This article is part of a regular series of thought leadership pieces from some of the more influential ETF asset managers in the money management industry. Today's article is by Bob Leggett, senior portfolio advisor at Akron, Ohio-based ValMark Securities, which markets the "TOPS" brand of asset allocation models.
Investors have suffered from “income anxiety” for the past several years as the interest paid on CDs, savings accounts and money market funds contracted to near-zero rates.
Since the Federal Reserve’s zero-interest-rate policy (ZIRP) was largely responsible for this situation, will the upcoming rate increase signaled by the Fed alleviate the situation? To answer that question, we will address these topics:
- The plight of risk-averse income-oriented investors
- The pace of Fed rate hikes
- The shape of the yield curve
Risk-Free, Zero Reward
As everyone knows, the options for investors focused on risk-free income are unattractive. If they decide to invest in shorter-term instruments including money market funds, Treasury obligations, or FDIC-guaranteed certificates of deposit and savings accounts, rates are less than 0.1%, in most cases. Fixed-income investors may enhance income by lengthening portfolio duration, but yields at the longer end of the curve are also near historic lows.
Most investors may be better off if they postpone adding long bonds to their portfolios until bond yields rise a few percentage points. Of course, poor timing (buying longer bonds too early or too late) is a risk for investors who attempt this strategy.
One commonly used process to take the timing issue out of play is to use “laddering,” whereby a fixed-income portfolio is built by purchasing individual bonds, CDs or ETFs (such as the Guggenheim BulletShares suite of products) that mature at specific dates over a period of time.
Climbing The ‘Ladder’
The investor receives the interest payments and rolls over (reinvests) maturities in a new security at the upper end of the ladder of maturities they have chosen. The unfortunate fact is that interest rates peaked several years ago, so ladders have generated less and less income with every reinvestment of recent years.
This demonstrates that a so-called risk-free investment can still have risks. The risk in this example was “reinvestment risk,” or the risk that interest rates will be lower when matured bonds are reinvested. The upside of a ladder is that it spreads out the reinvestment risk, as opposed to investing the whole portfolio in one maturity.
The second risk is that these are “nominal” interest payments, so a surge of inflation could greatly dilute buying power. The good news is that inflation is extremely low, so at least we can note that the small amount of income available is not being eaten up by inflation.