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Bonds: Rising Rates Meet Low Liquidity

Investors will need to watch for new risks as the environment changes

INTEREST RATES IN THE U.S. have been on a downward trend for the past 30 years. The 10-year Treasury yield is around 2.2% as of Dec. 8, 2015, versus an average of 10.6% in the 1980s and 4.4% in the 2000s. At some point, the Federal Reserve will begin to normalize interest rates from the very low level where they've remained since the 2008–2009 financial crisis. Going forward, we expect bond markets to be characterized by slowly rising but still relatively low yields, decreased liquidity and higher volatility. Investors should consider the risks this change in monetary policy will bring. While inflation, a typical risk for bondholders, appears likely to stay low in 2016, other risks—involving liquidity, credit and duration—are worth watching.

Bond market liquidity is not what it used to be
Liquidity is the degree to which an asset can be bought or sold at the quoted price without affecting its price. In liquid markets, investors can buy or sell assets quickly with minimal price movement. The price impact is higher for illiquid assets, and higher still during periods of market stress.

Bond markets have become less liquid since the financial crisis. Therefore, periods of extreme stress—when a large number of investors sell at one time—may create wider price swings than in normal environments. In some instances when markets are stressed, as they were this summer, liquidity can evaporate. Marty Mauro, fixed income strategist at Bank of America Merrill Lynch, sees high-yield bonds as most vulnerable to liquidity risk.

We see at least two reasons for lower bond market liquidity. First, the increased regulation of financial services companies has made it more costly for these market makers to warehouse bonds on their balance sheets and facilitate quick transactions. As a result, dealer inventories have been scaled back. Second, th¬¬¬e structure of the market, with new types of bond buyers—such as mutual funds and exchange-traded funds—has led to concentrated positions and the possibility that managers of those funds will attempt to sell large quantities at the same time.

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These changes leave fewer market participants to step in and act as marginal buyers during periods of stress. Therefore, investors wanting to sell in stressed markets might have to accept a larger discount to complete the transaction.

With fewer market participants to step in during periods of stress, investors wanting to sell might have to accept a larger discount to complete the transaction.

Understanding liquidity risk
Investors' best protection against liquidity risk is awareness. Knowing what they own and what can provide liquidity when they need it is essential. Where certain investments can't provide liquidity in stressed markets, investors can determine with their financial advisor whether the liquidity risk is worth the potential of an increased return. For buy-and-hold investors, illiquidity should be of less concern. Their main focus should be achieving an appropriate balance between credit risk (which reflects the bond issuer's underlying credit quality) and duration risk (the degree to which an increase in interest rates will reduce a bond's value). Investors with shorter time horizons and greater liquidity needs should consider keeping a reserve for those needs in cash or cash-like investments. This helps ensure that the liquidity of their investments matches the portfolio's time horizon.

Generating portfolio income requires thinking broadly
Most investors think of income solely as the cash flows from bond interest and stock dividends. But investors can also look to adopt a more holistic, total return approach that takes into account price appreciation as well as direct investment income. By diversifying across multiple sources of portfolio income—from bond coupons to stock dividends, financial strategies and capital growth—investors can optimize their spending rate from a portfolio through different market cycles and align their investments with their goals.

Bond coupons: Even though yields are relatively low, bonds remain an essential part of most balanced portfolios, with high-quality bonds providing income and diversification. With many kinds of bonds available to generate income, investors must choose between limiting risk and stretching for a higher yield. We believe U.S. Treasuries, investment-grade corporates and high-quality municipals should be at the core of most portfolios. Satellite holdings can include riskier bonds, such as high-yield and emerging markets issues, that are sized appropriately and take into account credit, currency and liquidity risks.

Equity dividends: Dividend-paying stocks can offer both current and potentially growing income. Higher-yielding equities can typically be found in more mature industries, such as utilities and telecom, or may be issued by low-growth firms that don't need to reinvest profits. More interesting are dividend-growth stocks that offer expected increases in dividend payouts. Even with a portfolio of coupon and dividend income, yields still may offer a range of only 2% to 3%. For higher yields, investors may consider real estate investment trusts (REITs) and look abroad to European and emerging market stocks.

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Financial strategies: Financial strategies involve specialized approaches that encompass a potentially broad range of income solutions such as annuities and market-linked securities, among others. Often income from these sources depends not on a stock dividend or a bond coupon but on something else, such as the creditworthiness of an insurance company. These strategies can be valuable to investors in diversifying sources of income. Owing to their somewhat more complex nature, these may offer rates of return that may be higher than coupons and dividends, but they also carry special risks.

Harvesting capital growth: Focusing on cash flows from stocks and bonds for income can be a part of the solution. Investors can also harvest capital growth by selling portions of appreciating assets at regular intervals to complement income from securities in a portfolio. While there are potential taxes and fees associated with this approach, its simplicity and the ability to tie asset sales to a consistent portfolio rebalancing process are key to success.

There are $6 trillion of negative yielding government bonds and $17 trillion of bonds yielding less than 1%, according to BofA Merrill Lynch Global Research.1

In conclusion, each source of income offers some degree of cash flow and opportunity for capital appreciation and poses some risks from liquidity, volatility and growth. The appropriate blend must be tied to one's overall financial goals, taking into consideration risk tolerance, time horizon, income and liquidity needs, as well as a sustainable spending rate.

 

 

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1 "Global Investment Strategy Year Ahead," Michael Hartnett, Nov. 22, 2015

Investing involves risk, including the possible loss of principal. All opinions are subject to change due to market conditions and fluctuations. Past performance is no guarantee of future results.

This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument, or strategy. Before acting on any information in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Any opinions expressed herein are given in good faith, are subject to change without notice, and are only correct as of the stated date of their issue.

Neither Merrill Lynch nor any of its affiliates or financial advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.

The investments discussed have varying degrees of risk. Some of the risks involved with equities include the possibility that the value of the stocks may fluctuate in response to events specific to the companies or markets, as well as economic, political or social events in the U.S. or abroad. Bonds are subject to interest rate, inflation and credit risks. Investments in high-yield bonds may be subject to greater market fluctuations and risk of loss of income and principal than securities in higher rated categories.

Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates, and risk related to renting properties, such as rental defaults. In addition to the risks associated with direct ownership in real estate, REITs may carry additional risks because they are dependent upon management skills, may not be diversified, are less liquid and are subject to heavy cash flow dependency, defaults by borrowers and self-liquidation. A REIT could also fail to qualify for tax-free pass-through of income under the Internal Revenue Code or fail to maintain its exemption from registration under the Investment Company Act.

 Investments in foreign securities involve special risks, including foreign currency risk and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investments made in emerging markets. Investments in a certain industry or sector may pose additional risk due to lack of diversification and sector concentration.

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