The new rate regime: managing income and volatility

After nearly four decades of declining interest rates and central bank policy rates hitting zero, the combination of quantitative easing policies, low inflation and tepid growth has driven sovereign bond rates to historic lows. The best case today is that rates remain stubbornly low, but investors face the risk that a new reliance on fiscal stimuli could create budget strains, and drive inflation and rates higher.

Sourcing income and managing potential income volatility in this new rate regime presents unprecedented challenges for both fixed-income and equity investors, particularly given that most have only lived through a period of declining rates.

After having the wind at their backs for decades, fixed-income investors are facing new potential headwinds. With bond yields still low, small rate changes result in large volatility, and a modest uptick in yields would produce negative returns. In such an environment, fixed-income investors need to consider that interest rates/duration is just one part of fixed-income investing; credit quality, currency exposure, and inflation present new opportunities and risks.

Equity investors who rely on dividends for income need to identify companies that can initiate and/or grow dividends and pay attention to factors that are harbingers of potential dividend reductions.

It is easy for an investor to misunderstand the risk associated with a fixed-income investment and this misunderstanding can have significant portfolio strategy implications.

For most domestic, investment-grade bonds, most of the risk is interest rate risk, i.e., rates rise and bond prices decline. Similarly, Treasury inflation-protected securities and investment-grade corporate bonds derive much of their volatility from the direction of interest rates.

Meanwhile, below-investment-grade securities like high-yield bonds and bank loans, derive most of their volatility from credit risk because changes in corporate credit metrics and default probabilities account for most of the volatility of these sectors. Duration risk is low in both asset classes, though, despite the fixed-rate nature of high-yield bonds vs. the floating-rate nature of bank loans. In international markets, currency risk drives a significant portion of the volatility profile.

Despite the current challenges in fixed income, most investors still desire bonds in their portfolios. When allocating to fixed income, the best starting point is selecting the risk factors to which an investor wants exposure and then choosing the appropriate sources. Investors should seek opportunities presented by bond market risk factors beyond duration. Today's bond market offers profitable total return opportunities for investors who allocate their risk budgets efficiently.

When looking to equities for income in this more challenging rate environment, it is important to seek companies with relatively high dividend yields, that are growing dividends and have the ability to sustain the dividend payout. Those factors can be combined with an environmental, social and governance factor to create an income portfolio positioned for long-term success.

Simply put, companies that initiate and grow dividends have outperformed. Dividend growers and initiators (S&P 500 index companies that have grown cash dividends or initiated one over the prior 12 months) have had an annual average gain of 9.9%. By comparison, companies that have not paid dividends in the prior 12 months have an average annual return of 2.4%, and the S&P 500 Geometric Equal-Weighted Total Return index had an average annual return of 7.5% (see exhibit 1).

It is also critical to avoid companies that reduce their dividends before that action. The impact of a dividend cut is twofold: not only is the dividend income lost, but the stock's price usually declines. Importantly, investors feel the pain before a dividend cut is announced (see exhibit 2). That is why it is critical to look for factors that may indicate the health of a company and how likely it is they can maintain its dividend. Strong balance sheets with limited debt and ample free cash flow can be predictive of dividend sustainability.

Beyond being aware of traditional financial metrics that support dividend sustainability, business models that incorporate ESG measures should reduce event risk that could impact stock prices and/or dividend payout.

Classifying sustainability factors that are material or immaterial according to a specific company's industry has produced positive investment results.

For example, environmental issues have a relatively immaterial bearing on banks, but they have a material impact on steel companies. Yet social issues such as data security and customer privacy, are material factors for banks. And while child labor practices are likely not material for accounting firms, they are critically important for clothing retailers.

Investments that take a strategic approach through this ESG lens, combined with a focus on traditional financial metrics supporting sustainable dividend growth, can help investors source income in this new rate regime.

After close to four decades of declining interest rates, sourcing income and managing volatility in this new rate regime presents unprecedented challenges. Fixed-income investors need to not only pay attention to interest rate risk, but also consider credit quality, currency exposure and inflation factors in their strategies. The opportunity for equity investors who turn to dividends for income is to identify companies that can initiate and grow dividends and pay attention to signs of potential dividend reductions.

Edward Kerschner is chief portfolio strategist at Columbia Threadneedle Investments, based in New York. This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.