our own (we are invested in the same things our clients own).
Where does that leave us? We are constantly hunting for relative value. Not all REITs (substitute any sector here) are created equal, and we have benefited from our security specific underwriting process. This environment creates a much heavier workload as the best values aren’t staring you in the face.
We have found better relative values in the industrial sector as well as the financial sector. Banks trading below book value with government approval to buy back stock and raise dividends have lagged the market and we think are going to play catchup at some point.
A large part of our bond portfolios are municipal bonds, where we constantly are hunting for cushion bonds for the higher cash flow upfront and a potential kick on our yield to maturity.
When it comes to buying bonds, we have extended our average maturity a few years from 5-6 to 8-9 years. Adding a few 12-15 year bonds to a ladder that had an average maturity of 6 years doesn’t do much to the duration, but keeps the cash flow more consistent … and who knows where interest rates will be in the future?
Lastly, we do not believe market timing to be an effective strategy, so owning the right companies can take you through tough times. Though we may pare positions down at certain valuations, we often trade around a core position and keep low basis stock we have owned for years at a good price.
Has this extended period of low interest rates changed the way we manage our business? Indeed it has.
—Peter Bermont and Michael D. Gold, managing directors, Bermont Advisory Group, Raymond James & Associates, Coral Gables, Florida
Morgan Stanley Advisors’ Opinions
I believe that any significant change in the dynamics of the market require adjusting your approach. Perhaps the most important thing that we have to remind our clients about in a period of low yields is their risk tolerance.
Clients face a tremendous temptation to chase higher yields and often times do so in a way that is clearly inconsistent with their risk tolerance. In a period of low interest rates, quality spreads are compressed, and it’s typically the worst time to chase higher-yielding investments.
We believe that the fixed-income markets are likely to continue to perform well [and] that we will continue to be in a lateral window on interest rates for some time. We are recommending high-quality paper (taxable and tax free, depending on the account’s tax sensitivity) that are intermediate term in duration and have extended call protection. We particularly like premium bonds because of their defensive nature should interest rates begin to rise at some point.
—Mark Donohue, Morgan Stanley Private Wealth Management, New York
With low yields on fixed income, we are forced to keep a larger weighting in equities with a tilt towards consumer staples, telecommunications, and utilities. Also, my bond laddering strategy has helped me keep the durations short but allow me to reinvest maturing paper with intermediate term bonds which offer more attractive yields.
—Scott Magnesen, Morgan Stanley Wealth Management, Oak Brook, Illinois