Yields offered by traditional income vehicles for U.S. investors have fallen to historic lows—both on an absolute basis and relative to inflation. The initial income potential of a balanced portfolio combining bond and equity funds isn’t much better. To compound the problem, a large portion of the U.S. investor base is aging and entering retirement, creating a greater need for cash flows from their portfolios. These factors are prompting many fixed-income investors to reassess the constraints they have traditionally placed on their bond positions and the role they play within their portfolio.
To achieve more desirable income levels, investors have focused on adding more “opportunistic fixed income,” such as high-yield debt and securitized loans, into their portfolios. These fixed-income sectors currently offer stronger income and return potential than U.S. Treasurys; however, both alternatives present risk factors that extend beyond simple changes in the current yield environment.
In this environment, yields on many traditional income vehicles have fallen to levels not seen since the 1950s.1 At current rates, most traditional fixed-income markets do not exceed the corrosive effects of inflation. Today securing yields in excess of inflation often involves expanding traditional investment and risk parameters. For example, the yield on the Barclays U.S. Aggregate Index, a commonly followed barometer of the universe of investment-grade fixed income in the United States, currently sits at 1.74 percent,2 near its lowest point since the index’s inception in 1976 (Figure 1).
The scarcity of income opportunities in government and prime corporate debt extends beyond our shores to the bond markets of most other developed countries. In fact, 80 percent of the market value of the world’s investable bond markets is in securities that yield less than 2.5 percent.3 Among issuers outside the United States, the overwhelming majority of these securities are issued by European and Japanese governments, agencies and corporations.4 As these countries continue to issue debt at historically low interest rates, the effects of low yields in market-capitalization-weighted indexes continue to bias the overall yield lower; these indexes continue to increase weight to developed-market issuers with the most debt outstanding.
In this environment, lower income streams from both core fixed-income and balanced portfolios suggest a greater dependence on principal return for both growth and cash flow generation. Inevitably, investors must consider their new options: to lower their return and income expectations; incur greater principal risk; or seek to augment a portfolio’s income potential by reassessing their approach to fixed income.
For most, the strategy that provides the best chance of achieving one’s goals involves a combination of all three adjustments. Expectations for absolute returns remain stubbornly high for many investors and will probably continue to remain anchored to returns in more traditional interest rate environments. With initial yield levels on many U.S. bonds and stocks failing to exceed current core inflation trends, investors face greater exposure to the risk of principal losses given the need to sell securities to supplement cash flow.
Increasingly, investors have begun to think about how to generate income from their fixed-income allocations by reassessing the fixed-income opportunity set.
The “high yield” U.S. fixed-income sector has traditionally been a popular means of enhancing portfolio yield. As investors point to record-low default rates and continue to assume ever greater credit risks, the yields and credit spreads on high-yield investments have declined greatly. Many market pundits now question if the yields offered by the high-yield segment are adequate enough to compensate for the additional credit risk they entail.
A comparison of the major fixed-income sectors relative to core inflation before the 2008 crisis and at the end of June 2012 illustrates the gap between traditional and opportunistic fixed income.
Real yields (after subtracting trailing core inflation) were comfortably above 1 percent for all core fixed-income sectors at the end of 2007. U.S. investment-grade corporate bonds offered yields of nearly 3 percent in excess of inflation. Four and a half years later, that’s no longer the case. As of June 30, 2012:
- Investment-grade credits offered only 1 percent in yield over inflation.
- Only high-yield debt and emerging market (EM) debt offered above 3 percent in yield relative to U.S. inflation.
What is striking about these options is that the part of the world that is offering compelling yield today is typically doing so with shorter durations (Figure 2). Meaning, investors can take on lower interest rate risk to secure higher interest rates—assuming they are comfortable taking on, in some cases, currency risk, credit risk and/or the liquidity risk of investing in rapidly emerging new asset classes.