Pursue Total Return 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.

Implementation Ideas

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:

To pursue higher levels of income that now may be worth the risk, focus on high yield corporates, as they have implicit Fed support, and consider:

To straddle the line between income and total return potential, consider: