Investing in a low interest rate world
Summary
Near-zero interest rates across the developed world are a puzzling issue for long-term investors to understand and navigate. Sufficient diversification across four to six asset classes and geographies with appropriate allocation to growth securities will be critical to achieving longer-term financial success.Introduction
Very low, or even negative, central bank rates push down short-term rates on all types of fixed income securities. Negative rates spur banks and other investors seeking yield to buy short-term government debt, pushing up prices and lowering yields on these securities.
Since the financial crisis, investors have been used to near-zero interest rates in many of the main reserve currencies, such as the Euro, Japanese Yen and Swiss Franc. This low-interest-rate investment environment was further accelerated by the Covid-19 pandemic to also affect the US Dollar, with significant implications for multi-generation investing.
Near-zero interest rates across the developed world are an important issue for long-term investors to understand, as they will need to adapt to manage money effectively in this new world.
Cash and fixed income investment returns
Under normal economic conditions, cash and fixed income securities provide reliable income for investors. However, these returns are currently very low.
Cash is generally thought of as a steady investment, but in this low-interest-rate environment, investors cannot sit with an overabundance of cash. There needs to be enough cash to provide liquidity and optionality and to avoid having to sell during a correction. However, too much becomes counterproductive.
The low-interest-rate environment has also reduced the attractiveness of fixed income investing. Longer-term US treasuries are yielding between 50-100bps and close to zero in both Europe and Japan. These are three major reserve currency areas.
Portfolio construction considerations
The low-interest-rate environment is not a reason to remove fixed income instruments entirely from a portfolio. These instruments remain an important means of balancing more risky asset classes. A slightly higher allocation to corporate and emerging market fixed income instruments, which tend to have higher yields, may be an option for certain investors seeking regular income.
The best course of action for investors is to remain focused on long-term financial goals and to construct a well-diversified portfolio that will grow and capture risk premiums in most investment environments, produce low drawdowns, and be less vulnerable to left-tail risks.
Proper diversification implies the distribution of a portfolio across four to six asset classes and geographies. Such diversification will improve risk-adjusted returns better than anything else an investor can do.
Conclusion
The unknowns of the post-Covid-19 landscape will force long-term investors to review and rethink some of their current strategies. In this investment environment, diversification is more important than ever.
