FOR NEARLY A DECADE, with the Federal Reserve keeping interest rates at historic lows, the only way to get a reasonable level of income from your stocks and bonds—a solid yield—was to accept heightened risk.
Very low interest rates can help encourage business activity and consumer spending, and the Federal Reserve had vowed to keep rates low for as long as needed to help the U.S. economy recover from the deep slump that began in 2007. It wasn't until late in 2015 that "the Fed decided we were finally getting where we needed to be in terms of the economic recovery," says Ethan Harris, head of Global Economics at BofA Merrill Lynch Global Research. Last December, the U.S. central bank increased the federal funds rate—the interest banks charge one another for overnight loans—by a quarter of a percentage point, and one or two additional small hikes in interest rates are expected during 2016. Yet further increases will come slowly, Harris says. Getting back to more typical rates will likely happen over years, not months.
So, what does it all mean for me now?
Because of this gradual rise, drawing steady income from your portfolio—for retirement, to pay college bills or to support a business, among other purposes—will continue to be a challenge. But the equity and fixed income strategies you can consider have already begun to shift.
"Even a very slow increase in interest rates will likely mark a major change for investors," says Karin Kimbrough, head of Macro and Economic Policy at Merrill Lynch Wealth Management. As the year proceeds, it's a good idea to review how much your bond portfolio might have changed in value, as well as to look at payments from bond interest or stock dividends, and how all of those factors might change as rates rise.
What's crucial now, as always, is to find a mix of investments tailored to your particular goals, Kimbrough says—and what works for you may not be appropriate for someone else. Here, our experts suggest various strategies to consider, depending on your priorities and where you are in life.
Will my assets last in retirement?
Nowadays, as people live longer and longer, one of the chief concerns of older Americans is making sure they won't outlive their money. And retirees, perhaps most of all, have felt the pinch of lower rates, with their savings and fixed income portfolios earning next to nothing. That challenge should ease a bit as rates rise—but retirees may need to review and adjust their existing asset allocations.
"Someone at age 75 or so may not be able to take as much investment risk," Kimbrough says. Still, you'll need your holdings to grow enough to outpace inflation, which is currently low but could rise along with interest rates. To help maintain income while you pursue growth, Kimbrough suggests the following approach: Consider dividing your assets into two buckets—one for guaranteed income-type investments and the other for more aggressive, longer-term investments. For the first bucket, you could purchase an immediate annuity that is designed to provide guaranteed monthly income for life. Most immediate annuities can be set up to also provide income to a surviving spouse.
"Even a very slow increase in interest rates will likely mark a major change for investors." — Karin Kimbrough, Head of Macro and Economic Policy, Merrill Lynch Wealth Management
Just be aware that those potential benefits come with some risks—for example, that unless you buy inflation protection your buying power could wane; you might die too soon to recoup your investment; or the insurer promising your payments could fail.
Meanwhile, for the other bucket, you might consider investing your remaining funds in a diversified but more aggressively allocated portfolio that you don't plan to touch for the next 15 years. Potentially, those assets can grow long-term while you spend the income from your immediate annuity. This strategy may not work for those who are near retirement or won't accept the additional risks that are associated with more aggressive investments.
Another option is to consider blue-chip stocks that have a history of paying dividends, or quarterly payments to stockholders, which are currently higher than the yields on many bonds. To complement that, you could go with a fixed income portfolio concentrated in investments whose yields remain low now—such as U.S. Treasuries, municipal bonds and certificates of deposit (CDs)—but could be replaced as they mature with newer fixed-income investments that are likely to provide more generous payments years from now when interest rates are potentially higher.
Are you meeting your need for income? In this video, our experts offer strategies you can consider now.
What if I have time to invest more aggressively?
In most cases, people who aren't in or near retirement may be able to pursue a more flexible strategy. But different age groups may have different needs. A young entrepreneur in her thirties, for example, might need portfolio income to supplement the paycheck from a fledgling business. A fiftysomething parent with kids in college, on the other hand, may require additional income to cover ongoing tuition and expenses.
If you do have several decades to invest and no immediate need to draw reliable income, you may want to keep many of your holdings in stocks. When interest rates trend higher, an option may be to buy stock in historically solid growth companies that have paid dividends—and that could increase payouts in the future. According to the U.S. Equity Strategy team at BofA Merrill Lynch Global Research, the current choices in U.S. equities are likely large, high-quality companies, particularly those with strong balance sheets.
However, a well-diversified bond portfolio can also play an important role in a long-term investment strategy. High-quality, investment-grade corporate bonds can offer above-average stability and potential steady income. Those looking for higher income and who can accept lower credit quality may want to consider preferred securities. Preferreds—a class of ownership in a corporation—generally pay regular fixed dividends to shareholders. They have advantages over common stock in that they typically have higher yields, and they rank ahead of common shares, but behind bonds in payment priority.
But they also have very long maturities or are perpetual, so their prices would be sensitive to a rise in market yields, notes Martin Mauro, fixed income strategist at BofA Merrill Lynch Global Research. "That interest rate risk could be lessened with fixed-to-floating rate preferreds." These securities switch to a variable rate five or 10 years after being issued, so their coupon could rise if short-term rates do.
If you're in a higher tax bracket, you may also want to add high-quality municipal bonds to your investment mix, and might consider munis with longer maturities. "Those bonds, in our view, wouldn't suffer that much if rates rise only a little bit," says Kimbrough. You could also hedge the interest-rate risk of your bonds by building a bond ladder that uses cash from maturing bonds to reinvest in new bonds that could be offering higher rates.
Another option to consider, says Kimbrough, is to "sell some of your stocks that have grown in value over time and take your earnings as cash." The proceeds could go toward helping pay for current expenses or re-investing in more attractively valued investments.
Meanwhile, events in the markets may continue to cause some uncertainty. As the Fed continues on its planned path of slowly but steadily raising interest rates, volatility could remain elevated. This makes it more important than ever to consider what your short- and long-term goals are and to develop a strategy that helps you stay on track.
3 Questions to Ask Your Advisor
- Can I tell which stocks are likely to increase their dividends over time?
- Could a bond ladder be an appropriate strategy for me, especially as interest rates rise?
- Would purchasing an immediate annuity be a good step at my current stage of life?
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Investments in high-yield bonds (sometimes referred to as “junk bonds”) offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a junk bond issuer’s ability to make principal and interest payments.
Income from investing in municipal bonds is generally exempt from Federal and state taxes for residents of the issuing state. While the interest income is tax-exempt, any capital gains distributed are taxable to the investor. Income for some investors may be subject to the Federal alternative minimum tax (AMT).
Companies may reduce or eliminate dividends to shareholders. Historically, dividends make up a larger percentage of a stock’s total return.
This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. 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. All sector and asset allocation recommendations must be considered by each individual investor to determine if the sector is suitable for their own portfolio based upon their own goals, time horizon, and risk tolerances.
Investing in fixed income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices typically drop, and vice versa.
Investments focused in a certain industry may pose additional risks due to lack of diversification, industry volatility, economic turmoil, susceptibility to economic, political or regulatory risks, and other sector concentration risks.