Generating Income In Today’s Low Interest Rate Environment

Talking heads and financial people love to espouse their knowledge of when to buy and sell in the stock and bond markets. Unless their crystal ball is working better than ours, we remain skeptical of their consistent success. Investing in stocks and bonds does not need to be a “long only” gamble on the linear price moves of the markets; it can be more calculated and consistent. This article will outline specific ways for retirees and income oriented investors to generate a more consistent income from their portfolios and mitigate downside risk.

Our firm began using custom structured notes in 2008 as a way to generate a return for clients using “shaped rather than linear returns.” We have placed over 100 of these strategies, giving us a strong working knowledge of the pros and cons of structured notes. These investments, like any product, can be marketed and used properly or improperly by financial firms.

The core concept to understand with these investments is that they are a credit investment. This means that the payout profile of the investment is reliant on the issuing firm being in business at maturity; so it is important to choose your counter party wisely. Goldman Sachs, JP Morgan, Barclays, RBC, Morgan Stanley, HSBC and the other major institutional firms are all in the business of manufacturing these investments. It is prudent for investors to recognize the importance of using multiple issuers when building a portfolio.

Where Can I get Income?

Many retirees are struggling to generate enough income to maintain their lifestyle in today’s low interest rate environment. They are concerned about the negative affects that rising rates will have on the principal value of their sovereign and high credit quality fixed income investments. What options are out there? Here are a few:

Annuities – The product lineup in the annuity universe is getting more and more complicated. Guaranteed income benefits, guaranteed withdraw benefits, and indexed annuity products can appear very attractive, but “buyer beware.” Income guarantees from these investments are often just that, an income guarantee. Unfortunately, many investors misunderstand the fact that their 5% or 6% income guarantee simply means that they will receive an income based on this annual return, but the lump sum value has no guarantees. The first evolutions of these products were much more cost effective, but the associated costs of these products have risen dramatically. Many carry annual internal costs approaching 4%… quite a drag on any upside performance.

Bonds – As of the writing of the article investors are receiving the following yields in bonds :
2 year treasury .38%
10 year treasury 2.84%
3-5 year A credit corporate bonds 1.6%

Faced with these historically low interest rates, investors should be aware of the possibility of principal discounts in bonds as a result of rising rates in the future. Let’s explore this in a little more detail.

Let’s assume Don bought a 10 year treasury on January 22, 2013 for $1,000 knowing he will receive a 1.86% yield ($18.60 per year) for the next 10 years.

One year later on January 21, 2014 Don is looking at the value of his bond and it is reflecting a value of only $910. Why is this? Well, the 10 year treasury rate increased over the course of 1 year to 2.84%. Therefore, anyone looking to buy a new 10 year bond would be paying par value of $1,000 to receive $28.40 each year. They certainly would not pay Don the same $1,000 for his bond that is only paying $18.60; they would pay closer to $910 (a deep discount).

This puts Don in a tough spot as he can certainly hold the bond to maturity, but he will continue to receive the below market income OR he can sell his bond at a substantial discount.

The low coupons in these types of bonds and the backdrop of historically low rates pose a serious problem for retirees and other income oriented investors.

Dividend paying stocks

Increasing one’s allocation to dividend paying stocks may sound like a good idea to enhance yield and return, but what happens if stocks pull back 20% or 30%? Does that change your entire retirement plan? It is easy to get comfortable with the stock market when the S&P 500 is posting double digit annual returns, but it is best to maintain a diversified, low correlated portfolio with stocks making up only a reasonable portion of the portfolio. Let’s not forget that dividend paying stocks are still stocks and they will experience significant losses in a bear market.

Custom Institutional Structured Notes

The thesis for these “Outcome Driven” investments is “to deliver an average to above average current income with a high probability of a return of principal with little to no interest rate sensitivity.” The way to offload the interest rate sensitivity referenced above is to link the income or return to a measured financial experience. For example, let’s look at a 3 year note placed on January 25, 2012 linked to the S&P 500 with a 7.5% annual coupon. The annual income of 7.5 % is based on the number of trading days the S&P is above 1000(a 32% imbedded downside protection). Therefore, if the index is above 1000 for the entire year, investors will receive the full 7.5% coupon, half of the year..half of the coupon(3.75%). At maturity, investors will receive their principal as long as the S&P 500 is above 1000. The best part is that the first 32% of downside in the index is fully protected. If one were t investors generate a healthy return whether the index is up or down ( just not down below 1000) and experience little to no interest rate sensitivity.

Pro and Cons

It is easy to see the benefits of making investments that can generate income in both up and down equity markets, but it is important to understand that there is “no free lunch.” As mentioned in the beginning of this article, these investments are credit strategies and are therefore dependent on the solvency of the issuer. They are also less liquid than individual securities, so they are no meant to serve as short term trading instruments. In the end, these “Outcome Driven Investments” are designed to deliver a higher probability of consistent income with imbedded downside protections. These structured strategies combined with traditional modern portfolio theory investment strategies can deliver a very strong “sleep well at night portfolio.”

• Cornerstone Advisory, LLP, is registered as an investment adviser with the SEC. The firm only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. Registration does not constitute an endorsement of the firm by the Commission nor does it indicate that the adviser has attained a particular level of skill or ability.
• Information presented does not involve the rendering of personalized investment advice and should not be construed as an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein.
• Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for a client’s portfolio.
• Historical performance results for investment indexes and/or categories, generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment-management fee, the incurrence of which would have the effect of decreasing historical performance results. There can be no assurances that an investment or portfolio will match or outperform any particular benchmark.
• Examples should not be construed as representing the performance of Cornerstone Advisory, LLP, or any of its advisory clients. All returns will be reduced by advisory fees and other expenses.

 

As always, if you have any questions or would like to have a conversation, please reach out to us or your portfolio manager.