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BlackRock: Using ‘Risk Temperature’ To Refresh an Income Portfolio

The Exchange

By Michael Fredericks, Managing Director, BlackRock

Gyrations in financial markets and interest rates have many investors asking: “As the market moves up and down, how do I keep my income steady?” It’s not necessarily a new question, nor one that’s likely to go away anytime soon. Recent talk of Fed tapering, however, has made for heightened volatility, and that is raising the volume on the now time-honored query.

The answer? Today, to better steer your income portfolio, knowing your “risk temperature” can be an enormously useful guide.

Indeed, traditional core income investments such as government and corporate bonds have yields near all-time lows and are highly sensitive to interest rate movements, making the asset class risky for an income portfolio. It makes sense for investors with traditional core bonds to consider moving beyond those assets and taking on other kinds of income “risks” – with potentially more attractive returns. But investors need first to fully understand the specific risk/return tradeoffs of those other assets and consciously decide what risks they are comfortable adopting – in short, their fixed income “risk temperature.”

Building a better understanding of the risks of potential income investments can help you better balance these risks with the returns you are seeking to achieve, maintain a more diversified income stream, and -- ultimately -- reduce the gut-wrenching ups and downs of your income portfolio in unpredictable markets.

Understanding the Risks of “Traditional” Fixed Income

As a first step in assessing what kinds of fixed income risk you want to take on, start with your “traditional” income allocation. In our experience, the average income investor holds what they believe to be a “balanced” portfolio consisting of approximately 50% bonds and 50% stocks. But they may not know that the risks in that portfolio are not balanced at all. While bonds are traditionally thought of as being the “safety” component of a portfolio, the interest rate risk that many US government and corporate bonds hold today is higher than it has been in decades.

Specifically, we believe for income investors the risk of holding a portfolio of US government and corporate bonds whose values are highly sensitive to changes in interest rates outweighs the reward right now. For example, if interest rates increase just 1%, an investor holding a popular bond market index of US government and corporate bonds would lose almost 5%.

In this case, knowing your risk temperature means understanding how interest rate risk and the potential for rising interest rates can affect the bond portion of your income portfolio. But more broadly, examining the risks associated with a broader array of “non-traditional” fixed income options will improve your understanding and ability to make informed choices for your entire portfolio.

Increase Your Knowledge of Non-Traditional Income Sources

Once you decide to expand your horizons to include non-traditional investments, here are some asset types to consider:

High Yield Bonds: This investment may not be entirely mainstream, but has been one of our favorites. Attractive yields and default expectations lower than historical averages make these bonds attractive in the current slow growth environment. It cannot be ignored, however, that high yield bonds do carry risk and in many cases appear expensive, making this sector one that investors should be careful to watch.

Floating Rate Loans: This sector offers a yield that resets as interest rates reset, so if interest rates rise, so too will the yield on the floating rate loan. However, with the volatile interest rate environment recently, more investors have found this feature to be attractive as well, so it too is more expensive than it was.

Preferred Stock: For diversification, preferred stock is worth getting to know because it offers a combination of lower volatility and healthy yield. The risks for preferred stock includes high valuations, and many preferred shares also bear the risk of getting “called away” at par.

Real Estate & Energy: We believe investors can find opportunity in both the real estate and energy markets given the burgeoning recovery in housing and dramatic increase in domestic energy production. Given the rise in interest rates, the risk level in real estate can be high. For a less volatile option, look to mortgage-backed securities, which offer enhanced yield relative to Treasuries. Master Limited Partnerships (MLPs) offer exposure to the pipeline & storage infrastructure that supports domestic energy production, but investors should be careful to watch the lower liquidity and potential higher volatility of these investments.

High Dividend Emerging Markets Corporate Stock: This is an asset class that has been beaten up lately amid volatile markets but we believe holds strong long-term value. In the emerging market space, another potential sector to consider longer-term for its attractive yield and better credit fundamentals is emerging market debt. However, this sector too can experience some volatility.

High-Quality, Dividend-Paying Stocks: These stocks remain an attractive option for income seekers, even in times of market stress. The category performed well recently as stock market volatility picked up. These companies are solid global enterprises with healthy yields and the ability to grow earnings and dividends over time. These shares hold equity risk – volatility – but also are popular with investors, so prices are very high.

For a better approach to maintaining steady income in an uncertain market environment, look to expand your horizons – with a good understanding of your personal risk temperature as support. Traditional investments may not behave the way you thought they would, and there may be non-traditional investments that may offer solutions to your investment needs. A flexible multi-asset income fund, one which scours the globe for the best income ideas in a risk-aware portfolio, could be a solution to consider for an investor seeking to reduce the ups and downs of the current market environment.

Michael Fredericks, Managing Director, is head of US Retail Asset Allocation for the BlackRock Multi-Asset Portfolio Strategies (MAPS) group. He is responsible for the development and management of asset allocation strategies for individual investor clients.

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