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Low rates and extraordinary monetary policy complicate the search for income
Low rates from stimulus measures in response to COVID-19 have upended the risk/return paradigm for certain credit-sensitive instruments — creating income-oriented opportunities that may be worth the risk even though volatility remains high. As a result, investors now need to balance defense, income and capital appreciation in the hunt for a sufficient total return.
The Impact of Low Rates and Crisis Policy Tools
At the start of 2020, the US 10-year Treasury yield was 1.92%. Following the severe risk-off moves, a 150 basis point rate cut from the Federal Reserve (Fed) and their alphabet soup of lending facilities, the 10-year now resides in the 0.70% range — a level it has traded around since early April. By any measure, 0.70% yield for the 10-year is expensive. Our preferred measure is the current yield difference to an exponential 36-month moving average, and the current yield level is 67% below that metric.1
All of this indicates little upside in Treasuries, as duration remains extended and the probability of yields declining significantly again is questionable, as Fed Chair Powell has come out strongly against negative rates.2 In addition, the yield curve may steepen over the coming months, reflecting the significant amount the US Treasury is planning to borrow to fund the stimulus in response to the pandemic. We have already seen the curve widen to a degree,3 even though the Fed has bought $1.5 trillion in Treasuries over the nine weeks since the crisis began.4
Of course, core bonds are meant to seek income and provide ballast to the equity side of the portfolio. In today’s core portfolios, overweighting two segments (mortgage-backed securities [MBS] and short-term corporates) may help provide higher income than Treasuries while still offering balance from a risk/return perspective.
Don’t Fight the Fed
The old Wall Street mantra of “Don’t fight the Fed” refers to the notion that investors can do well by investing in a way that aligns with the Fed’s current monetary policies rather than against them.5 In addition to Treasuries, the Fed is also purchasing agency MBS as part of its unlimited quantitative easing (QE).6 Beyond having a large, constant buyer that will likely support a steady “bid” on the asset class, MBS have a structurally unique yield-per unit-of-risk exposure, as shown below, that may prove beneficial for investors seeking to balance rate and credit risk in the hunt for yield in this uncertain environment.
Another part of the Fed’s stimulus arsenal is purchasing individual bonds of US investment-grade-rated firms with a maturity of five years or less, as well as broad corporate bond ETFs. Under this program, roughly $220 billion of short-term corporate bonds could be bought.7 The Fed’s supportive bid for short-term corporate bonds will likely put a ceiling on how high spreads could widen. As a result, allocating alongside the Fed and overweighting the short-term segment may be a way to balance yield — yield per unit of duration is higher than the Agg, as shown above — as well as credit risks within a portfolio’s corporate exposure, particularly if future stressors emerge and the size of the program increases with Chair Powell’s “no-limits” approach to the Fed’s COVID-19 response.8
Risk Dynamics Altered for High Yield
The Fed’s lending programs also include the provision to buy high yield debt that was previously rated investment grade (IG) prior to March 22 and high yield ETFs. With these actions, the Fed may be aiming to target a specific spread level to limit panic-driven selloffs and add support, similar to how the Bank of Japan’s specific yield curve target supports capital formation and lending markets. As a result, the Fed’s new lending programs have transformed once risky bonds, such as corporates, fallen angels and even junk bond ETFs, into risky bonds that are now implicitly backed by the Fed.
Income-starved investors, such as pensioners, retirees and savers, don’t have many low-risk options to generate much-needed income in their portfolios. As of right now, the traditional standard 60/40 portfolio yields a paltry 1.98% — the lowest yield on record — and nearly 30% below the long-term median.9
However, there are deteriorating fundamentals in credit markets.10 So, investors may be forced to hold their noses when purchasing previously risky segments of the bond market, such as corporates, fallen angels and junk bonds. This is never a comfortable starting position for any investment decision. But the Fed, a deep-pocketed buyer of these risky bonds, doesn’t care about price or crumbling fundamentals. And as shown below, some of the strongest returns for high yield come when spreads are at this wide of a level (current spread is ~780 basis points11), indicating potential upside if the historical trend continues and a recovery takes shape. As far as the downside, the Fed is implicitly providing a ceiling.
There will be winners and losers at the individual bond level, but the broad asset class should benefit from the policy actions and provide both the income and total return necessary to improve the yield profile on portfolios.
Hybrids in the Driver’s Seat
Convertible issuance is on pace to break records, with $40.5 billion in bonds coming to market (annualizing $108.8 billion in 2020 vs. $58.1 billion in 2019).12 Firms are issuing more convertible debt as a result of customized financing terms that make convertibles attractive (i.e., lower coupons) at a time when straight debt spreads are elevated and corporate balance sheet management is vital to shore up liquidity needs.
New issuance that is further out of the money has lower deltas and larger premiums. With new issuance replacing older convertible debt with high deltas and low premiums, broad-based intermediate convertible securities have a balanced mix of bond- and stock-like characteristics. The average stock delta (the sensitivity of the convertible bond to the underlying stock) and the premium to parity (the value of the underlying equity if the convertible is converted) are close to their long-term averages.13
Convertibles, at 3.39%, currently yield more than IG corporates.14 Further, convertibles’ bond-like properties have mitigated severe downside moves relative to equities ─ as they typically do.15 This has led convertibles to outperform stocks by 8.4% in 2020.16 Meanwhile, convertibles’ equity-like traits have allowed them to participate in the recovery more than straight credit has ─ outperforming investment-grade and high yield credit since the bottom of the market by 15% and 12%, respectively.17 This profile may be beneficial for generating sufficient total return from both the coupon and capital appreciation standpoint, while positioning portfolios for a potential recovery that may feature periods of aftershocks of idiosyncratic volatility.
With interest rates at extreme lows, it is nearly impossible for investors to generate much-needed income using traditionally low risk investments. These funds may help investors thoughtfully invest alongside the Fed and pursue total return.
To balance income and play defense, target traditional sectors with explicit Fed support, such as MBS and short-duration corporates, and consider:
1 The exponential moving average yield is 2.19%, per Bloomberg Finance L.P.; calculations by SPDR Americas Research, as of 05/18/2020. 2 “Fed Chair Powell: The U.S. won't have negative interest rates”, CBS News 05/18/2020. 3 The spread between the 30- and 5-year yield has widened by 50 basis points from the start of the year, and the difference between the 10- and 2-year yield is 20 basis points wider as well, per Bloomberg Finance L.P., as of 05/18/2020. 4 Bloomberg Finance L.P., as of 05/18/2020. 5 What is the Meaning of 'Don't Fight the Fed'? www.thebalance.com . 6 “Fed Unveils Unlimited QE and Aid for Businesses, States”, Bloomberg 3/23/2020. 7 The program is the Federal Reserve Secondary Market Corporate Credit Facility (SMCCF) and has $25 billion of capital allocated by the US Treasury. The Fed can, however, lend roughly 10 times what it holds in collateral for non-government securities, meaning the size of the program could be as large as $250 billion. Calculations based on removing any active, non-US focused corporate bond ETFs, then applying a 20% constraint to the current asset levels. 8 CBS 60 Minutes 05/17/2020. 9 Based upon a standard 60/40% blend of the yields for the MSCI ACWI Index and the Bloomberg Barclays US Aggregate Index per Bloomberg Finance L.P. as of 05/18/2020; calculations by SPDR Americas Research. The long-term median yield is 2.68%. 10 Moody’s expects the global default rate to climb to 10.4% at the end of 2020 and to edge higher to 10.7% by the end of April 2021, April Default Report Moody’s Credit Research 5/11/2020, and there have 1,800 downgrades for North American issuers so far through May 2020; this is more than the last two years combined per Bloomberg Finance L.P. as of 05/18/2020. 11 Based on the trailing 30-day average spread for the ICE US BoFA US High Yield Index as of 05/18/2020. 12 Barclays May 2020. 13 Current stock delta for the Bloomberg Barclays U.S. Convertibles Liquid Bond Index is 62, versus long-term average (since 2003) of 61. Current premium is 31, versus long-term average (since 2003) of 33. 14 The lesser of the yield to worst, yield to maturity, and current yield for the Bloomberg Barclays U.S. Convertibles Liquid Bond Index as per industry convention to assess the yield on convertibles per Barclays as of 05/18/2020 15 Factset, as of 05/18/2020 based on the standard deviation of monthly returns (11.03% versus 14.29%) from 4/2010 to 4/2020 and the max drawdown (-16.33% versus -20.90%) during that period for the Bloomberg Barclays Liquid Convertible Bond Index and the Russell 3000 Index, respectively. 16 Return difference between the Bloomberg Barclays U.S. Convertibles Liquid Bond Index and the Russell 3000 Index as of 05/18/2020 per Bloomberg Finance L.P. 17 Return difference between the Bloomberg Barclays U.S. Convertibles Liquid Bond Index and the Bloomberg Barclays US Corporate Index and ICE BoFA US High Yield from 03/23/2020 to 05/18/2020 per Bloomberg Finance L.P.
Basis Point (bps)
A unit of measure for interest rates, investment performance, pricing of investment services and other percentages in finance. One basis point is equal to one-hundredth of 1 percent, or 0.01%.
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 U.S. Convertibles Liquid Bond Index
An Index designed to represent the market of U.S. convertible securities, such as convertible bonds and convertible preferred stock. Convertible bonds are bonds that can be exchanged, at the option of the holder or issuer, for a specific number of shares of the issuer’s equity securities. Convertible preferred stock is preferred stock that includes an option for the holder to convert to common stock.
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 1-3 Year Corporate Bond Index
A benchmark designed to measure the performance of the short-term U.S. corporate bond market. It includes publicly issued U.S. dollar-denominated and investment-grade corporate issues that have a remaining maturity of greater than or equal to one year and less than three years.
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 specific decline in the stock market during a specific time period that is measured in percentage terms as a peak-to-trough move.
ICE BoFA US High Yield Index
An Index that tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market. Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $250 million.
MSCI ACWI Index, or MSCI All Country World Index
A free-float weighted global equity index that includes companies in 23 emerging market countries and 23 developed market countries and is designed to be a proxy for most of the investable equities universe around the world.
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).
Russell 3000® Index
A capitalization-weighted equities benchmark that is designed to be reflect the entire US stock market. The index measures performance of the 3,000 US public companies and represents about 98% of the market cap of US stocks. It is a composite index that combines the Russell 1000® Index of large-cap US stocks as well as the Russell 2000® Index of small-cap US stocks.
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.
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.
Important Risk Discussion
The views expressed in this material are the views of Michael Arone and Matthew Bartolini through the period ended May 21, 2020 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.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA's express written consent.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
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.
Issuers of convertible securities may not be as financially strong as those issuing securities with higher credit ratings and may be more vulnerable to changes in the economy. Other risks associated with convertible bond investments include: Call risk which is the risk that bond issuers may repay securities with higher coupon or interest rates before the security's maturity date; liquidity risk which is the risk that certain types of investments may not be possible to sell the investment at any particular time or at an acceptable price; and investments in derivatives, which can be more sensitive to sudden fluctuations in interest rates or market prices, potential illiquidity of the markets, as well as potential loss of principal.
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.
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