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.