Over the past 12 years, U.S. investors have faced four investment challenges that were much more severe than they were in the period from 1982 through 1999:
(1) Low interest rates and higher future risk for fixed income
(2) Sluggish equity returns
(3) Higher correlations among many asset classes
(4) Less liquidity for certain investments in times of stress
In light of these challenges, many investors are exploring investments beyond the "traditional" investments of U.S. stocks and bonds. More than $25 billion has been invested in buy-write funds since the 2002 introduction of the first major benchmark for options performance, the CBOE S&P 500 BuyWrite Index (BXM).
Challenge No. 1: Low Interest Rates And Higher Risk For Fixed Income
Many investors think of fixed-income investments as being very safe, and many fixed-income instruments have performed relatively well during the past few decades. For example, as shown later in this article, the Treasury bond index had slightly higher returns than the S&P 500 Index over a recent two-decade period.
However, with interest rates so low in 2012, some commentators are noting that the outlook for U.S. fixed-income investments might not be very rosy. Professor Burton Malkiel of Princeton University wrote in a March 2012 op-ed piece:
Bonds are the worst asset class for investors. Usually thought of as the safest of investments, they are anything but safe today. At a yield of 2.25%, the 10-year U.S. Treasury note is a sure loser. Even if the overall inflation rate is only 2.25% over the next decade, an investor who holds a 10-year Treasury until maturity will realize a zero real (after-inflation) return. … Given the likely trends, U.S. Treasurys and high quality bonds are likely to be extremely poor investments and are very risky.¹
Further, an August 2012 news article noted:
For many investors, the appeal of investment-grade corporate bonds is obvious. Interest rates on Treasury bonds are even lower … But skeptics say the ravenous demand for corporate bonds has pushed yields on the securities down too far to compensate investors for their risk. … When interest rates eventually rise, prices of recently issued corporate bonds will fall. "The guy buying a [new] bond today is a guy buying a certain loss," says Anders Maxwell, a managing director at investment bank Peter J. Solomon Co. "Rates have to go higher, and when they do these low-coupon bonds will drop precipitously in value."²
The average yields in Figure 1 were 6.71 percent for 10-year Treasurys, and 3.07 percent dividend yield for the S&P 500.
Key interest rates in the Wall Street Journal on August 20, 2012, included:
- 0.11 percent: 4-week U.S. Treasury bills
- 0.44 percent: 3-month Libor
- 1.41 percent: 5-year CD
- 1.82 percent: 10-year U.S. Treasury notes
- 1.95 percent: Barclays Capital Aggregate
- 5.93 percent: Merrill Lynch High-Yield 100