How could investors respond to this challenge? They may wish to reassess their risk profile, recognizing that assuming a greater degree of risk may be a good way to escape the trap of low to negative yields. In the process, investors may find that adding the credit risk of some investments may in fact balance the interest-rate risk of a portfolio overweighted toward high-quality, fixed-income instruments, thereby reducing the overall volatility or risk in their portfolio. Here, we identify five factors that argue in favor of a reexamination of risk weightings in an investment portfolio.

1) Minimal Risk Can Bring Negative Real Returns
Historically, high-quality, short-term investments have often provided a return equal to or in excess of inflation. That is certainly not the case today. From 1928 through 2011, for example, three-month Treasury bills provided a compounded annual return of 3.61%, compared with a 3.11% inflation rate, an inflation-adjusted, or real, return of 0.50%.¹ With the Bureau of Labor Statistics recently reporting core inflation at 2.1%, and three-month Treasury bills struggling to yield even 10 basis points (bps), according to data from the Treasury Department, Treasury bills today provide an unappetizing negative real yield of -2.0%. And even these pitiful returns are better than the absolute negative returns offered by German, Danish, and Swiss two-year government bonds (these securities recently traded at rates below zero percent, according to data from Bloomberg).

The solution may be to capture more return by choosing some additional risk, but high-quality securities (that is, those with the highest investment-grade rating from major credit rating agencies) offer little incentive. Within high-quality markets, the maturity risk inherent in longer-dated instruments seems to offer an ineffective trade-off between risk and return. Ten-year U.S. Treasuries recently traded at a negative real yield of -0.7%, according to data from Bloomberg, yet involve a substantial increase in duration risk versus short-dated Treasury bills.

High-quality corporate bonds also struggle to provide yield in excess of inflation, as investors have recently pushed yields on some 'AAA' rated corporates below government obligations of comparable maturity. As a group, 'AAA' rated corporates with maturities of seven to 10 years barely yield 2.0%, according to data from Bloomberg, at best matching core inflation. Furthermore, a historical comparison of 'AAA' yield spreads versus 10-year Treasury notes today suggests that they offer below-average spreads compared with those of the last 10–20 years.

Low absolute yields, often negative real yields, unattractive spreads, and significant downside price risk if rates do rise make for an ugly combination of investment characteristics for longer-term, high-quality securities. It is not surprising, then, that many investors instead settle on money market funds that yield only 6 bps, until they realize that at that rate, it will take 1,156 years, or 40 generations, to double one's principal investment.

As long as short-term interest rates are anchored at 0–25 bps and the Federal Reserve is committed to keeping rates low while targeting inflation at 2%, owning high-quality U.S. fixed income seems frustrating at best, with the added risk that prices of such securities will likely decline if long rates do rise at some point.

2) High Quality May Mean Greater Risk
Beyond low yield, there are other reasons why investors may want to reconsider an excessive allocation to high-quality securities. It may seem paradoxical, but owning high-quality bonds, particularly over the next 12–24 months, could actually prove riskier in terms of price volatility than owning their lower-quality counterparts. An end to the Fed's Operation Twist (the Fed's program of selling shorter-maturity Treasuries to purchase longer maturities), consequences of congressional action (or inaction) regarding the "fiscal cliff," and fear of inflation all combine to create an environment capable of affecting U.S. Treasury prices more adversely than prices of lower-quality securities.

Operation Twist comes to an end in December 2012. The closure of this program removes a major and consistent buyer from the longer maturities of the yield curve. Without the Fed's support, others may be less inclined to purchase longer-dated Treasuries, potentially pressuring prices lower and yields higher. In contrast, lower-quality corporate bonds have not enjoyed the benefit of the Fed's purchases, nor are they likely to see much adverse reaction as Operation Twist draws to a close.

At the same time that Operation Twist is scheduled to end, the so-called fiscal cliff looms before Congress. Unwillingness on the part of U.S. lawmakers to make tough decisions could invite a ratings downgrade of the United States that also reduces demand for U.S. Treasury debt, this time by investors who by regulation need debt rated 'AAA' by at least two credit rating agencies. Again, Treasuries are likely to be affected, while lower-quality debt may encounter little consequence.

Finally, hints of higher inflation are more likely to affect high-quality securities than more economically sensitive, lower-quality debt. This will be particularly true if inflation is a by-product of a slight increase in economic growth that benefits the profitability and stability of lower-quality companies. In such an environment, economic growth could improve investors' perceptions of lower-quality companies, just as an accompanying increase in inflation potentially erodes the attractiveness of lower-yielding, high-quality debt. Longer term, if growth and potential inflation continue to increase, the Fed may at some point reverse easy monetary policy—and its ongoing quantitative easing program—and dispose of its sizable holdings of Treasury securities. This would push rates higher and Treasury prices lower. Once again, such actions may have much less influence on the prices of lower-quality corporate debt. An alternative, then, to an overemphasis on high quality may be found among selective credit risks, some of which we look at below.

3) Lower-quality Bonds Are Relatively Attractive
Lower-quality corporate bonds (that is, those with ratings below investment grade from major credit rating agencies) have recently offered higher-than-average yield spreads versus 10-year Treasury notes, yet incur lower-than-average risk based on default rates. Based on data from Credit Suisse, since mid-1986, high-yield debt has offered an average of 594 bps above U.S. Treasuries of comparable maturity, while defaults have averaged about 4.2% per year. Recently, that spread has been about 640 bps, while defaults have been less than 2.0%.

And 640 bps today may represent more relative value than it has historically because other interest rates are so much lower today. For instance, during the past 25 years, 10-year Treasuries yielded above 5% for much of the time. In fact, the average daily yield from July 31, 1986, to July 31, 2012, was 5.63%, according to Bloomberg data. If the average spread on high-yield debt has been 594 bps over that same period, then high yield has on average offered about 106% more than the yield available on 10-year Treasuries. Today, the spread of 640 bps represents about 375% of the 1.7% available on 10-year Treasuries.

Compared with history, high-yield bonds today appear to offer a relatively attractive risk/reward combination. For investors who are uncomfortable with, or institutions that are prohibited from, investing in below investment-grade securities, bonds rated 'A' or 'BBB' (by Standard & Poor's) offer similarly attractive yield spreads compared with historical averages.

4) Munis Offer Another Appealing Approach
If taxable bonds offer value because their yield spreads are historically attractive, then municipal credits may offer an even better reason to embrace credit risk. For investors at high marginal tax rates, the pretax equivalent yield of municipal bonds compares favorably to corporate bonds with the same quality rating. 'A' and 'BBB' rated municipals exhibit significant yield advantages over similarly rated taxable bonds when compared on the same pretax basis (see Chart 1).

And the risk may be even less than it appears. Historically, municipals have offered lower default rates and higher recovery rates than corporate bonds of the same rating. Data from Moody's Investors Service show that from 1970 to 2011, the average 10-year cumulative default rate on 'A' and 'Baa' rated corporates was 2.22% and 4.71%, respectively, compared with 0.04% and 0.37% for municipal bonds with the same ratings.² Over the same period, recovery rates (that is, the percentage of their principal that investors recouped through bankruptcy or other proceedings after an issuer default) were 65% for municipal bonds, versus 49% for corporate senior unsecured bonds.

While default and recovery rates represent extreme situations, a more reasonable and relevant measure for evaluating the undesirable investment experience of bonds may be a ratings decline, especially over the past few years. Here, too, municipals seem to have provided a better experience. During 2008–11, for example, about 0.06% of 'A' rated municipals were downgraded annually to below investment grade or default, compared with a rate of 1.43% for 'A' rated corporate bonds.³

Whether comparing yields, defaults, recovery rates, or a ratings downgrade, municipal bonds seem to have historically offered relatively attractive characteristics, at least compared with corporate bonds of similar quality. This is another instance in which selective credit risk may indeed be appropriate for some investors.

5) Equities Can Provide Needed Diversification—and Return
In addition to the fixed-income categories detailed above, investors also can consider equities as a sensible way to adjust their risk profile. In a growing economy, especially if that growth leads to rising inflation, stocks are far better positioned to provide earnings and, in turn, returns, than current low-yielding, short-term securities or longer-term bonds that, in anticipation of inflation, may adjust lower in price. Diversification, then, through adequate exposure to equities, is a key consideration in assessing portfolio risk.

Dividend income also may offer some investors adequate rationale for additional equities, even if economic growth fails to speed up to the point where inflation becomes a problem for bonds. As of August 31, 2012, the dividend yield⁴ on the S&P 500^® Index⁵ was 2.08%, noticeably more than the yield of 1.55% on the 10-year Treasury note on that date. On an individual company basis, dividend yields today often exceed the yield on the same company's debt. And while future tax treatment of dividends is uncertain as of this writing, dividend income over most of the last decade has been tax advantaged. The same can be said of capital gains, which investors have historically come to expect from equities.

And while many investors know that, over the long term, those capital gains, in combination with dividends, have provided a relatively attractive total return, few appreciate that dividend growth alone historically has kept ahead of inflation. Chart 2 tracks S&P 500 dividend growth and inflation. Although there is no guarantee that this trend will continue in the future, the performance gap suggests that, long term, owning dividend-paying equities has been an effective hedge against inflation.

Therefore, an appropriate allocation to equities may be a worthy consideration as investors assess risk in their portfolios.

A Summing-up
The prospect of low or negative yields on government debt and other fixed-income instruments can be discouraging. Making some well-considered changes to your portfolio's risk profile—including selective additions of lower-quality corporate bonds and municipals, or certain equities—may be the best way to navigate the low-rate world we inhabit now.