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Yield Hunters Have Three Options

The traditional “60/40” portfolio of stocks and bonds can be saved with a few modest tweaks.

(Bloomberg Opinion) -- With the U.S. election (mostly) over, a divided government ahead and an effective Covid-19 vaccine on the way, the recent focus of investors has been on equities. It’s easy to see why: The S&P 500 Index has soared 9.64% this month to a new record. But investors would be wrong to overlook the fixed-income portion of their portfolios at this time. Returns from bonds are very likely to be lower over the next decade than they were over the last. Worse, there’s not a whole lot investors can do about it.

So let’s talk bonds. Fixed-income assets have been in a secular bull market ever since then Federal Reserve Chairman Paul Volcker raised the federal funds rate to 20% in June 1981. That move caused a recession, but crushed inflation and set up a bull market in stocks that lasted from 1982 to 2000. During the four decades since, bond yields have steadily fallen, dropping to almost nothing for benchmark government securities.

It was only a decade ago that 10-year Treasury notes yielded more than 4%. For bondholders, though, that might as well have been a lifetime ago. Today, yields are below 1%. Yield-seeking investors have three choices: 1) take on more risk to generate higher yields; 2) lower return expectations (temporarily); or 3) accept low rates as something they cannot change.

To be clear, none of these options are a “magic bullet.” Before discussing what to do and what to avoid, let’s consider the reasons to hold bonds in the first place.

Fixed-income assets serves two purposes. The first is yield. In a properly constructed portfolio, regular interest payments can combine with dividends to provide a valuable income stream. The second function is as a diversifier. Bonds dampen overall portfolio volatility when held with riskier assets such has equities. Investment-grade fixed-income assets are not only less volatile, but usually rise in price when equities fall.

Let’s consider each of our three truisms, and the specific investment strategies bond investors can deploy:

  • Accept More Risk: If an investor wants more than the risk-free rate of return offered by Treasuries, the investor must take on riskier assets. More risk means a potentially higher return, but it also means an increased possibility of lower returns. This is the textbook definition of risk.

Those who are willing to accept greater risk have these choices (in increasing order of risk):

-Buy high grade corporate bonds: Corporate bonds with the highest AAA ratings are yielding about 2.7%. There is obviously a greater risk of default versus notes offered by Uncle Sam, but not much if you stay with the highest rated corporates.

-Look into preferred equity: A hybrid asset class with characteristics of both bonds and equities, these securities sell at par to yield about 5% or better. The bad news is that in March as the pandemic hit, they fell in lockstep with stocks, plunging from 30% to 35%. And many have yet to fully recover their losses. One option for an investor might be to swap riskier, higher yielding securities and junk bonds for an exchange-traded or mutual fund focusing on preferred shares. 

-Increase equity allocation: More equity exposure, such as allowing a portfolio with a traditional 60% allocation to stocks and 40% to bonds (aka 60/40) to become a 65/35 or even a 70/30, can help make up for lower yielding bonds. This can be done via regular rebalancing or by allowing organic growth in equities to move portfolios toward the larger stock allocation. This increases your portfolio’s volatility by removing some of the dampener bonds provide.

  • Lower Return Expectations: Foundations and endowments build return expectations into their portfolio construction to meet future liabilities. Lowering fixed income yield expectations leads to these options:

-Build a bond ladder: A bond ladder is simply a fixed-income portfolio with staggered maturities. The modest assumption behind a ladder is that bond yields won’t be near zero forever. For example, let’s take $100,000 in five rungs of $20,000 each, with the following maturity dates: 2022, ‘24, ‘26, ‘28 and ‘30. When the 2022 bonds mature, you roll them into a 2032, and so on. So instead of locking in today’s lower rates with all your money, you are creating the possibility of each ladder rung rolling into higher yielding assets if rates rise in the future.

-Buy municipal bonds: Depending upon the state an investor lives in, there may be the opportunity to generate higher after-tax yield by buying tax-free state and local bonds (assuming they are not held in a tax deferred account). It pays to be selective, only buying the highest quality “munis;” otherwise, the investor is back in the “accept more risk” category.

  • Accept Low Rates as Reality: The last option is to accept the current rate regime as the new normal. This provides you with a few options:

-Consider Treasury Inflation-Protected Securities (TIPS): Real (after inflation) returns matter more than just yield. Getting 6% on your Treasuries doesn’t preserve your purchasing power if inflation is 7%. TIPS were designed to protect against faster inflation, with their principal amounts increasing as the Consumer Price Index  rises.

-Shorten your duration: The difference between 3-month Treasury bill rates and 10-year note yields is about 75 basis points, or 0.75 percentage point. That’s not a lot of extra yield relative for locking up capital for a decade (if held to maturity). An investor that does not want to use a ladder strategy can consider shortening the duration of bond holdings by moving into 3-month Treasury bills. As yields go higher, shift a portion of these back into the 10-year Treasuries.

The ideal strategy is not the one that generates the highest return, but rather, one an investor can live with. Bonds need not be problematic for portfolios – so long as you understand the risks of whatever changes you make, and avoid reaching too far for yield.

To contact the author of this story:
Barry Ritholtz at [email protected]

TAGS: Equities
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