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For four decades, investors have gotten a boost from falling interest rates. Now it’s more important than ever to focus on reliability of investment income.
Investors have been through an extended period of unprecedented conditions, including four decades of declining interest rates, and it’s important to appreciate just how unusual this environment has been. Historically, interest rates were fairly constant; from the late 1800s to the early 1900s, rates stayed in a range of about 3%–5.5%. It wasn’t until after World War II that interest rates began to rise. And later in the 1970s, the Federal Reserve raised federal funds rates to 20% to combat rising inflation. This caused a severe recession in the U.S., but it brought inflation under control. It also launched the extraordinary period of declining interest rates that may soon be coming to an end.
The best case scenario today is that rates remain low, but policy changes could drive interest rates higher. This new interest rate regime presents challenges for investors who rely on their fixed-income and equity investments to generate reliable income.
Fixed income: the end of a four decade bull market
The bond market has actually been a relatively easy place to make money. Decreasing interest rates produced a prolonged bull market in bonds. In fact, from 1981 through 2016, the average annual gain in 10-year U.S. Treasury bonds was over 8% per year. There were double-digit returns in 13 of those years, and returns of over 20% in four of those years.*
Now, the challenge for fixed-income investors is fairly intuitive: if interest rates go up, the price of bonds will go down. This means the coupon payment (or interest income) on bonds would be a significant part of fixed-income total return, and investors can no longer depend on declining interest rates and rising bond prices to prop up their fixed-income return.
With bond yields still very low, even small interest rate changes can result in significant income volatility and negative returns. For example, the exhibit below shows that if interest rates rose just 50 basis points (a basis point is 1/100 of a percent), a 10-year bond with a 2% yield would cause that yield to be wiped out.
A small change in interest rates can have a big effect
(Assumes a 10-year bond with a 2% starting yield)
Equity: not immune to rising interest rates
For equity investors, the challenge may seem less obvious — there isn’t as direct a connection between a change in interest rates and stock prices. But when interest rates rise, stock prices tend to decline and therefore, dividends become even more important because they compose a more significant part of total return. In recent decades dividends have accounted for 15%-20% of the S&P 500 Index total return. However, from 1930 through 2016, a period that includes more typical interest rate environments, dividends contributed 43% of the S&P 500 total return.
The bottom line
After close to four decades of declining interest rates, sourcing consistent income in a new rate regime presents unprecedented challenges. Understanding that interest rates are only one component of fixed-income return, and focusing on consistent and growing dividends rather than chasing high yields, may be a good way to prepare for this change. Read this white paper to learn more.