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Investors should look to diversify into higher income sources

In this lower for longer interest rate environment, investors can no longer rely on government bonds for income.  A multi-asset approach can help uncover new opportunities for income with a broader asset mix, while balancing risks through diversification.

Zach Bevevino, BlackRock’s Director and product strategist in the BlackRock Multi-Asset Strategies & Solutions (MASS) team, offers you insights to take some risks to thrive in a challenging interest rate environment.

Central bank actions are challenging the role of government bonds in portfolios

Low interest rates are not a new story for investors. In fact, interest rates having been trending lower for decades. Yet, 2020 brought new, previously unthinkable, depths. Why? Major central banks have cut interest rates to incredibly low levels and have added over USD $12 trillion to their balance sheets (the equivalent of roughly 15% of global GDP) to stem the impact of the coronavirus outbreak.

These measures, alongside record fiscal stimulus, were certainly needed to plug the economic hole left by the virus. However, it will bring  damaging effect  to those who rely on higher yields to earn a reasonable return on their portfolios. The prospective returns for US treasuries and other traditional bonds are now uninspiring for even the most conservative investors. This also means the safety-net role that government bonds used to play in portfolios will not be as impactful either.

Rates are likely lower for longer as central banks remain committed to righting the ship. But investors should consider that given today’s paltry yields, even a small rise in interest rates can result in negative returns on most traditional bonds (bond prices move in the opposite direction of interest rates). In this world, investors should seek out other sources of income and diversification for their portfolios.

What’s the real story with interest rates?

Most investors can clearly see the effects of lower yields today through lower income earned on their savings and investments. What’s less obvious is the income earned after factoring in inflation - an investor’s real yield. This is another potential cost of all this stimulus, and it paints an even direr picture for low-yielding cash and bonds.

Here's the quick math: take the yield on the US 10-year treasury of 1.0% today and subtract the expected level of inflation over the next 10 years (the so-called 10-year breakeven) which is 1.9% and you get a real yield of roughly -1.0%. In other words, investors would lose -1.0% per year in purchasing power holding that investment. Similar dynamics exists in other markets. In fact, it is estimated that over USD $30 trillion in global bonds have a negative real yield today1. Most investors can't afford to sit in investments where you consistently lose purchasing power.

Despite this challenge, global investors continue to hold huge allocations to cash and low-yielding bonds as the below chart shows.

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Recently, investors have started to reallocate away from safe-haven assets as approved vaccines come within reach. Even still, the world is swimming in cash. The bottom line? We expect investors to continue to seek out alternatives to low yielding assets in the years to come, providing an ongoing tailwind to markets that offer attractive income.

Multi-asset can help investors find income and embrace risks thoughtfully

No one asset class can solve today’s income challenges. A multi-asset approach can help investors uncover new opportunities for income while simultaneously balancing risks through diversification. A flexible, diversified approach also means investors can achieve compelling income across a variety of market environments.

A few areas we favor today include US high yield bonds, Asian credit, global dividend stocks, emerging market stocks, covered calls, and preferred stocks. Why? We are likely in the early stages of a multiple-year economic expansion that will continue to support income producing assets over cash and government bonds. Widely available vaccines should allow the global economy to achieve a broader and deeper recovery in 2021. Furthermore, it’s clear that central banks and governments will continue to support the recovery.

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Source: Bloomberg. As of November 2020. Index returns are for illustrative purposes only. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Fixed income yields represented by yield-to-worst, equity yields by 12 month dividend yield. Cash: Bloomberg Barclays US Treasury Bills 1-3 Month Index. US Treasuries: Bloomberg Barclays US Agg Treasury Index. MBS: Bloomberg Barclays US MBS Index. Inv. Grade Bonds: Bloomberg Barclays US Agg Corporate Index. High Yield: Bloomberg Barclays US High Yield 2% Issuer Cap Index. Global Equities: MSCI World Index. EM Equities: MSCI Emerging Market Index. Dividend Stocks: MSCI World High Dividend Yield Index. CLOs: JPM CLO Index. Global REITs: FTSE NAREIT All REITs Index.  Preferred Stock: S&P Preferred Stock Index. Asian Credit: JP Morgan Asian Credit Index.

Looking at similar points in the past can also provide useful perspective on how to think about today’s markets. Since 2008, we’ve seen global interest rates bottom two times previously, 2012 and 2016. In each instance, investors were rewarded in the following years for diversifying away from interest rate sensitive traditional bonds into higher yielding stocks and bonds. We think a similar act can play out this time.