Extraordinary monetary policy, uncertain economic growth, demographic shifts, and fiscal imbalances have kept interest rates near all-time lows. However, today’s fixed income landscape is more challenging than just a low-yield environment; it’s not hyperbole to say that investors are facing some of the least attractive rates in modern times.
Generating attractive income is no longer just a matter of moving further out along the yield curve or down the credit quality spectrum.
Recent volatility triggered by concerns of a Federal Reserve policy error has made it difficult to not only find yield, but also to achieve price returns and portfolio diversification. In the current environment, investors should consider incorporating other segments (and other risks) of the fixed income universe in pursuit of higher returns.
Rethinking high yield bonds for stability and diversification
Despite these challenging valuations, bond allocation can still provide stability during times of market and economic stress as we saw at the beginning of the Covid-19 crisis. At the same time, interest rates can move up suddenly and that risk needs to be managed.
The most direct way to do this is to reduce duration, as an allocation to shorter maturity fixed income can help minimize drawdowns if rates swing unexpectedly.
Despite tighter spreads, high yield bonds tend to have lower interest rate risk as well, due to their shorter maturities. While the duration of investment grade corporate bonds averages 8.5 years, high yield bonds have less than half that sensitivity to rate moves, as they average only 3.8 years of duration.
Although utilising high yield bonds for “stability and diversification” may be counterintuitive by historical standards, in today’s market – when many super short duration assets are in negative yield territory – this new thinking is one way that investors can position a portfolio that accounts for more of the risks facing fixed income.
Municipal bonds to manage macroeconomic and policy risks
Fixed income investors also need to manage broader macroeconomic and policy risks. Political debate continues over fiscal imbalances, and future tax-rate changes may be imminent to pay for trillions of dollars of short-term emergency spending. In the United States, the Biden administration has already outlined plans for some higher individual and corporate tax rates.
As a result, investors should begin preparing for higher federal taxes now. Tax-exempt securities like municipal bonds can help mitigate these tax policy risks. Not only do munis offer the potential to generate tax free income, but the overall sector has also maintained its value as government finances have stabilised.
Take advantage of global market inefficiencies to find attractive opportunities in emerging market debt
To ensure portfolios reach the broadest set of bond market opportunities, investors may need to look beyond the US too. Both local-currency and dollar-denominated emerging market debt have performed well during different market environments over the past decade and can also provide attractive risk-adjusted yield premium opportunities. Weakening of the US dollar may well provide a tailwind for local currency emerging market debt by supporting emerging market currencies and preventing outflows. Moreover, many emerging market regions also stand to benefit from both the global growth recovery and higher commodity prices.
In other words, investors who can take advantage of global market inefficiencies will be able to find attractive opportunities outside US bond markets.
Gaining yield and total return through private debt and preferred securities
Investors seeking to generate yield and total return may need to explore areas of the bond market they are less familiar with. Through direct, non-bank lending that targets different parts of the capital structure, investors can gain fixed income exposure that is often less correlated with public bonds, while also less sensitive to public market price volatility.
Another option is preferred securities, which often have equity-like attributes that can improve yields and reduce a portfolio’s correlation to the US and global bond markets. While preferred spreads have tightened from historic standards, they still represent a significant value relative to treasuries and corporates. The current environment should be supportive of preferred securities spreads. Banks and financials, which issue two-thirds of all preferred securities, should continue to be supported by fiscal stimulus.
For bond investors today, an expanded strategy will be needed to achieve greater diversification, generate income, preserve capital, and protect against inflation. By investing in bonds across the full risk spectrum, investors may be better positioned to balance their investment objectives in today’s market.
Seema Shah is chief global strategist at Principal Global Investors. The views expressed above are his own and should not be taken as investment advice.