Investing Ideas In An Era Of Low-Yield Bonds

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Investors are trying to navigate through a treacherous strait in the market, with bonds generating near-zero income yields on one side and stocks with increasing volatility on the other side. With good reasons to assume that the Federal Reserve will continue to buy Treasury bonds at an aggressive pace to cap bond yields for years to come, it is time to start thinking about alternatives to owning traditional bonds.

The Low Bond Yield Conundrum

The traditional retirement portfolio has always included a mix of both stock and bonds. When investors are young, they are generally advised to own far more stocks than bonds because stocks tend to generate higher returns but with more price volatility. Young investors have a long time horizon in which to invest, which allows them to be patient as their portfolio recovers from market-driven drawdowns in value. As investors age and approach retirement, the proportion of stocks should decrease while the proportion of bonds should increase. Bonds are less volatile than stocks, and it makes sense to reduce risk as your investment time horizon shrinks. In addition, bonds historically have paid a higher level of income than stocks, and retirees are more often than not dependent on generating investment income to fund their living expenses.

Unfortunately, the bond market has become almost uninvestable. The 10-year Treasury’s yield-to-maturity is currently 1%, which is more than it was in August 2020 when it touched an all-time low of 0.5%, but this paltry yield is still nowhere close to compensating investors for future inflation. Put differently, the real (i.e., inflation-adjusted) interest rate on 10-year U.S. Treasury bonds is currently below 0%. While these yields are pitifully low, they stand well above the negative interest rates available from European and Japanese government bonds. The chart below shows 10-year Treasury yields dating back to 1965.

Moreover, the problem of bond yields being too low is not limited to the Treasury market. As Treasury yields have declined, so too have municipal bond yields and corporate bond yields. As recently as 15 years ago, high-quality, investment-grade corporate bonds that yielded 5.5% or more until maturity could be purchased without too much difficulty. Today, most investment-grade corporate bonds offer yields of just 1.5% until maturity or less. Currently, 75% of the global bond market pays a yield of less than 1%, while only 10% of the global bond market pays a yield of more than 3%. Unsurprisingly, those bonds that pay a yield of more than 3% today are generally classified as either 1) “deep junk” bonds, issued by companies with weak balance sheets and significant credit risk or 2) have maturities that force the owners to bear material interest rate risk. In fact, a record amount of global bonds trade with a negative yield, about $17 trillion in total value, which means that holders are certain to receive a negative return from holding their bonds to maturity. 

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Making matters worse, bond yields could remain this low for years. The Debt/GDP ratio for the United States and the world is currently at a record high level. As a result, if the 10-Year Treasury bond yield were to rise to just 4%, it would create enormous problems for the U.S. economy, as debt service costs would skyrocket for consumers, corporations, and governments alike. The result would likely be a ballooning Federal deficit, widespread debt defaults, a housing crash, and a market crash. Knowing this, the Federal Reserve printed more than $10 trillion in 2020 to purchase U.S. Treasury bonds, keeping Treasury yields low and providing financing for record-breaking U.S. deficits. As long as the Debt/GDP ratio remains high, the Federal Reserve will likely continue printing money to keep bond yields as low as possible. 

As a result, investors in U.S. Treasuries, investment-grade municipal bonds, and investment-grade corporate bonds are likely to generate negative real (inflation-adjusted) returns for years, resulting in significant wealth transfers from lenders (creditors) to borrowers (debtors).

Bond Alternatives

Investors have owned bonds in investment portfolios for two primary reasons. First, bonds have provided an attractive fixed income return. Second, bond prices are less volatile than stocks and tend to be uncorrelated to stock prices; investors realize a diversification benefit from owning bonds and stocks together in a balanced portfolio.

Even with uncommonly low bond yields, owning bonds can still provide a portfolio diversification benefit. However, without enough yield, it is difficult to own as meaningful of an allocation to investment grade bonds because the expected return is simply too low. To help you think about what else you might want to own, let’s look at a wide range of bond substitutes, none of which are perfect, but all of which offer certain advantages over investment-grade corporate, municipal, and Treasury bonds today. Of course, there is no free lunch in investing; these substitutes also have their own disadvantages relative to bonds.

  • Dividend-paying stocks: Most publicly traded stocks pay a dividend and, depending on the company and the industry, certain stocks offer investors an attractive dividend yield. The stock market is richly valued primarily because technology stocks are especially expensive, and most technology stocks do not pay a large dividend. However, blue-chip companies outside of the technology industry are not as richly valued, and many of them pay an attractive dividend to investors. For example, Verizon’s VZ dividend yield currently stands at 4.5%. 
  • Real estate: Real estate investments generate cash flow from rental income and generally pay out that cash flow to investors. While certain real estate sectors, such as office real estate, are currently too risky due to coronavirus-related uncertainty, other real estate market subsectors are not. For example, the fundamentals of industrial real estate and multi-family real estate are currently attractive, depending on the location and valuation. Most private real estate funds target an internal rate of return of more than 10% after fees and benefit from being able to finance their acquisitions at an exceedingly low-interest rate.
  • Business development companies: Business development companies (“BDCs”) are investment companies that buy leveraged loans and pay out all of their earnings to investors. Leveraged loans are generally issued by companies that do not have a strong balance sheet, so the interest rate is well above the interest rates offered by investment-grade bonds. If a company goes bankrupt, leveraged loans receive the first priority in the capital stack, ahead of bonds, which means that leveraged loans generally recover more than bonds do in a bankruptcy.
  • Mortgage REITs: Mortgage real estate investment trusts (“REITs”) are investment companies that buy mortgage-backed securities using leverage and, like BDCs, distribute nearly all of their income to investors as dividends. The safety of these investments typically depends on the investment strategy. Some REIT managers pursue a more aggressive approach by purchasing junk-rated mortgage-backed securities, while others only buy the highest quality issues.
  • Closed-end bond funds: Closed-end bond funds are pooled investment funds that are deployed in a specific bond strategy. As “closed-end” funds, their shares can be purchased throughout the trading day, and the price of those shares could trade at a premium or a discount to the net asset value of the underlying assets. In some instances, certain closed-end bond funds are trading at substantial discounts to net asset values, allowing investors to indirectly purchase bond portfolios that offer a better yield than buying investment grade fixed income securities.
  • Preferred stocks: Preferred stocks are fixed-income issues of companies that receive a lower priority than bonds in the capital stack. A wide variety of companies issue preferred stock, but financial services companies tend to issue preferred stock more than the companies from other industries. Because preferred stocks are riskier than straight bond issues, the yield is typically far higher. Most preferred stocks do not mature for years, which means that the price of preferred stock issues will decline should interest rates rise significantly.
  • Inflation protected bonds: Many kinds of inflation-protected bonds exist, but the most common are Treasury Inflation-Protected Securities (“TIPS”). The par value of these bonds step up with the Consumer Price Index, which provides some inflation protection for investors. Inflation protected bonds perform best when inflation expectations are rising quickly, and they perform worst when inflation expectations are falling quickly.
  • Emerging market debt: Emerging market debt is issued by emerging market sovereign governments or companies and is denominated in foreign currency. Emerging market debt typically pays a somewhat attractive yield because investors need to be paid for the currency risk and credit risk of owning such bonds. Emerging market debt can be an attractive asset class to own when the dollar is depreciating but an unattractive asset class to own when the dollar is appreciating against various emerging market currencies.
  • Precious metals: Gold is also a worthwhile bond alternative. It does not pay investors any income, but bonds do not pay investors much income anymore either. Unlike U.S. dollar-denominated bonds, however, gold can appreciate in value as the dollar depreciates. Gold also tends to rise in price when real bond yields are negative, as they are today. Moreover, the gold price is uncorrelated to stocks. It can provide significant diversification benefits to a portfolio, which is an important consideration for investors who own stocks and are reducing their fixed income exposure. For example, between February and March of last year, the S&P 500 Index declined by 33.9%, while gold only declined by 2.8%.
  • Cash: Put simply, cash is cash. It yields nothing currently, but it is safe and has no volatility. Moreover, cash is the very definition of what it means to be liquid. As a short-term store of value, cash still works perfectly well as a bond substitute.

Portfolio Construction

Each of these bond substitutes acts somewhat differently, with varying volatility, yield, liquidity, and diversification parameters along with unique advantages and disadvantages versus bonds. Unfortunately, there is no single perfect replacement for corporate, municipal, and government bonds. It may make the most sense to employ a mix of bond substitutes in your investment portfolio while also continuing to invest in corporate or municipal bonds, albeit with a lower allocation given the uncommonly low-interest-rate environment.

The goal of making any adjustments is to generate more income than you would otherwise earn with a straight bond portfolio while managing the additional volatility that comes with some of these alternative securities. Navigating the current low-yield bond market may require pursuing alternative investment ideas that might maintain or increase the inflation-adjusted value of your retirement savings. For those investors who can take more risk, it may be worthwhile to be more aggressive in seeking out bond alternatives. For other investors with a more compressed investing time horizon, an elevated spending rate, or a low tolerance for risk, it probably makes sense to only minimally use bond substitutes.

Disclosure: This article is for informational purposes only and is not a recommendation of a particular strategy or security. The views are those of Adam Strauss as of the date of publication and are subject to change and to the disclaimer of Pekin Hardy Strauss Wealth Management