As a result of overly accommodative global monetary policies and pandemic performance trends, the traditional 60/40 portfolio carries its lowest yield on record, creating a scarcity of income.1 To generate income for portfolio needs, investors have to outlay more risk – either through duration (long-term Treasuries), equity (high-yield dividend stocks) or credit (high-yield bonds). However, riskier sources of income, such as high yield, historically have had a higher correlation with equities than other fixed income asset classes have, thus reducing overall portfolio diversification.
With the Federal Reserve (Fed) pledging to hold rates at near zero until inflation averages 2%, the hunt for yield remains a top priority for investors. And given that the popular broad benchmark index for the US bond market — the Bloomberg Barclays US Aggregate Index (Agg) —has yielded just 1.18%,2 investors are rethinking their portfolio construction. To pursue income while balancing sources of risk, consider expanding your portfolio beyond traditional exposures with:
Senior Loans to Help Reduce Credit Volatility
Overall, issuer default forecasts have been revised sharply higher as a result of COVID-19, posing problems for credit investors. However, loans — which are typically more senior in their capital structure — generally have higher recovery rates than high-yield bonds do — 66% vs. 40%, respectively — and may not be as adversely impacted in this default cycle.3 Therefore, income-seeking investors who are averse to the increased credit risk of high-yield bonds may want to consider senior loans, as their yield is currently close to 5%4 and historically have had lesser volatility than high yield has, as shown below.
With a higher-yield-per-unit of average volatility than high-yield bonds (0.87% vs. 0.61%),5 senior loans may offer smoother income potential. And with a beta of only 0.28 to equities (versus 0.45 for high yield),6 senior loans may provide income without adding implicit equity risk.
The SPDR Blackstone/GSO Senior Loan ETF’s [SRLN] active mandate seeks to avoid weak or failing credits that may be included in a passive bank loan strategy, thereby potentially improving the credit quality and relative defensiveness to high-yield bonds without reducing the income potential from the asset class.
Preferreds to Pursue Income Diversification
Preferreds may be an option for investors seeking some of the highest yields in the investment-grade universe while maintaining overall portfolio diversification. With relatively low historical correlations to traditional stocks and bonds – 0.52 and 0.40, respectively — and a beta of 0.26 to stocks,7 preferreds may help to diversify portfolio income generation.
These hybrid vehicles may also generate attractive income per unit of risk, considering that their yield per unit of trailing 36-month volatility is 0.53 versus 0.11, 0.19, and 0.63 for long-term Treasuries, US large-cap dividend equities, and high-yield bonds, respectively.8 Only high yield has a better ratio, yet that comes with higher equity sensitivity and more credit volatility. Overall, preferreds may offer an income stream (4.70%)9 similar to that of high-yield exposures, but with potentially lower credit risk and equity sensitivity because they typically hold mostly investment-grade-rated securities from the highly regulated banking and insurance sectors.
The SPDR Wells Fargo Preferred Stock ETF [PSK] employs a stringent credit-quality criteria and largely holds investment-grade securities.
Emerging Market Debt to Pursue Currency-Driven Income
Currency trends play a significant role in the risk and return of local emerging market debt (EMD), as shown below. And a weakening US dollar (USD) may be a total-return tailwind to the asset class’ income potential. Weakening 10% since late March,10 the USD may fall further given the US’ waning yield advantages over other currencies and a ballooning public deficit that is likely to increase if a second stimulus bill is eventually passed. In the big picture, the easing of lockdown measures across emerging markets has aided a rebound in manufacturing activity and domestic consumption, and recent economic data has generally surprised to the upside to beat low expectations. The stabilization of oil prices on a continued demand recovery should also be positive factors for EMD.
With broad US Treasuries and Agg bonds yielding just 0.48% and 1.18%,11 respectively, local EMD’s 3.57% yield12 looks potentially attractive, as it is 1.6 to 2.4 percentage points greater than that of traditional investment-grade corporates and core Agg bonds, respectively. With 85% of the issues rated above BBB,13 EMD is still considered investment grade. And given that a primary source of return deviations is from currency, EMD may further diversify income generation within a portfolio.
The SPDR Bloomberg Barclays Emerging Markets Local Bond ETF (EBND) offers broad EM exposure to fixed-rate local currency sovereign debt diversified across more than 20 markets.
1 Source: Bloomberg Finance, L.P. as of 09/30/2020. Dividend Yield (%) of the S&P 500 and Yield to Worst (%) of the Bloomberg Barclays Global Agg represented.
2 Bloomberg Finance, L.P. as of 09/30/2020.
3 Source: GSO, JP Morgan Default Monitor as of 08/31/2020. 20-year averages represented.
4 S&P Dow Jones as of 09/30/2020. Senior Loans are represented by the S&P LSTA US Leveraged Loan 100 Index. YTM = 4.93%.
5 Factset, Bloomberg Finance, L.P. as of 09/30/2020. Yield is represented by YTW and volatility by the average rolling 36M standard deviation for the S&P LSTA US Leveraged Loan 100 Index and the Bloomberg Barclays High Yield VLI.
6 Factset 09/30/2010-09/30/2020. S&P/LSTA US Leveraged Loan Index used to represent Senior Loans and S&P 500 Index used to represent Equities. The Bloomberg Barclays High Yield VLI represents high yield.
7 Factset, Bloomberg Finance, L.P, Correlation and Beta measured for the 10 year period ending 09/30/2020. Wells Fargo Hybrid and Preferred Securities Aggregate Index used to represent Preferreds, S&P 500 used to represent Equities and the Bloomberg Barclays US Aggregate Bond Index used to represent bonds.
8 Factset, Bloomberg Finance, L.P. as of 09/30/2020. For Hybrids, the yield to worst for the Wells Fargo Hybrid and Preferred Securities Aggregate Index was divided by the 36-month trailing standard deviation of returns, yield to worst of the Bloomberg Barclays US Treasury 20+ Years Bond Index, divided by its 36-month trailing standard deviation of returns, the dividend yield on the S&P 500 High Yield Aristocrats Index divided by its 36-month trailing standard deviation of returns, and the yield to worst of the Bloomberg Barclays High Yield VLI divided by the trailling 36-month standard deviation of returns.
9 Morningstar as of 09/30/2020. Wells Fargo Hybrid and Preferred Securities Aggregate Index used to represent Preferreds.
11 Bloomberg Finance, L.P. as of 09/30/2020. Bloomberg Barclays US Treasury Index used to represent Treasuries and the Bloomberg Barclays US Aggregate Bond Index is used to represent the Agg.
12 Bloomberg Finance, L.P. EMD represented by the Bloomberg Barclays EM Local Currency Government Diversified Index.
13 Bloomberg Finance L.P. as of 09/30/2020. Investment Grade Corporates represented by the Bloomberg Barclays US Corporate Index and Core Agg Bonds represented by the Bloomberg Barclays US Aggregate Bond Index.
Beta Measures the volatility of a security or portfolio in relation to the market, with the broad market usually measured by the S&P 500 Index. A beta of 1 indicates the security will move with the market. A beta of 1.3 means the security is expected to be 30% more volatile than the market, while a beta of 0.8 means the security is expected to be 20% less volatile than the market.
Bloomberg Barclays US Aggregate Bond Index A benchmark that provides a measure of the performance of the US 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.
Emerging Markets Developing countries where the characteristics of mature economies — such as political stability, market liquidity and accounting transparency — are beginning to manifest. Emerging market investments are generally expected to achieve higher returns than those of developed markets but are also accompanied by greater risk, decreasing their correlation to investments in developed markets.
High Yield A company or bond that is rated “BB” or lower is known as junk grade or high yield, in which case the probability that the company will repay its issued debt is deemed to be speculative.
Investment-Grade Credit 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.
Senior Loans Floating-rate debt issued by corporations and backed by collateral, such as real estate or other assets.
Treasuries 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.
Volatility The tendency of a market index or security to jump around in price. Volatility is typically expressed as the annualized standard deviation of returns. In modern portfolio theory, securities with higher volatility are generally seen as riskier due to higher potential losses.
Yield The income produced by an investment, typically calculated as the interest received annually divided by the price of the investment. Yield comes from interest-bearing securities, such as bonds and dividend-paying stocks.
Important Risk Discussion
The views expressed in this material are the views of Matthew Bartolini through the period ended September 30, 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.
Investing involves risk, including the risk of loss of principal.
Diversification does not ensure a profit or guarantee against loss.
The value of the debt securities may increase or decrease as a result of the following: market fluctuations, increases in interest rates, inability of issuers to repay principal and interest or illiquidity in the debt securities markets; the risk of low rates of return due to reinvestment of securities during periods of falling interest rates or repayment by issuers with higher coupon or interest rates; and/or the risk of low income due to falling interest rates. To the extent that interest rates rise, certain underlying obligations may be paid off substantially slower than originally anticipated and the value of those securities may fall sharply. This may result in a reduction in income from debt securities income.
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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.
Actively managed funds do not seek to replicate the performance of a specified index. 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.
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. Securities with floating or variable interest rates may decline in value if their coupon rates do not keep pace with comparable market interest rates. Narrowly focused investments typically exhibit higher volatility and are subject to greater geographic or asset class risk. The fund is subject to credit risk, which refers to the possibility that the debt issuers will not be able to make principal.
Because of their narrow focus, financial sector funds tend to be more volatile. Preferred Securities are subordinated to bonds and other debt instruments, and will be subject to greater credit risk. The municipal market can be affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. The fund may contain interest rate risk (as interest rates rise bond prices usually fall); the risk of issuer default; inflation risk; and issuer call risk. The Fund may invest in U.S. dollar-denominated securities of foreign issuers traded in the United States.
Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.
ETFs trade like stocks, are subject to investment risk, fluctuate in market value and may trade at prices above or below the ETFs net asset value. Brokerage commissions and ETF expenses will reduce returns.
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