• After decades of interest rate tailwinds, investors will likely face headwinds.
• Equity investors need to pay attention to factors that are harbingers of potential dividend reductions.
• Fixed income investors need to consider interest rate risk in connection with credit, currency and inflation risks.

After close to four decades of declining US interest rates and central bank policy rates hitting zero, the combination of quantitative easing policies, low inflation and tepid growth drove sovereign bond rates to historic lows. The best case today is rates remain stubbornly low, but there is the risk that a new reliance on fiscal stimuli creates budget strains that drive inflation and rates higher. Sourcing income and managing potential income volatility in this new rate regime presents unprecedented challenges for both fixed income and equity investors.

UNPRECEDENTED LOW RATES

We have just experienced an exceptional range of bond yields in the US treasury market (see Figure 1). Yields rose from under 2% in 1941 to almost 15% in 1982, and then fell back to under 2% in 2013. In the late 19th century and early 20th century, yields ranged from 3.1% to 5.6%. Then bond yields rose as inflation began to rise after World War II and surged in the 1970s, fueled by oil and OPEC, and the cost of fighting two wars: the War in Vietnam and a war on social inequities in the US - so called 'Guns and Butter.' By the end of the 1970s all seemed out of control. And while the US experience might have been the most extreme, it was shared by the rest of the developed world.

Figure 1 - US 10-year bond yields

%, 1871-2016)

Source: US Treasury, "Irrational Exuberance," Robert Shiller, March 2000, Columbia Threadneedle Investments; data as at 31 December 2016.

But the pledge by US Federal Reserve System chairman, Paul Volcker, in 1979 to make fighting inflation his top priority proved a turning point. By 1993, inflation globally was below 5%, and continued to slide. The 2008 global financial crisis heralded coordinated stimulative policies worldwide. 2016 ended with inflation just above 1.5% in Germany and the UK, positive but near zero in Japan and around 2.0% in the US.

The fall in bond yields to unprecedented lows drove a long bull market (see Figure 2). From 1981 to 2016, US 10-year bonds had an average annual return of 8.4%, with double-digit returns in 13 years, and returns over 20% in four.

Figure 2 - Return on 10-year bonds

10-year CAGR, 1970 - 2016

Source: OECD, Columbia Threadneedle Investments; data as at 31 December 2016.

A NEW RATE REGIME: AFTER THE ZERO INTEREST RATE POLICY

Expectations now are that monetary policy has effectively reached its limits, and fiscal policy needs to be the tool to stimulate growth. But with already large budget deficits, such policies could well prove ineffective in stimulating growth and/or have a far greater inflationary than growth impact.

At the current very low/near zero levels, it would seem the best case is interest rate stability, with the risk of higher interest rates if inflation picks up. Either way, after close to four decades of falling rates, we are likely entering a new rate regime. We see evidence of this as the 10-year yield in the US has risen by 69% from 1.45% on 31 July 2016, while rates in Germany and Japan have turned positive.

After having the wind at their back for decades, fixed income investors are facing potential headwinds. With bond yields still low, small rate changes result in large volatility, and a modest uptick in yields would produce negative returns. For example, a 10-year bond with a 2% yield would see that yield wiped out, and a total return of -1.1% with just a 50 basis point rise in yields.

Income strategies must be reviewed as the US moves from a falling interest rate regime to one where rates gradually rise, while other developed markets may (at best) linger at 'zero interest rate policy.'

BOND MARKET OPPORTUNITIES: MANAGING INTEREST RATE RISK IN CONTEXT

Interest rates are just one part of fixed income investing.¹ There are three other sources of risk and return - credit quality, currency exposure, and inflation. These risk factors each perform well at different periods throughout economic cycles. With the 'tailwind' of falling interest rates likely past, a flexible approach should allow investors to generate income from a variety of different sources, while focusing the portfolio's risks on the areas that offer the most attractive relative value.

Figure 3 - Bond market risk factor returns by calendar year

1994 - 2016

Sources: Bloomberg Barclays Indices and Columbia Management Investment Advisers, LLC as at 31 December 2016.

Figure 3 illustrates two primary points. Firstly, bond market risk factors are not highly correlated. Secondly, every year something works. Being in or out of the market is not an all or nothing game - but one of strategic and tactical repositioning to drive the best outcome.

That's where it gets tricky. Forecasting what factor will work at any one time is not easy. For example:

• 2008 flight to quality: was a good year for duration, but bad for credit.
• 2009 risk sentiment was renewed: good for credit, bad for duration.
• Inflation: performs poorly in 2008 and bounces back in 2009.
• 1997 currency risk: as the Asian currency crisis causes flight to safety in the US dollar.²

Figure 4 - Risk factors

Source: Harnessing Fixed-Income Returns Through the Cycle, Gene Tannuzzo, Gordon Bowers III, Columbia Threadneedle Investments, 2017.

It is easy to misunderstand the risk associated with fixed income investment. A look at the risk composition of bond indices is revealing. For domestic investment grade indices, most of the risk comes from duration, or interest rate risk. However, investors in US treasury inflation protected securities or investment grade corporate bonds may be surprised that much of their return derives from duration.

The story changes further down the risk spectrum. Below-investment grade securities, like high yield bonds and bank loans, are most sensitive to credit risk. This is because changes in corporate credit metrics and default probabilities account for most of their performance. In international markets, currency risk drives a significant portion of volatility. In fact, it explains more than half of the performance volatility of the Barclays Global Aggregate Index.

As our colleagues Gene Tannuzzo and Gordon Bowers concluded in a recent paper, investors still need bonds. The best starting point is selecting the risk factors an investor wants exposure to, and then choosing alpha sources. Today's bond market offers profitable total return opportunities for investors who allocate their risk budgets efficiently.³

EQUITY MARKET OPPORTUNITIES: SUSTAINABLE DIVIDENDS FOR INCOME

When looking to equities for income, in this more challenging rate environment it is important to seek companies able to sustain dividend payouts. We believe companies likely to offer sustainable dividend income are those with:

• Strong balance sheets with limited debt and ample free cash flow.
• Business models that incorporate Environmental, Social and Governance (ESG) measures which should reduce event risk that could impact stock prices and/or dividend payout.

Stocks with solid, relatively high and growing dividend yields, along with ESG attributes, can create an income portfolio positioned for long-term success. Dividends are an important part of total return and, historically, have proven to be a consistent source of returns throughout each decade (see Figure 5).

Figure 5 - S&P 500 returns

by dividend & capital appreciation, 1930 - 2016

Source: Ned Davis Research as at 31 December 2016. Past performance is not a guarantee of future results.

Companies that can initiate and grow dividends have outperformed. Dividend growers and initiators (those companies in the S&P 500 Index that have either grown their cash dividend or initiated one in the prior 12 months) have had an annual average gain of 9.9%. Non dividend-paying stocks (those that have not paid dividends in the prior 12 months) have only had an average annual return of 2.4%, and the S&P 500 geometric equal-weighted total return index had an average annual return of 7.5%.

We believe that income-related metrics such as dividend yield and dividend growth, as well as gauges of dependability and quality such as free cash flow or net income, are predictive of dividend sustainability. Business models that incorporate ESG measures should reduce event risk that could impact stock prices and/or dividend payout.

After close to four decades of declining interest rates, sourcing income and managing volatility in this new rate regime presents unprecedented challenges. Fixed income investors need to consider that interest rates are just one part of fixed income investing. There are three other sources of risk and return: credit quality, currency exposure, and inflation. Equity investors, who turn to dividends for income need to identify companies that can initiate and grow dividends, and importantly pay attention to factors that are harbingers of potential dividend reductions.

Download PDF

¹ Columbia Threadneedle Investments, Gene Tannuzzo and Gordon Bowers, III, "Harnessing Fixed-Income Returns Through the Cycle," January 2016.

² Columbia Strategic Income Strategy, "Income in All Markets", 2017.

³ Columbia Threadneedle Investments, Gene Tannuzzo and Gordon Bowers, III, "Harnessing Fixed-Income Returns Through the Cycle," January 2016.