Fueled by expectations for higher growth and inflation, consensus economic estimates are for the US 10-year yield to surpass 1.8% by the end of the year and reach 2% by Q2 2022.1 And if growth does accelerate amid the reopening, policymakers will likely begin tapering bond purchases, possibly sending yields higher.2
Yet, while rates may be rising, they remain low for core bonds from a historical perspective, meaning that generating income is a challenge. And if rates do rise to meet the consensus forecasts, the duration induced price declines could present total return headwinds as well.
In this environment, targeting more growth-oriented bond sectors that are less impacted by rising rates may help you navigate a bond market distorted by the pandemic as well as impacted by the reopening’s reflation regime shift.
Since the 1980s, traditional core aggregate bond returns have declined over subsequent decades. In the 1980s, the Bloomberg Barclays US Aggregate Bond Index (Agg) returned a cumulative 223%. The Agg’s return then fell to 110% in the 1990s, 85% in the 2000s, and 44% in the 2010s. Seventeen months into the 2020s, the Agg is up just 4.25%.3
The Agg’s current 1.58% yield — in the bottom third percentile historically — suggests more downside than upside, given that growth and inflation dynamics are putting upward pressure on rates. Even if rates rise only to 2% a year from now, the return on the Agg, forecasted based on a risk model, would be -1.51% due to its extended duration profile.4 If rates retest pre-COVID levels (2.34%), the loss could extend to -3.34%.5
The Agg’s 6.5-year duration stems from its 40% allocation to US Treasuries, a sector that will likely be a drag on current returns for core bonds due to its highly asymmetrical yield and duration profile. Yet, core bonds cannot be abandoned completely since owning a credit only portfolio curtails some of the potential diversification of bonds. Therefore, investors may want to consider removing Treasuries and owning mortgage-backed securities (MBS) as a defensive core option to decrease rate risk while preserving a low correlation to equities.
Year to date, MBS are outperforming the Agg and Treasuries, by 2.97% and 2.06%, respectively.6 This outperformance during a rising rate period is not confined to 2021. Over the past 30 years, when the US 10-year yield has increased month over month, the average monthly return on MBS has been -0.40% versus -0.60% for US Treasuries7 — underscoring the sector’s lower sensitivity to rate movements. In fact, the return on MBS is also greater than investment-grade (IG) credit (-0.54%) — the other major bond segment in the Agg.8
From a portfolio construction perspective, MBS yield more than US Treasuries (1.79% versus 0.99%),9 have a lower standard deviation of returns (2.09% versus 4.05%),10 and more importantly, a lower duration (4.2 versus 6.9 years).11 As shown below, this current optimal profile of a stronger yield per unit of duration has been persistent. And with a negative correlation to stocks (-23%),12 MBS still preserve some of core bonds’ diversification benefits.
Yield per Unit of Duration: Mortgage-Backed Securities versus Treasuries versus the Agg versus Investment-Grade Corporates
While MBS may increase yield in the core, the level of income produced is still low overall. And while looking outside the Agg for income generation naturally leads to credit exposures, the credit markets are, to a degree, priced to perfection and represent an asymmetrical return profile as well.
Yields for IG credit, broad high yield, or different rating bands are all historically in the bottom decile. And in some cases, the yields are the lowest on record. These spreads, yields, and the average bond price in the broader categories paint a picture of tight credit markets:
While tight, the environment for credit remains constructive given accommodative monetary policies, improving corporate profits, and rebounding economic data. Yet, as within the core, managing duration risk alongside credit sensitivities is important. And IG credit has posted a -4.14% return in 2021,15 even as credit spreads have declined, with yield curve changes accounting for more than 100% of that decline (-5.5%).16
High yield credit is also not immune to duration headwinds, as yield curve changes have subtracted 145 percentage points from the overall 1.92% return in 2021.17 One high income sector — senior loans — has been able to sidestep duration-induced price declines as a result of its floating rate structure, while still participating in the credit rally. So far this year, senior loans are up 2.4%.18
Because the base rate of the floating rate component is usually one to three-month LIBOR, the duration for senior loans is usually between 30 to 90 days. Thus, concerns about inflation and the potential for interest rates to rise further (as the consensus has forecasted) may mean the loan category — as a result of its lower duration — may hold its value more than other credit instruments. And, if the Federal Reserve raises rates to temper any inflationary headwinds — and short-term interest rates (LIBOR) increase — then the loan coupon also increases.
Due to these structural traits, senior loans have outperformed the broader Agg for 12 out of the last 13 consecutive months during this reflation rally.19 High yield bonds have had a similar performance trend versus the Agg. However, while the average price of high yield bonds has climbed, the average price on senior loans remains well below par ($97.79)20 — indicating further potential upside price appreciation from a continuation in this credit rally for loans relative to high yield.
This shorter duration does not detract from the relative income potential. Senior loans have a similar yield to fixed rate high yield deb (3.73% vs 4.15%).21 And if the credit rally stalls, loans are more senior in their capital structure, historically witnessing lower relative levels of volatility (5.6% vs 7.4%).22 Loans’ high income, low duration, low relative volatility profile compared to other segments is shown below.
Bond Sector Yields and Risk Profiles
To target income opportunities, close to 4% in the satellite sleeves, preferred securities, and high yield municipal bonds are two more non-traditional sectors for you to explore.
High yield municipal bonds (HYM) have already been less impacted by the rise in rates so far this year — outperforming traditional IG corporates by 7.63% and high yield corporates by 1.58%.23 A government generally issues high yield bonds to pay for projects with undefined or uncertain revenue. These revenue bonds tend to offer higher yields as compensation for the risk and uncertainty associated with the project’s revenue stream. And because municipal bonds’ income is generally exempt from federal income taxes, the after-tax yield is also advantageous.
The current yield-to-worst on HYM is 2.82%24 while high yield corporates yield 4.15% pre-tax, but 2.62% post-tax.25 And income from high yield municipals is generated with lower volatility than both high yield corporates and large-cap dividend equities (8.38% versus 9.02% versus 17.90%).26 High yield municipals are also less correlated to equities than corporate investment-grade and high yield bonds (16% versus 34% and 77%, respectively),27 leading to a potential source of higher income generation without any additional equity risk. With less correlation to traditional core Agg bonds than US IG corporates (53% versus 82%),28 high yield municipals also offer an attractive risk/reward payoff in the current reflationary environment.
Political tailwinds also support high yield municipal bonds. The $362 billion dedicated to shoring up state and local balance sheets from the $1.9 trillion American Rescue Plan Act of 2021 may alleviate any concerns of increased default risk among high yield municipal bond issuers since the bill permits governments to use federal dollars to replace revenue lost due to the pandemic.29 Not to mention, the risk of default may continue to decrease as the broader economy reopens and economic growth improves.
If you are seeking higher income, you may also want to consider preferred securities. The current yield-to-maturity on preferreds — primarily investment-grade rated issuers is 4.66%, which is 308 and 243 percentage points higher than the broader Agg and IG Credit, respectively.31 Moreover, with duration sitting at 5.45 years, preferreds offer a strong yield per unit of duration (0.84 versus 0.23 and 0.26, respectively).32
Income may be generated without taking on excess volatility or sizable equity risk as well, thereby preserving some of the diversification benefits. As a hybrid, preferreds have balanced equity and bond correlations (56% and 43%, respectively), with significantly lower correlation to equities than high yield (77%).33 Preferreds’ lower volatility than both high yield and equities (6.9% versus 7.7% and 14.9%)34 can lead to more attractive yield per unit of volatility measures as well.
Beyond these structural benefits, there are some potential tailwinds as a result of the underlying composition of the exposure. Roughly 70% of the preferreds market is made up of issuers from the Financials sector.34 The Financials sector, as discussed in one of our other themes, is a favored market. The industry is expected to post earnings growth of 43% in 2021, almost double the estimate of 25% at the start of the year.35
With potential for long-term rates to move higher, you may need to manage duration risks and avoid loading up on plain vanilla credit given the tight markets.
Consider mortgages to better balance yield and duration in the core:
Consider actively managed senior loans as a high income/low duration credit strategy:
Consider the high income potential from non-traditional bond sectors that offer attractive yield per unit of volatility metrics without elevated equity risk:
1 Bloomberg Finance, L.P., as of May 13, 2021 based on consensus economists’ forecasts.
2 “Fed to Announce Bond Taper in Fourth Quarter, Economists Say”, Bloomberg April 25, 2021.
3 Bloomberg Finance, L.P., as of May 13, 2021.
4 Based on shocking the US 10 year by 40 basis point within the Bloomberg Fixed Income Risk Model for the Bloomberg Barclays US Aggregate Bond Index.
5 Based on shocking the US 10 year by 90 basis point within the Bloomberg Fixed Income Risk Model for the Bloomberg Barclays US Aggregate Bond Index.
6 Bloomberg Finance, L.P., as of May 13, 2021 based on the Bloomberg Barclays US Aggregate Bond Index, Bloomberg Barclays US MBS Index and the Bloomberg Barclays US Treasury Index.
7 Bloomberg Finance, L.P., as of May 13, 2021 based on the monthly returns of the Bloomberg Barclays US MBS Index and the Bloomberg Barclays US Treasury Index from 1980 to 2021.
8 Bloomberg Finance, L.P., as of May 13, 2021 based on the monthly returns of the Bloomberg Barclays US MBS Index and the Bloomberg Barclays US Treasury Index from 1980 to 2021.
9 Bloomberg Finance, L.P., as of May 13, 2021 based on the Bloomberg Barclays US MBS Index and the Bloomberg Barclays US Treasury Index.
10 FactSet, as of April 30, 2021 based on the trailing five years of monthly returns for the Bloomberg Barclays US MBS Index and the Bloomberg Barclays US Treasury Index.
11 Bloomberg Finance, L.P., as of May 13, 2021 based on the Bloomberg Barclays US MBS Index and the Bloomberg Barclays US Treasury Index.
12 Bloomberg Finance, L.P., as of May 13, 2021 based on the monthly returns of the Bloomberg Barclays US MBS Index and the S&P 500 from 05/2016 to 05/2021.
13 Bloomberg Finance, L.P., as of May 13, 2021 based on the Bloomberg Barclays US Corporate Bond Index data from 1990 to 2021.
14 Bloomberg Finance, L.P., as of May 13, 2021 based on the Bloomberg Barclays US Corporate Bond Index data from 1990 to 2021.
15 Bloomberg Finance, L.P., as of May 13, 2021 based on the Bloomberg Barclays US Corporate Bond Index.
16 Bloomberg Finance, L.P., as of May 13, 2021 based on the Bloomberg Barclays US Corporate Bond Index returns 12/31/19 to 05/13/21.
17 Bloomberg Finance, L.P., as of May 13, 2021 based on the Bloomberg Barclays US Corporate High Yield Bond Index returns 12/31/19 to 05/13/21.
18 Bloomberg Finance, L.P., as of May 13, 2021 based on the S&P Leveraged Loan Index total returns 12/31/19 to 05/13/21.
19 Bloomberg Finance, L.P., as of May 13, 2021 based on the S&P Leveraged Loan Index and Bloomberg Barclays US Corporate High Yield Bond Index total returns.
20 Source: S&P/LSTA Leveraged Loan Index.
21 Bloomberg Finance, L.P., S&P Global, as of May 13, 2021. Based on the Yield-to-Worst of the S&P/LSTA Leveraged 100 Loan Index and Bloomberg Barclays US Corporate High Yield Bond Index.
22 Factset, as of April 30, 2021. Based on annualized standard deviation over the trailing 60-month period. Senior Loans = S&P/LSTA Leveraged 100 Loan Index and High Yield = Bloomberg Barclays US Corporate High Yield Bond Index.
23 FactSet, as of May 13, 2021. High Yield Municipal Bonds = Bloomberg Barclays Municipal Bond High Yield Index. IG Corporates = Bloomberg Barclays US Corporate Investment Grade Index. High Yield = Bloomberg Barclays High Yield Corporate Bond Index.
24 Bloomberg Finance, L.P., as of May 13, 2021. High Yield Municipal Bonds = Bloomberg Barclays Municipal Bond High Yield Index.
25 Bloomberg Finance, L.P., as of May 13, 2021. High Yield Municipal Bonds = Bloomberg Barclays Municipal Bond High Yield Index. After-tax yield is based on the yield-to-worst and applying the highest marginal federal income tax rate of 37%.
26 FactSet, as of April 30, 2021. Based on trailing 36M standard deviation of returns. High Yield Municipal Bonds = Bloomberg Barclays Municipal Bond High Yield Index. High Yield = Bloomberg Barclays US Corporate Bond Index. Large Cap Dividend Equities = S&P High Yield Dividend Aristocrats Index.
27 FactSet, 04/30/2011 – 04/30/2021. High Yield Municipal Bonds = Bloomberg Barclays Municipal Bond High Yield Index. IG Corporates = Bloomberg Barclays US Corporate Investment Grade Index. High Yield = Bloomberg Barclays US Corporate Bond Index. Equities = S&P 500 Index.
28 FactSet, 04/30/2011 – 04/30/2021. High Yield Municipal Bonds = Bloomberg Barclays Municipal Bond High Yield Index. IG Corporates = Bloomberg Barclays US Corporate Investment Grade Index. Agg Bonds = Bloomberg Barclays US Aggregate Bond Index.
29 American Rescue Plan Act of 2021, March 11, 2021.
30 Bloomberg Finance, L.P. Based on the yields for the ICE BofA Hybrid Preferred Securities Index and the Bloomberg Barclays US Corporate Bond Index and the Bloomberg Barclays US Aggregate Bond Index.
31 Bloomberg Finance, L.P. Based on the yield and duration profile for the ICE Exchange-Listed Fixed & Adjustable Rate Preferred securities Index and the Bloomberg Barclays US Corporate Bond Index and the Bloomberg Barclays US Aggregate Bond Index.
32 Bloomberg Finance, L.P., as of April 30, 2021 for the monthly returns from 4/2016 – 4/2021 for the Bloomberg Barclays US Corporate High Yield Bond Index and the ICE BofA Hybrid Preferred Securities Index relative to the S&P 500 and Bloomberg Barclays US Aggregate Bond Index.
33 Bloomberg Finance, L.P., as of April 30, 2021 for the standard deviation of monthly returns from 4/2016 –4/2021 for the Bloomberg Barclays US Corporate High Yield Bond Index and the ICE BofA Hybrid Preferred Securities Index relative to the S&P 500 Index.
34 Bloomberg Finance, L.P., as of May 13, 2021 based on the holdings of the ICE Exchange-Listed Fixed & Adjustable Rate Preferred securities Index.
35 FactSet, as of May 13, 2021 based on the Financial sector within the S&P 500 Index.
Bloomberg Barclays US Aggregate Bond Index
A benchmark that provides a measure of the performance of the U.S. dollar-denominated investment-grade bond market. The “Agg” includes investment-grade government bonds, investment-grade corporate bonds, mortgage pass-through securities, commercial mortgage-backed securities and asset-backed securities that are publicly for sale in the US.
Bloomberg Barclays US Corporate Bond Index
A fixed-income benchmark that measures the investment-grade, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by US and non-US industrial, utility and financial issuers.
Bloomberg Barclays US Corporate High Yield Index
A fixed-income benchmark of US dollar-denominated, high yield and fixed-rate corporate bonds. Securities are classified as high yield if the middle rating of Moody's, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded.
Bloomberg Barclays US MBS Index
A benchmark designed to measure the performance of the US agency mortgage pass-through segment of the U.S. investment-grade bond market. The term “U.S. agency mortgage pass-through security” refers to a category of pass-through securities backed by pools of mortgages and issued by US. government-sponsored agencies.
Bloomberg Barclays US Treasury Bond Index
A benchmark of US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index.
A fixed-income security, such as a corporate or municipal bond, that has a relatively low risk of default. Bond-rating firms, such as Standard & Poor’s, use different lettered descriptions to identify a bond’s credit quality. In S&P’s system, investment-grade credits include those with “AAA” or “AA” ratings (high credit quality), as well as “A” and “BBB” (medium credit quality). Anything below this “BBB” rating is considered non-investment grade.
Pooled securities that are backed by mortgage loans. Agency mortgage-backed securities refer to securities backed by pools of mortgages issued by US government-sponsored enterprises such as Government National Mortgage Association (GNMA), Federal National Mortgage Association (FNMA) and Federal Home Loan Mortgage Corporation (FHLMC).
S&P/LSTA U.S. Leveraged Loan 100 Index
A benchmark that is designed to reflect the largest loan facilities in the leveraged loan market. It mirrors the market-weighted performance of the largest institutional leveraged loans based upon market weightings, spreads, and interest payments. The index consists of 100 loan facilities drawn from a larger benchmark, the S&P/LSTA (Loan Syndications and Trading Association) Leveraged Loan Index (LLI).
Floating-rate debt issued by corporations and backed by collateral, such as real estate or other assets.
A statistical measure of volatility that quantifies the historical dispersion of a security, fund or index around an average. Investors use standard deviation to measure expected risk or volatility, and a higher standard deviation means the security has tended to show higher volatility or price swings in the past. As an example, for a normally distributed return series, about two-thirds of the time returns will be within 1 standard deviation of the average return.
The debt obligations of a national government. Also known as “government securities,” Treasuries are backed by the credit and taxing power of a country, and are thus regarded as having relatively little or no risk of default.
A graph or line that plots the interest rates or yields of bonds with similar credit quality but different durations, typically from shortest to longest duration. When the yield curve is said to be “flat,” it means the difference in yields between bonds with shorter and longer durations is relatively narrow. When the yield curve is said to be “steep,” it means the difference in yields between bonds with shorter and longer durations is relatively wide.
The views expressed in this material are the views of Michael Arone, Matthew Bartolini and Anqi Dong through the period ended May 17, 2021 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Investing in high yield fixed income securities, otherwise known as "junk bonds", is considered speculative and involves greater risk of loss of principal and interest than investing in investment grade fixed income securities. These Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
Investments in mortgage securities are subject to prepayment risk, which can limit the potential for gain during a declining interest rate environment and increase the potential for loss in a rising interest rate environment. The mortgage industry can also be significantly affected by regulatory changes, interest rate movements, home mortgage demand, refinancing activity, and residential delinquency trends.
Investments in senior loans are subject to credit risk and general investment risk. Credit risk refers to the possibility that the borrower of a Senior Loan will be unable and/or unwilling to make timely interest payments and/or repay the principal on its obligation. Default in the payment of interest or principal on a Senior Loan will result in a reduction in the value of the Senior Loan and consequently a reduction in the value of the Portfolio’s investments and a potential decrease in the net asset value (“NAV”) of the Portfolio.
An actively managed fund may underperform its benchmarks. An investment in the fund is not appropriate for all investors and is not intended to be a complete investment program. Investing in the fund involves risks, including the risk that investors may receive little or no return on the investment or that investors may lose part or even all of the investment.
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