Fixed Income Outlook: Barbell Credit with Defensives for Yield and Durability

As investors head into the fourth quarter and the effects of the coronavirus delta variant linger, bond portfolios face a multitude of variables that may impact their trajectory over the coming months. These issues are set against a backdrop of the recent hawkish tilt from the Federal Reserve (Fed), which said in September that it may start tapering by November, with a potential rate hike next year.1 After the Fed’s September meeting, it was revealed that nine of the 18 Fed officials expect the central bank to begin raising rates next year2 – up from seven at June’s meeting.3

While rate hikes may be off in the future, we do expect long-term rates to rise as the Fed starts to normalize policies and pandemic-related factors such as supply chain disruptions, consumer demand and employee shortages continue fueling inflationary forces, a situation that may be heightened during the holiday shopping season.4 This is why we feel that Treasury Inflation-Protected Securities (TIPS) may be the more attractive defensive treasury position once again next quarter, as opposed to nominals.

Yet rates will still be low relative to historic standards, and on a real basis. Currently, 78 percent of all investment-grade bonds trade below the market’s expectation for inflation over the next 10 years5 (10-year breakeven rates are 2.37 percent).6 As a result, there are not a lot of positive real income opportunities in the largest part of the bond market, exacerbating the challenge of generating income in our low but rising rate environment.

With a significant amount of long-dated issuance coming to market (both corporate and Treasury), duration profiles for investment-grade bonds have become extended. For instance, the duration on the Bloomberg US Aggregate Bond Index (Agg) has increased from six years before the pandemic to 6.6.7 As a result, the yield-per-unit-of-duration profile of the broad Bloomberg US Aggregate Bond Index sits at 0.23 — a level 28 percent below that of the prior three-year average.8 Given our view for an upward bias on rates, taking on any extended duration risks to obtain a diminutive yield may not be a valuable trade-off in this market — from either an income or total return perspective.

In order to achieve higher portfolio yields, investors typically need to accept exposures with increased credit risks that often exhibit higher correlation to the equity market. Credit has benefited from some of the same forces that have propelled equity markets, including still accommodative policies and supportive growth.9

More so, the fears of China credit concerns spilling over into other areas of the global credit markets appear contained, evidenced by the fact that global high yield credit spreads registered an increase of just five basis points in the month of September – compared with the increase of 300 from the China high yield market.10 As a result, we are constructive on credit in this market to potentially produce positive real income and total return opportunities.

For the next quarter, a barbell of defensive real return treasury positions (TIPS) and high-income credit exposures may be a valuable allocation to navigate the low, and still uncertain, return environment, as the Fed starts to taper and the economy continues to reopen.

Focus on loans for real income and less rate risk
Despite taper talks and a more hawkish dot plot view, monetary policies are likely to continue to foster liquidity and the TINA (there is no alternative)-style risk taking that has been a tailwind for credit markets. Positive rating trends offer fundamental support for this outlook on credit, as the ratio of high yield upgrades-to-downgrades is at the highest level ever.11 Return momentum is also in credit’s favor, as below-investment-grade bonds have posted gains in 18 out of the past 20 months, while core global bonds are registering their worst return since 2005 given the rise in rates this year.12

Credit, however, is not immune to duration headwinds, as yield curve changes have subtracted 176 basis points from high yield’s overall 4.54 percent return in 2021.13 And within investment-grade bonds, the impact has been even worse as curve changes have pushed returns negative on the year.14 Senior loans, with their floating rate structure, have been able to sidestep duration-induced price declines while still participating in the credit rally. Yield curve changes so far this year have been negligible for loans, a fact underscored by loans outperforming the more duration-sensitive investment-grade corporate bond market (+580 basis points).15

Looking ahead, senior loans’ floating rate structure may prove to be even more valuable should rate hikes impact the short end of the curve. In addition to mitigating any potential duration-induced return headwinds, loans’ floating rate component increases the potential yield as the securities’ underlying coupons adjust to the prevailing short-term market rate they are tied to (the London Interbank Offered Rate, or LIBOR).

Beyond the potential benefit of limiting rate sensitivity, senior loans might be an effective tool for generating potential real income, as yields are above breakevens and comparable to high yield corporate bonds. Senior loans currently yield 3.71 percent,16 just below high yield corporates’ 4.04 percent, but with far less interest rate risk due to the frequent resetting of loans’ coupon payments. The chart below illustrates senior loans’ strong yield-per-unit-of-duration, underscoring their potential to generate high income while mitigating any duration-induced price impacts.

Additionally, if the credit rally does stall (even though loan defaults are expected to remain near all-time lows through the remainder of 2021 and into 202218) or if macro risks pile up, loans are more senior in their capital structure and historically have witnessed lower relative levels of volatility than fixed-rate high yield (4.67 percent vs. 6.73 percent).19 The downside deviation for loans is also better than high yield (7.53 percent vs. 11.95 percent).20

Overall, loans’ lower volatility profile relative to fixed-rate high yield, potential to generate higher income, and floating rate structure that can reduce the negative impact of higher rates, make loans an integral part of a diversified credit portfolio in this environment.

For an actively managed senior loan exposure that may add more value over an indexed approach through credit selection, consider the SPDR® Blackstone Senior Loan ETF (SRLN).

Preferreds may offer real yield and diversification
With the economic backdrop likely to remain conducive for risk-taking, an overweight to hybrid exposures such as preferred stocks may be warranted for those in search of a real yield that may also provide additional diversification beyond pure credit.

For starters, preferreds currently generate yields higher than inflation expectations (4.64 percent vs. 2.37 percent)21 and are more favorable than high yield bonds, even though they are primarily investment-grade rated.22 As shown below, preferreds out-yield all other traditional and income-sensitive segments. As a result, given the low rates around the world, a potential 4 percent-plus yield for a group of primarily investment-grade-rated securities, and not just junkier credits, is worth considering.

Preferreds may also help to enhance overall portfolio diversification. Due to regulatory and rating agency capital requirements, preferred securities tend to be issued primarily by financial institutions, such as banks and insurance companies. Thus, relative to their credit counterparts, preferreds are heavily allocated toward Financials (73.30 percent),23 which strengthens their credit quality profile. The banking sector is one area that may benefit should rates rise, as bank margins benefit if the long end of the yield curve rises. Outside of financials, preferreds also provide exposure to a variety of other sectors including Utilities (14.04 percent),24 Real Estate (6.88 percent)25 and Communications (4.53 percent).26 Because this differs from their credit counterparts that provide more exposure to the volatile Energy sector,27 adding preferreds to the mix can help to diversify credit sector exposures.

Cross-asset correlation impacts should be on investors’ portfolio construction checklist, especially as we enter the fourth quarter that historically has been a volatile time for markets.28 Preferreds are both bond- and stock-like, and as a result their correlation profile is low relative to both asset classes. Their correlation to basic US Treasuries is very low at 0.04 over the past 15 years (based on monthly returns).29 They also have a 0.42 correlation or less to equity-sensitive high yield bonds and to equities themselves — from all parts of the world.30 Preferreds’ volatility profile (5.78 percent)31 is also lower than that of common stocks (13.21 percent)32 and credit-sensitive high yield bonds (6.73 percent).33

Overall, in a market with low rates and abundant macro risks, preferred security exposures, like the SPDR® ICE Preferred Securities ETF (PSK), could possibly add high income to a bond allocation without outsized volatility and equity risk.

Include TIPS for a defensive ballast in portfolios
Barbelling credit with TIPS could add another real income stream, this time from the defensive side of the bond portfolio. Because TIPS are backed by the full faith and credit of the US government, they have low credit risk and investors can be assured that they will never receive less than the original face value of the bond at maturity, even in the event of deflation during the life of the bond. Adding TIPs to a portfolio also could help counteract some of the equity risk introduced by overweights to credit.

US inflation expectations, as measured by the 10-year breakeven inflation rate, are above the 10-year average. Similarly, personal consumption expenditures, which the Fed uses as its inflation gauge, saw the largest annual increase since 1991.34 US personal spending recently increased 0.8 percent from a month earlier, following a downwardly revised 0.1 percent decline in July.35 Price increases are being felt across many advanced economies because of pandemic-related factors such as supply chain disruption, consumer demand and employee shortages. As a result, so far this year owning TIPS instead of nominals has been a beneficial swap, as TIPS have outperformed nominals by 5.98 percent.36 TIPS have also outperformed the Agg by 4.94 percent,37 even though they have a longer duration (8.4 years versus 6.97).38 Given that inflationary forces will likely remain high (still-accommodative policies even with a taper, plus increased fiscal spending), a TIPS allocation may continue to be rewarded.

As a distinct asset class from Treasuries — and not a component of the widely followed Bloomberg US Aggregate Bond Index — TIPS tend to behave differently from other investments that are commonly found in core bond portfolios. TIPS are not perfectly correlated to common fixed income investments and have a low correlation to equities, making them a valuable portfolio diversifier. Thus, including TIPS may help improve the risk/return profile of a diversified portfolio irrespective of the market’s inflation dynamics.

Investors may want to consider the SPDR® Portfolio TIPS ETF (SPIP) to add a source of real income and diversification for defensive positioning. Because TIPS ETFs pay out all earned income in the portfolio, including the inflation adjustment that is applied to the fund's underlying securities (unlike individual TIPS), a TIPS ETF may be a better source of current real income than owning TIPS outright.