Fixed-income investing used to be so simple. You just needed a nice balance of high-quality and high-yield bonds, with some foreign bond exposure tossed into the mix for good measure. But aggressive moves by leading central banks have decimated global bond yields in many regions, which has forced investors to step up their efforts to find decent payouts.
Of further concern, a multi-decade surge in bond prices, which boosted total returns for fixed-income investors, has largely played out. The 10-year Treasury, for example, began 2016 with an already-low 2.3% yield. It now yields around 1.6%. Equivalent bonds in Europe and Japan yield less than that. Any reversal in bond prices offset the income from whatever yields may be on offer.
That doesn’t mean bonds can simply be shunned. In fact, the right fixed-income strategies can deliver decent yields and preserve capital. That’s not a small consideration if you think that the current bull market in equities may be in the late innings.
Negative Interest Rates: Not Such A Good Idea After All?
To build a fixed-income road map for the years ahead, it pays to assess the current monetary and fiscal policies, and how future moves may impact inflation—and interest rates. While all eyes have been on the U.S. Federal Reserve in the past half-decade, thanks to its pioneering moves in bond buying (quantitative easing) and race to the interest rate floor, it’s the central bankers in Europe and Japan that are now holding sway over bond market sentiment.
Their move into negative interest rate territory, which would have been inconceivable just a few years ago, has created a range of distortions in fixed-income markets, and bond strategists are divided on whether the policy has been effective.
Unintended Consequences
The goal of negative interest rates is to force savers to become spenders, boosting economic growth and kindling a bit of inflation. Rick Rieder, BlackRock’s global chief investment officer of fixed income, thinks the policy has had the opposite effect. “Consumers grow concerned about their income from fixed-income investments and start to save more instead of spend,” he says.
Negative rates are also hurting the financial sector. Joe Higgins, a fixed-income portfolio manager with TIAA Global Asset Management, notes that “pension plans are having a hard time closing funding gaps.”
Negative interest rates “should have steepened the yield curve, but they have had the opposite effect,” says David Lafferty, chief market strategist at Natixis Global Asset Management. As a result, banks now have less incentive to lend. That’s especially a concern in Europe, says Higgins, “where 70% of capital formation comes from banks,” roughly twice the rate seen in the United States.
Dan Ivascyn, lead portfolio manager for PIMCO’s income strategies and credit hedge fund strategies, says that “our financial system isn’t that well-equipped to handle negative rates.”
John Lovito, senior portfolio manager at American Century Investments, summarizes the view of many strategists when he suggests that “central banks are now being pushed to look to other mechanisms to support their economies.” These include stimulus spending on infrastructure, as well as tax reform and immigration policy reform (the latter move may be especially needed in Japan).
Still, not all agree that negative interest rate policies aren’t working. European purchasing managers’ indexes have shown modest improvements recently, and German business sentiment is back up at two-year highs.
The picture remains cloudier in Japan, which has pulled out all the stops to reverse a decades-long slump, to no avail. In addition to negative interest rates, the Japanese government has flooded the country with stimulus, and more recently announced plans to pursue “yield curve control” (pushing long rates noticeably higher than short rates), which is aimed at boosting bank lending and corporate spending.
The Japanese economy grew just 0.2% in the second quarter and remains perilously close to recession. That would create deep concerns about the world’s third-largest economy—which is already saddled with massive government debt. Still, “the Bank of Japan won’t let up on the gas pedal anytime soon because the nation’s demographics problem is so acute,” says Lafferty.
Needing to raise cash at a time of global economic strain, Japan, China and Saudi Arabia, our three largest creditors, have been net sellers of nearly $200 billion in U.S. Treasurys thus far in 2016, according to the Fed.
Inflation Or Deflation?
“There are risks that policies become more aggressive, which could lead to higher inflation than many anticipate,” says PIMCO’s Ivascyn. If that happens, he thinks Treasury Inflation-Protected Securities (TIPS) likely offer one of the best hedges against rising rates.
Still, for now, Ivascyn thinks “the deflationary risk remains the slightly greater risk,” and bond markets are even less prepared for that than inflation.
A potential economic slowdown is on the minds of Morgan Stanley economists. Matthew Hornbach, head of that firm’s global interest rate strategy, expects “real economic growth in the U.S. to inch lower over the course of 2017.” His firm is among the most bearish on Wall Street, predicting that the yield on U.S. 10-Year Treasury bills will fall back to 1% in the first quarter of 2017 (down from a current 1.62%).
Weak GDP growth, in Morgan Stanley’s view, will lead the Fed to sit on its hands for the next two years and keep short-term interest rates where they are. The current consensus view calls for one rate hike this coming December, two hikes in 2017, and three more in 2018.
If the consensus is on the mark, strategists broadly agree that U.S. long-term bonds hold diminished appeal. “The interest rate risk in relation to yield [for these bonds] is a very poor trade-off right now,” says Natixis’s Lafferty.
In response, many fixed-income strategists think bond portfolios should reduce exposure to duration (as short-term bond prices are much less sensitive to interest rate changes than long-term ones).
But Ashish Shah, chief investment officer of global credit at AllianceBernstein, thinks that many investors are poorly positioned for that shift. He notes that passively managed bond funds have an average duration of 7.5 years and an average yield to maturity of 1.8%. In contrast, actively managed funds hold bonds with an average duration of 5.8 years and offer a 3.3% yield, according to Shah. “Many people are unaware of the risk that these longer-duration funds bring,” he says.
His firm’s AB High Income Fund advisor class (AGDYX) has garnered five stars from Morningstar and has an average duration of four years and a 5.11% distribution yield, thanks in part to an emphasis on lower-quality bonds.
Opportunities Still Abound
Even with the headwinds created by low central bank interest rates, investors can still spot various bond classes with decent yields. TIAA Global’s Higgins has been focused on asset-backed securities such as mortgage bonds, as well as high-quality intermediate corporate bonds. That’s a focus for BlackRock’s Rieder as well, especially non-agency mortgage bonds that will mature in two to four years. The SPDR Barclays Mortgage Backed Bond ETF (MBG) carries a 0.20% expense ratio and currently sports a 3.06% trailing yield.
PIMCO’s Ivascyn agrees that housing-related fixed-income instruments hold a lot of appeal right now. “Consumer spending is stable, and low mortgage rates mean that mortgage payments are reasonable.” He’s especially keen on corporate bonds that are backed by home builders. And he’s also a fan of the agency-backed mortgage-backed securities being sold by Fannie Mae and Freddie Mac.
Lafferty at Natixis finds appealing yields in bank loan funds, which invest in floating-rate bank loans instead of bonds. Since bank loan rates generally adjust higher when rates rise, they don’t have the same interest-rate sensitivity as other bond classes. Think of these loans as having greater risk than high-quality corporates, but less default risk than high-yield bonds.
The key drawback is that many of the leading bank loan funds have expense ratios above 1.0%, which eats into returns. The Loomis Sayles Senior Floating Rate and Fixed Income Fund (LSFAX) carries a 0.82% expense ratio, and currently offers a 30-day yield of 6.08%.
The Muni Angle
Strategists at McDonnell Investment Management think municipal bonds hold strong relative appeal these days. While muni bonds came under severe pressure at the height of the 2008/2009 economic recession, they are now in much better shape. “The stronger economy has clearly improved state and local government finances, and property tax receipts are up,” says Dawn Daggy-Mangerson, director of the firm’s Municipal Portfolio Management Team.
The Nuveen High Yield Municipal Bond Fund (NHMAX), which focuses on revenue bonds, offers a 3.35% 30-day SEC yield, which can be especially robust on an after-tax basis. The T. Rowe Price Tax-Free High Yield Fund, which gets a “Gold” rating from Morningstar and focuses on general obligation (GO) bonds, offers a 2.20% yield. While revenue bonds have historically been seen as slightly riskier than GO bonds, they aren’t saddled with unfunded pension liabilities, as many GO bonds are, notes Daggy-Mangerson.
Leaving the Developed World Behind
If you are in search of solid yields in government bonds and high-quality corporates, it pays to venture away from the developed markets and their central bank-induced low rates, and toward emerging markets. These bonds have offered relatively high yields ever since the initial Fed-induced market scare in 2013 (known as the “taper tantrum,”) according to American Century’s Lovito.
Not only do these bonds offer higher yields, according to Fran Rodilosso, VanEck’s portfolio manager for fixed-income ETFs, but their economic backdrops are more appealing because of improving fundamentals. A recent survey by Bloomberg finds that emerging market economies should grow 3.9% this year, and 4.9% in 2017.
They’re also not as risky as they were. “Many EMs now have much lower levels of external debt compared to 15-20 years ago,” says Rodilosso, which makes them less susceptible to global currency moves.
American Century’s Lovito notes that there should be more interest rate easing going forward at the central banks of Turkey, Russia and Poland, and he predicts “we’ll see many EM local [currency] bond markets outperform as easing leads to bond price rallies.”
BlackRock’s Rieder says his firm’s BlackRock Strategic Global Bond Fund (MAWIX) now has much greater exposure to the emerging markets than it did a year or two ago, and currently highlights Brazil and Indonesia as areas of opportunity.
Broadly speaking, emerging market government bonds priced in local currencies offer yields of around 6.15%, a full percentage point higher than dollar-denominated emerging market sovereign bonds. That’s because of the perceived currency risk in local bonds. But that view may be due for a rethink. “We had been avoiding local currency exposure, but less so now,” says Christoph Hofmann, global head of distribution at emerging markets specialist Ashmore Investments. He adds that “the dollar strength has played out and won’t be much of a factor in the future.”
The Templeton Global Bond Fund (TPINX), which mostly focuses on emerging markets government debt, is the only one in its category to earn a “Gold” rating from Morningstar. Nearly 60% of the portfolio is invested in Mexican, Brazilian and Indonesian bonds.
While emerging markets high-yield corporate bonds, which offer an average yield just below 7%, may seem quite risky, Rodilosso notes that “they are actually rated higher than U.S. corporate high-yield issues.” Many good fund choices have a balanced weighting of both corporates and government bonds.
One fund, the iShares Emerging Markets High Yield Bond ETF (EMHY), offers a 6.30% 30-day yield, carries a 0.50% expense ratio and has a four-star rating from Morningstar.
The New Normal—For An Extended Period
So when will the major benchmark interest rates being to rise? “Only when the output gap closes,” says TIAA Global’s Higgins, citing a large amount of slack that remains in the developed markets. That’s why few expect that we’ll break out of this low bond yield environment anytime soon. “You can stay in this cycle for many, many years,” says PIMCO’s Ivascyn. That view is backed up by Morgan Stanley’s Hornbach, who predicts that “inflation will not reach the Fed’s 2% target over our forecast horizon.”