Balance Risk in the Pursuit of Income

The COVID-19 pandemic has distorted human interactions, corporate culture, and overall societal norms. It has also upended fixed income portfolios with generation-defining ramifications.

The policy responses and the general risk-off behavior in a heightened macro risk regime have pushed interest rates to historic lows. Yes, after the Global Financial Crisis (GFC), central bank rates went to zero — or near zero. But, for the decade after the GFC, US 10- and 30-year rates averaged around 2.3% and 3.2%, respectively.1 Today, they are trading around 0.90% and 1.65%, respectively, with the yield on the broader Bloomberg Barclays US Aggregate Bond Index (Agg) hovering around 1.23%.2

The challenge in structuring today’s fixed income portfolios is how to diversify the sources of risk in and outside of the core in order to pursue income needs and ensure portfolio diversification.

The lower the yield, the higher the probability of lower future returns

For bonds, there is a strong relationship between the yield at the time of purchase and the subsequent returns. This makes sense, given that the mathematics behind a bond’s yield equate to the expected cash flows from the coupon as well as any price movement related to trading at a premium (negative return expectation as the bond moves closer to maturity at par) or a discount (positive return expectation as the bond moves closer to maturity at par).

Extending the time horizon only magnifies this relationship. For instance, on a three-year subsequent return basis, the straight-line correlation to the yield at the time of purchase for the Agg is 93%, with the five- and 10-year figures at 98%.As shown below, the trend between yield and future returns has persisted over time. As yields move lower, so do the subsequent future returns. However, when viewing the correlation between yield and rolling returns on a similar rolling basis, there can be brief periods of decoupling — even if the long-term average is over 90%.

The sizable reduction in interest rates today has led to notable duration-induced price appreciation — core Agg bonds are up 7% so far in 20204 — with this historical relationship decoupling. Yet, this price appreciation will likely dampen potential future returns as the correlation may mean revert — as it has done historically after prior rolling correlation decouplings during other severe risk events (dot-com bust and GFC). In fact, the relationship has already started to mean revert.

With the current yield environment at a near-record low for core bond sectors (1.23%),5 and based on the relationship above, investors could expect a similarly low annualized return from core bonds over the next three to five years (i.e., around 1%). Yet, the low return is not being met by lower risk. The duration of an Agg exposure is six years,6 a problematic profile if rates do eventually rise. A modest rise of 50 basis points to the Agg’s yield would still result in a theoretical 1.27% capital loss, as the yield today is far too low to offset any impact duration has on price.7

Today’s low and asymmetrical income and risk/return profile is an issue for an exposure that often comprises a large part of an investor’s portfolio.

Overweighting mortgage-backed securities in the core

While we expect today’s generationally low rates to remain low for some time, the US Treasury curve may bear-steepen (long-term rates rise faster than short-term rates do) over the coming months, driven by three variables:

  1. The Federal Reserve keeping its policy rates low,8 anchoring short-term rates to the zero bound 
  2. The US Treasury continuing to borrow to fund stimulus programs, putting upward pressure on long-term rates 
  3. Positive vaccine news spurring longer-term growth expectations, lifting term premiums that have already climbed 36 basis points over the past three months9 even higher.

A higher US 10-year yield may improve income prospects, but it doesn’t overcome the asymmetrical risk/return profile of Treasuries and, therefore, the Treasury-heavy Agg. As a result, investors should consider overweighting mortgage-backed securities (MBS) in the core, as the sector has provided higher income than Treasuries (1.34% versus 0.61%) while offering more balance from a risk perspective (4.5 years less in duration, and lower historical volatility of 2.43% versus 4.87%).10 Additionally, MBS have had a higher yield, lower duration, and less historical volatility (1.34%, 2.5 years, and 2.43%, respectively)11 than the broader Agg itself (1.19%, 6.22 years, and 3.71%, respectively). And MBS’ historical negative correlation to equities (-22%) may allow them to be a potential diversification tool as well.12

MBS also have potential advantages over another core sector — investment-grade corporates. MBS now yield 61 basis points less than investment-grade credit, but with lower duration (2.5 versus 8.77 years), reduced spread risk (54 versus 114 basis points), and less historical volatility (2.43% versus 4.56%).13 Optimizing the broad corporate bond index to obtain a duration similar to MBS’ 2.5 years would equate to a yield on corporates of just 0.77%14 — indicating that MBS offer a higher yield on a duration-adjusted basis. This structurally unique yield per unit of risk exposure may results in a higher yield in the core without adding risk (in fact, volatility is reduced, as discussed above), allowing income-seeking investors to take risk elsewhere.

Adding ancillary bond segments

In this abnormal yield-starved environment, generating income on par with historical figures requires investors to outlay more risk through duration (long-term Treasuries), credit (high-yield bonds) or equity-related exposures (high-yield dividend/preferred stocks), for example. Adding duration is likely unattractive, as extending out to long-term core bonds results in an only 1.5 percentage point increase in yield, but it is accompanied by a 10-year extension of duration.15 With little uplift in yield — but a big increase in rate risk — that risk/return trade-off is vastly asymmetrical.

As a result, adding ancillary bond segments to the core may help to provide both income and diversification. Each of the three segments below carries a yield north of 3.5%, but with a different source of risk.

  • High yield bonds or senior loans: Both sectors may offer yields close to 5%. However, in this market — where spreads are tight (20% below 20-year average),16 defaults are elevated, and idiosyncratic risk is high — the profile and structure of senior loans represent a more ideal credit allocation. By bringing in duration and sitting higher in the capital structure, senior loans may be able to help navigate today’s credit dynamics better than a traditional high yield allocation would, as senior loans have historically experienced lower default rates (4.3% vs. 5.8%) and higher recovery rates (46.7% vs. 15.3%).17 And with a beta/correlation of only 0.23/0.63 to equities (versus 0.37/0.80 for high yield),18 senior loans may provide similar income, but without adding as much implicit equity risk.
  • Emerging market local debt: Emerging market local debt (EMD) currently yields 3.56%19 — two full percentage points above traditional core US aggregate bonds. Yet, the uptick in yield is not from additional below-investment-grade risk, as 85% of issuers are rated investment grade.20 And it is not from elevated rate risk, as EMD has a historical 9% correlation to the rate-sensitive Agg.21 Instead, currency trends play a significant role in the risk and return profile of EMD, as the correlation between EM local sovereign debt monthly returns and EM local currency monthly returns is 92%, with the R-squared of the regression at 85% — indicating a strong fit and relationship.22 As a result, the high levels of income are a function of associated currency/political risk. From a total return perspective, the currency risk may be rewarded over the coming months if the US dollar (USD) continues to weaken (USD is down 8% over the past six months),23 given the US’ waning yield advantages over other currencies and a ballooning public deficit that is likely to increase if a second stimulus bill is passed.
  • Preferred stock: At 4.62%, the yield on preferreds is comparable to that on high yield bonds. However, unlike high yield, preferreds are mainly (80%) investment grade.24 Additionally, with relatively low historical correlations to traditional stocks and bonds — 0.58 and 0.41, respectively — and a beta of 0.30 to stocks,25 preferreds may help diversify portfolio income generation. Overall, preferreds may offer an income stream similar to that of high-yield exposures, but with potentially lower credit risk and equity sensitivity because they typically hold mostly investment-grade-rated securities from the highly regulated banking and insurance sectors.26

As shown below, framing the income conversation as income per unit of volatility illustrates the potential benefit of these non-core bond sectors — as well as exposure to MBS in the core. With elevated ratios, they all may provide income in our low-rate environment without completely forcing a portfolio to pursue income from just one specific “risk bucket.” In addition, these market segments may still offer the necessary diversification when added to the broader portfolio, as correlations to traditional stocks and bonds are constructive.

Implementation Ideas

These funds may help investors seeking to balance risk in the pursuit of income.

In the core, target mortgages to reduce volatility but seek higher income, and consider:

Outside of the core, consider diversifying credit risk with senior loans; currency risk with emerging market debt; and a hybrid of credit and equity risk with preferreds, and consider: