It was a mix of good news and bad news in 2020 for fixed income investors. The good news was that most fixed income portfolios posted total returns well in excess of their starting yield at the beginning of the year as falling yields lifted bond prices. The bad news is that starting yields in 2021 are much lower and the environment for reinvestment is more challenging.
Fortunately, there are many different fixed income instruments that can be used to meet financial goals. In the current low interest rate environment, we believe it is sensible to split up the two roles of safety and income generation between different securities in portfolios. High-quality bonds and cash-equivalent securities provide safety and a potential source of funds during periods of market volatility. These lower-yielding positions can be offset by lower-rated and subordinated securities that provide higher yields in an attempt to maintain overall income and purchasing power.
Looking back on the year, 2020 marked another leg lower in what has been a 40-year trend in bond yields. Short-term government bond yields shifted downward as central banks lowered policy rates in response to the COVID-19 pandemic, while longer-term government bond yields also fell as expectations for economic growth were reduced. As the economic and financial market recovery has played out, central bank purchases of government bonds have kept longer-term government yields pinned close to the March lows. Meanwhile, corporate bond yields reversed their surge in March and moved steadily lower over the course of the year as investors gravitated to this category in search of yield enhancement.
These more docile market conditions have afforded companies an opportunity to extend debt maturities. This story can be told on a global basis by observing the decline in the Bloomberg Barclays Global Aggregate Bond Index yield over the last two years. At the end of Oct. 2018, this index yielded approximately 2.25 percent. As of the end of Oct. 2020, the index yield sits below one percent.
Income generation is more difficult
The challenge confronting income-oriented investors in 2021 is captured in the chart below, which looks at the combined income profile of a 50-50 mix of U.S. stocks and bonds. This combined yield has been weighed down over time—the primary culprit being the fixed income side as bond yields, as measured by the 10-year U.S. government bond yield, have fallen from over 10 percent to below one percent. The annual average decline in yields of around 25 basis points (bps) helped produce capital gains for bondholders on this path, but past gains don’t help generate future returns. Investor goals have largely not changed over the years either, creating an investment challenge that we believe calls for a more nuanced approach.
Declining yields have reduced income profile of balanced portfolios
Yield profile of a hypothetical portfolio of 50% U.S. stocks and 50% 10-year Treasuries
Source - Bloomberg; yield of U.S. stocks represented by the S&P 500 dividend yield; data through 11/2/20
Not one answer: Splitting the role of safety and income generation
We believe investors should be open to splitting the role of capital preservation and income generation across multiple positions when setting up fixed income portfolios in this uniquely challenging environment. Such an approach means a portfolio is populated with a mix of securities, those that can serve as a source of funds during periods of market volatility, and those that provide higher yields that deliver a source of cash flow to help returns keep pace with inflation. This approach can be utilized by all investors as it can be undertaken using individual bonds, as well as mutual funds and exchange-traded funds (ETFs), or a combination of all three.
Key for investors with a need to access funds
High-quality bonds and cash-equivalent securities can provide safety and a potential source of funds during periods of market volatility. This is of critical importance for investors with a known schedule of spending needs as it allows those needs to be met without the permanent impairment of capital that might occur if investors were forced to sell assets that may be subject to larger price swings during moments of financial volatility.
Peace of mind and flexibility
Even for investors without defined spending needs, we believe there is a significant portfolio management benefit to holding positions with a lower volatility profile that extends beyond smoothing returns. This is the ability to use these higher-quality securities as a source of funds after periods of financial market volatility, allowing an investor the flexibility to opportunistically rotate into securities that have become relatively much cheaper.
A prime example of an opportunity like this emerged in March 2020 when high-yield bonds underperformed government bonds by over 25 percent. Two years ago in the Global Insight 2019 Outlook we cautioned against reaching for yield in lower-quality bonds because valuations were such that only a modest amount of repricing could offset the incremental yield provided by these securities. The price action in February and March 2020 provided an example of what a period like this looks like. After this price adjustment occurred, there was a two-month stretch where the Bloomberg Barclays US Corporate High Yield Bond Index yielded over eight percent, providing at least 700 bps of yield pickup versus sub-one percent yields on government bonds.
Government bonds significantly outperformed high-yield corporate bonds in Q1 market stress
Source - Bloomberg; total returns shown; U.S. Treasury return measured by Bloomberg Barclays US Treasury Index, high-yield corporate bond return measured by Bloomberg Barclays US Corporate High Yield Bond Index; data through 10/30/20
A key role in meeting cash flow needs and maintaining purchasing power
The “safer” positions can be offset by higher-yielding securities in an attempt to generate an increased level of investment income to assist in maintaining purchasing power of the total investment capital. Given near-zero percent yields in most developed government bond markets, we believe mid-to-high single-digit yields from higher-risk securities—denoted by their lower credit ratings and their subordinated position in the capital structure—can be used to help returns keep pace with inflation.
The additional yield available on corporate bonds versus government bonds (i.e., the compensation for taking credit risk) remains near historical averages, even as government bond yields are at record lows. Compensation for credit risk makes up the lion’s share of the yield available on many bonds. For instance, compensation for credit risk accounted for only 25 percent of the total yield on the Bloomberg Barclays US Corporate Bond Index when it sported a yield in excess of four percent in 2018. That same index yielded two percent at the end of Oct. 2020, but nearly two-thirds of that yield comes from compensation for credit risk. This valuation method, while far from perfect, offers a lens into one of the reasons why investors have shown a strong appetite for higher-yielding corporate securities recently.
Compensation for credit risk represents large portion of total yield
Source - Bloomberg; compensation for credit risk is measured by comparing the option-adjusted credit spread to the total yield; Bloomberg Barclays US Corporate Bond Index option-adjusted credit spread and yield to worst used for calculations; data through 11/4/20
Be mindful of the “hidden cost” of higher-yielding positions
One cost of owning higher-yielding securities is price volatility. This cost can be hidden for extended periods of time, but during market selloffs higher-yielding fixed income securities are typically correlated with equities. This is something to be mindful of but can also be managed by holding higher-yielding assets in conjunction with those in the safety bucket, so that the portfolio is not overly concentrated.
One can also purchase a variety of income-producing assets that diversify risk across different product structures and sectors. In a simple example, investors looking to take credit risk to drive enhanced returns could allocate 100 percent of their fixed income holdings to investment-grade corporate bonds at a two percent yield, or get the same total yield by allocating just a quarter of their fixed income allocation to high-yield bonds and keeping the rest of their holdings in government bonds. There are a number of different ways of getting to the desired result.
Theory versus practice
While fixed income securities are categorized in a way that is designed to denote their risk—government bonds, investment-grade corporate bonds, and non-investment-grade corporate bonds—it can be a misconception to think there is a clear line of demarcation that separates each of these categories from a risk perspective. While there can be clarity at the extremes, i.e., short-term government bonds on one end and long-term bonds from a low-rated, highly-indebted corporate issuer on the other, we believe much of the key decision-making comes down to investments that sit somewhere in-between.
The continuum of risk concept can be extended at the portfolio level to include equities. Many investors prefer a more equity-focused approach on income generation, but the more heavily a portfolio is tilted to equities for income and growth, the more important it can become to have an adequate layer of safety in the fixed income holdings.
A balancing act is required
Balancing safety and liquidity with income generation is a task that requires more attention in the current environment. Investors with an excessive preference for liquidity are likely to experience lower returns in the current low interest rate world. Those on the other end of the spectrum who prioritize income over liquidity are more likely to experience a higher level of price volatility in their portfolio. To the extent that either aim is over-emphasized, resulting in insufficient income or higher-than-desired volatility, this can cause investors to fall short of their long-term goals. Striking the right balance in a portfolio is especially important in today’s environment when it is difficult to achieve the dual roles of safety and income with one investment type.