The amount of global debt trading below a 1% yield now outpaces the entire market capitalization of the S&P 500.1 That’s a problem as one of the primary functions of bonds in a portfolio is to generate income. In fact, with no major developed nation’s sovereign debt currently yielding above 1.4%,2 the promise of income from bonds has been, to a degree, broken – leaving just bonds’ potential benefit of diversification.
That is not the worst news, though. If we look at yields beyond the macro level and consider the actual income paid out to investors after taxes, the search for income becomes much more challenging.
One for you, nineteen for me
When yields on the Bloomberg Barclays US Aggregate Bond Index (US Agg) were 3.6% back in 2018, the after-tax yield was 2.27%.3 That was above the average rate of inflation4 and more than equities on a pre-tax basis,5 along with 80% lesser volatility.6 However, current yields on the US Agg are 1.2% pre-tax and 0.76% post-tax.7 On a global basis it’s even worse, with the Global Agg yielding 0.91% pre-tax and 0.57%8 post-tax.
Such low levels mean the standard 60/40 portfolio of global stocks and global bonds now yields the lowest amount on record on an assumed after-tax basis, as shown below. At less than 1%, the yield is below the current rate of inflation (1.4%),9 as well as the inflation expectations over the next three, five and 10 years.10 The same calculus holds if you change the bond side to include more than just investment-grade (IG) rated debt,11 also shown below. Swapping in this 95% IG/5% high yield mix for the 40% of the bond allocation, the entire mix also yields less than 1%, a level still well below inflation expectations. Adding in non-IG bonds in this fashion to a 60/40 allocation increases the after-tax yield by just 4 basis points. That’s a problem.
Now, consider the impact low rates are having to the range of standard asset allocation portfolios – spanning from aggressive to conservative. As shown below, the conservative 20/80 portfolio, an allocation typically utilized for retirees, yields just 0.67% on an after-tax basis. This is the lowest yield of all the portfolios shown below, and it’s the one allocation that is meant to provide a paycheck-like income stream for retirees. That’s a problem.
It’s not as if the volatility has been reduced, however. As shown below, for the common 60/40 portfolio, the after-tax yield per unit of trailing 36-month standard deviation has moved lower over time. While the events of 2020 make it abnormally low, the trend was apparent for years before. In fact, the ratio never fully recovered after the Great Financial Crisis and had been declining off its 2018 peak, touching its lowest levels since 2016 just prior to the pandemic. This is a problem.
In our 2021 market outlook, we discuss how in order to increase pre-tax yields investors will have to take some risk. Yet, they can diversify the sources of risk to obtain income by utilizing emerging market debt (currency risk), senior loans (credit risk), and preferreds (hybrid of equity and rate risk). Each market carries a current pre-tax yield north of 3.5%. The post-tax yield of a 3.5% rate equates to 2.2% – still low from a historical perspective, but at least above the current rate of inflation (1.4%).
In a post late last year, I showcased how investors can customize a bond portfolio by utilizing bond indices, tracked by cost efficient ETFs, that break the bond market up into specific components – while adhering to certain risk constraints. Today, the portfolio referenced in that post would yield 2.75% pre-tax and 1.73% post-tax.12 These levels are higher than either the core US Agg or Global Agg and would increase the post-tax yield of a standard 60/40 portfolio using traditional core bond exposures to 1.35% from 0.88%.13 An active manager, provided the fee doesn’t wipe out the yield potential, may also help in generating higher income than plain core bonds – a topic I covered in the Portfolio Construction for the Next Decade.
One asset that we had not discussed yet is municipal bonds – specifically, high-yield municipal bonds. As a refresher, municipal bonds are issued by US state and local governments as well as other public entities in order to finance capital improvements and public infrastructure projects that are expected to have a benefit to the local community. The interest income earned from most municipal bonds is exempt from all federal income taxes, regardless of tax bracket.
High-yield municipals are an underutilized asset class. They make up just 7% of municipal bond ETF assets and 0.45% of all bond ETF assets14 – even though they yield more than traditional corporate high-yield bonds on an after-tax basis. The current yield to worst on high-yield municipal bonds is 2.89% while high-yield corporates yield 3.98% pre-tax, but 2.51% post-tax.15 Not to mention, this income is generated alongside lower volatility than high-yield corporates. The chart below compares high-income producing assets, as well as traditional bond segments, based on the pre- and post-tax yield per unit of standard deviation (Std Dev). High-yield municipals have the highest ratio (comparable to preferreds), and for this reason should be a consideration for any portfolio designed to pursue additional income.
Beyond a current higher yield and lower historical volatility, high-yield municipals are also less correlated to equities than corporate investment-grade and high-yield bonds, as shown below, leading to a potential source of higher income generation without taking on implicit equity risk. High-yield municipals are also less correlated to traditional core Agg bonds than US IG corporates are. As a result, an active municipal bond approach may be an optimal yield solution for core mandates as an active manager can utilize high-yield municipals alongside investment-grade municipal bonds to increase yield, while seeking to control overall portfolio risk.
Bond ETFs’ low fees and greater tax efficiency relative to mutual funds16 contributed to ETF flows setting records last year. With current rates still low and plethora of products now available from active to index, ETFs likely will become even more desirable as investors seek to generate more efficient streams of income.
While the US 10-Year Yield has increased 53 basis points over the last four months,17 it still has a long way to go before hitting pre-pandemic levels. If rates continue their ascent, however, that may lead to duration-induced price declines for core Aggregate bonds that the new higher yield would be unlikely to offset, leaving the total return on core bonds likely negative. This makes it even more important for investors to seek out higher income opportunities that balance the sources of risk – and to consider how municipals could boost their after-tax yields.
1 The total market capitalization of bonds with a yield below 1% in the Bloomberg Barclays Global Aggregate Bond Index is 44.6 trillion while the market capitalization of the S&P 500 Index is $32.6 trillion based on data from Bloomberg Finance L.P. as of February 5, 2021
2 Bloomberg Finance L.P. as of February 5, 2021
3 After tax yield is based on the yield-to-worst and applying the highest marginal federal income tax rate of 37%. This may differ for actual investors based on their tax bracket and it is meant to be an illustration of the impact on taxes in a such low rate environment. It does not account for state taxes or net investment income taxes. Actual results may differ.
4 Average rate of inflation from 2000 to 2020 was 2.1% per Bloomberg Finance L.P. data as of February 5, 2021
5 Current yield on the MSCI ACWI Index is 1.74% per Bloomberg Finance L.P. data as of February 5, 2021
6 FactSet as of January 31, 2021 based on the monthly returns of the Bloomberg Barclays Global Aggregate Bond Index and the MSCI ACWI Index from January 2001 to January 2021
7 Bloomberg Finance L.P. data as of February 4, 2021
8 Bloomberg Finance L.P. data as of February 4, 2021 based on the Bloomberg Barclays Global Aggregate Bond Index
9 CPI as of February 10, 2021 is 1.4% per Bloomberg Finance L.P. data
10 Based on breakeven rates, inflation expectations are 2.4%, 2.3%, and 2.19% for the next three, five, and ten years, respectively per Bloomberg Finance L.P. as of February 5, 2021
11Based on the Bloomberg Barclays Multiverse Index and the MSCI ACWI Index. The Bloomberg Barclays Multiverse Index has a 5% below investment grade allocation per Bloomberg Finance L.P. as of February 5, 2021
12 Based on a illustrative portfolio of EM Local Debt = Bloomberg Barclays EM Local Currency Government Diversified Index at 12.5%. Senior Loans = S&P/LSTA US Leveraged Loan 100 Index at 12.5%. Preferreds = Wells Fargo Hybrid and Preferred Securities Aggregate Index at 12.5%. High yield = Bloomberg Barclays US Corporate High Yield Index at 12.5%, Mortgages = Bloomberg Barclays US Securitized Index at 20%, Treasuries = Bloomberg Barclays US Treasury 1-3 at 7.5%, 3-10 at 7%, and 10+ Index at 1.5%, Corporates = Bloomberg Barclays US Corporate 1-3 at 1.5%, Intermediate at 1.5%, and Long Term Index at 11% based on Bloomberg Finance L.P. data as of February 5, 2021 per calculations by SPDR Americas Research.
13 Based on the blended rate of the 40% illustrative fixed income portfolio and 60% MSCI ACWI Index per Bloomberg Finance L.P. data as of February 5, 2021 and calculations by SPDR Americas Research
14Bloomberg Finance L.P. as of February 5, 2020 based on SPDR Americas Research calculations
15 High yield municipal bond yield based on the Bloomberg Barclays Municipal Yield Index and US High Yield Corporates based on the ICE BofA US High Yield Index per Bloomberg Finance L.P as of February 5, 2020 and the highest marginal tax rate of 37% per the Internal Revenue Service for the US high Yield Corporates after tax rate
16The average fee for a fixed income ETF is 35 basis points versus 67 basis points for fixed income mutual funds per Morningstar as of February 5, 2021. Over the last three years, 13% fixed income ETFs paid capital gains versus 27% of mutual funds per Morningstar as of February 5, 2021.
17Bloomberg Finance L.P. as of February 5, 2021
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.
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