Searching for Income in a Low Interest Rate Environment

By Max Isaacman  NOV 12, 2013 1:06 PM

One strategy? Look to emerging markets debt, which is still risky, but could offer higher yield.

 


Investors are scrambling to get higher yields while also trying to protect against capital loss if and when interest rates start climbing. To develop securities to fill this need, ETF-makers are combing the globe, looking for short-term debt of riskier companies. There is short-term debt in both US and emerging markets that merits consideration. Especially in emerging markets, there are corporate debt offerings that may offer yield pickup and diversification benefits that are better than in the US and other advanced economy countries.
 
Investors are likely to experience volatility along the journey to the destination of high-yield short-term debt. Investing in foreign securities, including emerging market securities, could involve heightened risks from factors such as currency fluctuations, and political and economic risks. Also, the increase in global investor interest in emerging markets could make security valuations relatively high at times. Overall, however, given the emerging markets’ strong economic fundamentals and increasing role in global economic activity, emerging markets debt could offer a sensible, but still risky way to get higher yield.
 
One ETF to consider is the PowerShares Global Short Term High Yield Bond Portfolio (NYSEARCA:PGHY). The ETF is based on the DB Global Short Maturity High Yield Bond Index. The Index will generally invest at least 80% of its total assets in US and foreign short-term, non-investment grade bonds included in the Index, all of which are denominated in US dollars. The ETF does not include all of the securities that are listed in the Index, but uses a sampling method in seeking to achieve its investment objective. The ETF, as well as the Index, rebalances quarterly and reweights annually.
 
As of November 1, 2013, the 30-day SEC yield is 3.61%. This yield is based on its payments over the last 30 days. The distribution yield is 4.78%. This yield is based on interest return plus any other distribution. The effective duration of PGHY is 1.39 years. Duration is the number of years that is required for an investor to receive the value of all future payments, both interest and principal, from a bond. The length of time it takes to receive payments will reflect in a bond’s sensitivity to bond prices, because the shorter the duration is, the less sensitive the bond will be to changes in interest rates.   
 
About half of PGHY is invested in companies domiciled in the US. The other half is invested in companies domiciled in emerging markets such as Russia, Ukraine, Venezuela, and Brazil. This list of countries highlights that PGHY does have risk. Also the quality allocations are low, with 43% of the debt rated BB, and 31% rated B, both ratings from S&P.
 
Investing in Markets Through FDIC-Backed CDs
 
An investor in PGHY is subject to risk. If an investor doesn’t want to be in the market, there are other ways to invest and be linked to market changes without taking on a direct amount of risk. One of these is through Market Linked Certificates of Deposit (MLCD). I am referring to those MLCDs that are FDIC-backed, and an investor needs to be careful and check to see who is backing the MLCD. Not all MLCDs are FDIC-insured. MLCDs participate in stock market moves and are offered with links to different markets, including emerging markets' and developed countries' indices. Also MLCDs are offered with links to other asset classes, such as currencies or commodities.
 
The details of each are spelled out in each offering’s Preliminary Disclosure Supplement, and should be read and understood before buying an issue. The MLCDs I favor are those that specify that if an FDIC-insured MLCD is held to maturity, FDIC guarantees the return of principal, no matter what the market does. Maturities are usually in the four- to six-year range. Usually there is interest paid for the time the CD is held. Many of these CDs have a “Survivor Option,” meaning that if you die before the CD matures, your heirs can redeem the CD at par. MLCDs are offered by major banks such as Chase Bank (NYSE:JPM), Wells Fargo (NYSE:WFC), and Union Bank.
 
Typical terms are that at maturity the CD pays back your principal plus the greater of a percentage, for example, 2% for the term held or the sum of the quarterly percentage changes of the index, which is related to the performance of an index, such as the S&P 500 Index (INDEXSP:.INX). Negative quarterly percentage returns are usually uncapped, and positive quarterly percentage returns are sometimes capped at 4% to 5%. The purpose is to capture 60% to 80% of the gain of the index, depending on the issue. Typically there is no guarantee that there will not be a loss if a CD is sold before maturity, if the CD can even be sold before maturity, since there is usually no guaranteed secondary market.
 
Another way to invest in the market, and a method that's especially relevant when looking at the bigger picture, is through annuities. Annuities are contracts between an investor, or annuitant, and an insurance company. Annuities are designed to provide an income stream immediately or in the future. There are differences between annuities and other investment strategies, not the least of which is that the backing of annuities is the insurance company. So there is credit risk with annuities, but this risk varies from state to state, as some states have an insurance pool to protect insurance buyers from some of their risk.

With some annuities, returns are tied to the performance of an index, such as the S&P 500 Index. There is risk, of course, since markets do go down, but some annuities guarantee a return and give an upside potential if an index does perform. Annuities are different animals than securities and the two should not be confused. For instance, annuities cannot be sold, are not traded, and typically have a large penalty if surrendered before maturity.

Editor's Note: Max Isaacman is the author of Blizzard of Money, Winning with ETF Strategies, Investing with Intelligent ETFs, How to Be an Index Investor, and The NASDAQ Investor.
No positions in stocks mentioned.