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.”