Generating Income In Today's Low Interest Rate Environment

Includes: GOVT, PLW, TRSY
by: Thomas Biddison, III

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, JPMorgan, 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:

  • two-year treasury -- .38%
  • 10-year treasury -- 2.84%
  • three- to five-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 Jan. 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 Jan. 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 one 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 three-year note placed on Jan. 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 1,000 (a 32% embedded downside protection). Therefore, if the index is above 1,000 for the entire year, investors will receive the full 7.5% coupon and 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 1,000. The best part is that the first 32% of downside in the index is fully protected. Investors would generate a healthy return whether the index is up or down (just not down below 1,000) 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 for the retail investor. These investments are primarily suited to institutional firms who can create custom investments based on their investment thesis and meet minimum investment levels ranging from $1 million to $3 million per investment. Brokerage offering that are loaded with commissions and long dated maturities are available to the retail investor, but they are less attractive.

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 not meant to serve as short-term trading instruments. Generally it is best to hold these investments to maturity, but there is a smaller secondary market for these notes to satisfy immediate liquidity needs.

As with other fixed-income instruments, these redemptions prior to maturity can subject investors to a slightly discounted bid/ask spread price. In the end, these outcome-driven investments can deliver a higher probability of consistent income with embedded downside protections. These structured strategies combined with modern portfolio theory investment strategies can deliver a sleep-at-night portfolio.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.