The Problem With Negative Real Interest Rates
Fixed income is not only experiencing historically low nominal yields but also negative real yields. Negative real yields mean that fixed income investments reduce a portfolio’s overall real return. The challenge for institutions and nonprofit organizations continues to be trying to keep up with a real rate of spending in spite of negative real fixed income yields. Since the Federal Reserve announced that it will continue to keep short-term rates low until 2014, the issue of low and negative yields may persist for a couple more years.
Asset allocations are typically set with a target spending rate in mind. When the overall portfolio does not meet expected returns over prolonged periods, an organization appears to be left with just a few options to meet spending requirements. A recent article in the Financial Analysts Journal addressed this issue and offered three choices:1
- Maintain current spending but risk decreasing the future purchasing power of the corpus
- Increase exposure to risky assets for a higher expected return but increase overall risk
- Attempt to overcome the return shortfall through active management despite the evidence that only a minority of active investors succeed in beating their benchmarks
However, the author strongly cautions organizations against each option as each could present serious short- and long-term negative effects on the endowment. In addition, the author reminds institutions that, “In this environment, performance pressures are not a reason to abandon sound investment principles.”
The fact that real yields are negative now does not mean they will be negative in the future. Markets currently expect that rates won’t remain negative indefinitely, so committee members should keep this in mind when making decisions that might affect the long-term results of the portfolio.
A Better Approach
The author concludes that a better approach is to initially set an appropriate asset allocation based on “how much risk an institution prudently can and should bear and how it should optimally invest within that risk constraint so as to maximize return.” Furthermore, diversification is a helpful investment tool: “ To take advantage of as many sources of return as possible and to gain downside protection.” The article clarifies that diversification does not prevent declines in portfolio values but protects the “portfolio from being overinvested after the fact in the worst-performing asset class and against suffering a loss from which recovery might be difficult.”
One final alternative not mentioned in the article is to simply change the existing equity allocation to increase expected return and overcome the return shortfall. By shifting the equity allocation to riskier asset classes like small-cap and value stocks, the expected return of the portfolio increases without taking more equity risk (over bonds) in the portfolio. Thus, the potential for maintaining spending rates increases while remaining within the risk tolerance parameters dictated by an investment policy statement.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2012, The BAM ALLIANCE