Nostalgia—and our portfolios—have us yearning for the good ol’ days when it seemed like a snap to generate sufficient income via a well-constructed bond portfolio. But then the Great Recession happened, and when major central banks around the globe drastically cut interest rates to revive their economies it was like a knockout punch to yields.
At midday on February 7, for example, yields on the 12-month, 10-year and 30-year U.S. Treasurys were 1.47%, 1.59% and 2.05%, respectively. All were down more than 100 basis points from the year-earlier period. For perspective, 10-year Treasurys yielded more than 5% as of July 2007 and 6.5% when the 21st century began.
And higher-yielding U.S. corporate bonds aren’t a great deal, either. In early February, the Moody’s Seasoned Aaa corporate bond yield was 2.90%, or nearly 90 basis points less than a year earlier. This is the highest-rated, lowest-risk investment-grade tier for fixed-income securities, and investors can get higher yields—with more risk—further down the bond rating scale.
Looking for yield in government bonds overseas? The epidemic of negative interest rates in many of these markets makes that a no-go option.
Of course, there are still ways to generate sufficient income for clients via bonds, as well as through other investment vehicles. We asked several financial advisors to explain how they generate income for their clients, and their solutions run the gamut from the public to the private markets.
Sam G. Huszczo, Founder/Investment Advisor
SGH Wealth Management
Southfield, Michigan
$180 million in assets under management
We are strong believers in not being all things to all people. Differentiation is highly important in our industry, and we are constantly exploring ways to refine our services to fit our average client’s demographic, typically comprised of income-focused retirees in their 60s. There’s growing concern among this cohort that traditional fixed-income investments will not be able to keep up with their distribution needs in this era of low interest rates. This environment has led some clients to hunt for more complex and “creative” alternatives without assessing how much added risk these changes may bring to the overall portfolio.
On top of that, a shortcoming of bond mutual funds and indexes is that they live on in perpetuity without a true maturity date. They cannot quote an annualized rate of yield-to-maturity because they simply do not mature. That led to the creation of one of the most underappreciated innovations of the exchange-traded fund space: target maturity date bond ETFs.
Taking into account your client’s asset base should be one of the first steps in deciding which investment products to use. Clients might enjoy the excitement of owning individual positions, but with bond portfolios this can lead to inefficiencies if the account isn’t large enough to justify buying a sizable number of small holdings and, for the advisor, it doesn’t justify conducting the ongoing research required of each holding. In addition, the $0 commission movement has not yet been rolled out for bond commission trading. Target maturity date bond ETFs hold a diversified basket of bonds creating a more easily managed laddering strategy conducive to a model portfolio approach.
All underlying bonds within target maturity date bond ETFs mature in the year stated and then distribute a final distribution of the net asset value of the funds’ assets to the investor. This allows ETF providers to quote a weighted average yield to maturity of the underlying positions. This not only helps the client better understand the investment, but also gives the advisor a baseline to make future decisions from.
As with most laddering strategies, a chief benefit to clients is always having a part of their bond portfolio maturing in a relatively short time frame to help fund current income needs and unexpected expenses. This added level of control over duration allows an advisor to choose the specific rungs to the ladder, customized to their client’s specific distribution needs and/or market expectations. For instance, high-yield bonds carry a high correlation with the stock market, with longer duration high-yield bonds having the most relative volatility. If stock market volatility returns in 2020, a holding in high-yield bonds that mature relatively soon (say, in 2021) may have less downside risk versus their longer-duration counterparts. This could possibly create a trading opportunity in a market downturn to sell the shorter duration issues to purchase longer duration high-yield bonds which, in that environment, may be trading at wider discounts to par.
To recap: The diversification to match your client’s investable assets, the ability to communicate a yield to maturity, and enhanced control to target specific points on the yield curve make target maturity date bond ETFs our income producing investment to watch in 2020.
Alon Ozer, Chief Investment Officer
Omnia Family Wealth
Aventura, Florida
$2 billion in assets under advisement
Given the current market environment, where most assets in the U.S. are fairly priced or overvalued, the income-generating component in a portfolio is of utmost importance. It incorporates a combination of both public and private vehicles. We recommend that investors are diversified across assets, vehicle type, liquidity, debt type, sector exposure and fund’s vintage, as well as a few additional personalized components. A portfolio of this kind takes several years to build. Credit markets have been witnessing a significant pickup in the supply of capital, putting downward pressure on credit spreads and interest income, particularly in the public markets.
Below are four important components that we integrate into our clients’ income-generating portfolios:
As bank regulations increased after the 2008 financial crisis, private debt funds grew in popularity, filling the void in corporate loans. These funds can invest in first-lien, second-lien, unitranche, sponsored or non-sponsored backed loans. The funds look to generate very attractive relative and absolute returns. Diversifying across vintage is important as the investment period is usually three years and the fund term is seven years (with optional extension). Investors must be aware that at this point in the cycle direct lending is more vulnerable to lower yield, covenant-lite and higher EBITDA leverage conditions.
Commercial mortgage-backed securities (CMBS) are bonds offered to investors that are collateralized by a pool of commercial mortgage loans from which all of the principal and interest paid on those mortgages flows to investors. Since 2008, tighter regulations have caused banks to be very conservative and significantly increase loan origination standards. Banks have been reluctant to provide financing in excess of 60% loan-to-value. Credit profiles of loans significantly improved, especially over the past three years after the risk retention rule was introduced. The rule requires issuers of asset-backed securities to retain at least 5% of any security they issue. We see lower-grade CMBS with loan-to-values of under 60% and a coverage ratio of more than two times potentially generating double-digit returns on average with high current income. We took a larger position in CMBS than we would normally take as we see a superior risk/return profile to most other income-producing investments.