Summary: The Law of Unintended Consequences (Part 3) How should investors respond to a zero rates world? When the Fed first lowered rates to near zero in late 2008, many investors thought it would be a temporary situation; that short-term rates would rise at least to the inflation rate when the economy recovered. But rates have been here nearly four years now, and the Fed has made it clear that they will remain here for a considerable period. The extended outlook for extremely low rates has also affected yields on long-term bonds. We now live in a low rate world. For investors who depend upon their portfolios’ income, this is a trying time. They can’t just reinvest cash from maturing bonds or CDs and expect that the income will be adequate. Portfolios with such a “bond ladder” have seen their earnings decline steadily over time, and so their owners will have to find other ways replace that income. Sometimes this can be done, but the challenge is to alter your strategy without reducing your standards. Strategies can evolve; a bond portfolio that was limited to Treasury and Corporate debt might add Mortgage-backed and Asset-backed debt without adding to its risk; a total-return equity strategy could be tweaked to include more dividend-growth stocks and fewer zero-dividend companies. But lowering standards—reducing credit criteria; extending maturities; investing in illiquid instruments with lock-ups and complicated legalese—has had a long and unhappy history. Sometimes it works out and can be a temporary accommodation to an extraordinary situation. But usually it ends in tears. There are ways to maintain or even enhance income in a low-rate world. But reaching for yield by lowering the bar shouldn’t be on the list. Douglas R. Tengdin, CFA Chief Investment Officer Follow me on Twitter @tengdin
