Bond investing has rarely been this challenging.
A global rally in fixed-income markets has resulted in near-record low yields on Treasuries and other debt securities in the U.S. It also has produced $15 trillion of negative-yielding debt globally—a development that most longtime bond investors thought would never happen.
Investors are scratching their heads to make sense of a world seemingly turned upside down. Even Greece, a country that had to take bailouts just a few years ago, has now been able to issue debt with a negative yield—effectively getting paid to borrow money.
Compared with much of the world, America is a haven for yield. But that isn’t saying much. U.S. Treasuries offer 2% or less. Top-grade municipals, meanwhile, yield 1% to 3%; high-grade corporate bonds, 3% to 4%; emerging market debt, 4% to 5%; preferred stock, 5%; and junk bonds, 6%. These are averages; investors who want to take more risk can get higher yields.
“Weak growth in Europe and Japan is causing investors who want positive yields to come to the U.S. market, and that’s pushing down rates,” says Karen Schenone, a fixed-income strategist at BlackRock’s iShares unit, the leading issuer of exchange-traded funds, or ETFs.
So, where should investors turn for yield in a low-rate world?
Many favor stocks—including real estate investment trusts, utilities, telecom operators, master limited partnerships, and even banks—where investors can get yields of 3% to 8%. There is merit in this approach, and Barron’s weekly income column often features these sectors.
But the focus here is on fixed-income securities, because many investors want to maintain a chunk of their portfolios in bonds.
Given the narrow gap between short- and long-term yields, investors should consider U.S. taxable funds, ETFs, and bonds with maturities of one to three years at 2% to 3% yields.
For those willing to take more risk, junk funds now yield 5% to 6%—with leveraged closed-end funds over 7%. And for even more adventurous investors, depressed debt from oil and gas producers like Southwestern Energy (SWN), and Diamond Offshore Drilling (DO) can yield 10% or more.
There isn’t much yield in the hot municipal bond market, although the sector does look appealing, relative to U.S. Treasuries.
There also are some little-known taxable bond-investment programs targeting retail investors from corporations including Duke Energy (DUK), Dominion Energy (D), and General Motors (GM) that offer an alternative to money-market funds.
“For investors with a multi-asset portfolio, bonds can play an important role in providing ballast if stocks sell off,” Schenone says.
Be careful about the roaring preferred-stock market, where yields on bank issues have fallen to about 5% from 6% this year. There is plenty of downside risk if rates do eventually rise, which would push down prices.
Bonds have generated returns this year of about 9%, measured by a major taxable bond index. This reflects a course reversal by the Federal Reserve, which recently has been reducing short rates, rather than boosting them. As a result, yields have slid by one to two percentage points in 2019.
Investors, unfortunately, are getting little in the way of real returns on most U.S. bonds, with inflation running in the 1.5% to 2% annual range. Factor in taxes, and real returns slide even lower.
Low yields probably guarantee low future returns and higher risk. Investors can take comfort from the prevailing view that rates will stay low for years, thanks to anemic global economic growth, restrained inflation, and a surfeit of worldwide savings. But if that proves wrong, watch out. The price of a 30-year Treasury bond, currently yielding just 2%, would fall almost 20% if yields were to rise by a percentage point. That risk was evident this past week, when the 30-year bond fell almost 5% in price.
Despite the paltry yields, bonds remain very popular with individuals. This year, they’ve poured $249 billion into taxable bond funds, which held $4.3 trillion in assets at the end of August, according to Morningstar. Muni funds held $828 billion on Aug. 31, after drawing $71 billion of new money—about as much as they had in the previous three years combined. And individuals continue to directly hold an enormous amount of munis—roughly half the $3.8 trillion market.
Another major trend is the sharp growth of bond ETFs. Their assets totaled $776 billion at the end of August, up $144 billion since the start of this year. Since 2010, bond ETFs’ assets have risen at a 19% clip from a base of just $136 billion. In a low-yield world, fees matter, and exchange-traded funds cost less than their actively managed counterparts.
ETFs are well-entrenched in the Treasury and high-grade corporate bond markets, but are less popular in the less-liquid markets for mortgage securities, junk bonds, and municipals, where active managers historically have been able to add value. Fees are less than a tenth of a percentage point for most of the top bond ETFs. That really matters, given the low yields on the underlying securities.
Here are some ways to play bonds in a low-rate world:
Given the narrow rate differential between short- and long-term bonds, there’s a good argument for staying short.
Money-market fund yields have fallen below 2%, as the Fed has cut short rates by a half-percentage point this year, to a range of 1.75% to 2%. An additional rate reductions by the central bank is likely later this year, and one more is expected in 2020. That could drop money-fund yields to 1.5% by early 2020.
Among the short-term bond funds that offer higher yields are Pioneer Multi-Asset Ultrashort Income (MAFRX), which has a yield of nearly 3%, and Pimco Low Duration Income (PFIAX), with 3.5%. Both have large investments in mortgage securities.
JPMorgan Ultra-Short Income (JPST) and Pimco Enhanced Short Maturity Active (MINT) are large ETFs that yield about 2.5% and are heavy in corporate debt.
For more risk-wary investors, there is the iShares 1-3 Year Treasury Bond exchange-traded fund (SHY), which yields 2.1%. One benefit of Treasuries: Their interest is exempt from state and local taxes, enhancing their appeal for residents of high-tax states.
Warren Buffett favors ultrasafe Treasury bills for Berkshire Hathaway’s cash hoard of more than $120 billion. Investors who want to follow Buffett can buy T-bills directly through the TreasuryDirect website, or purchase the iShares Short Treasury Bond ETF (SHV), which holds Treasuries with less than a one-year maturity. This low-volatility fund yields about 2%. It’s a good alternative to money-market funds.
Retail corporate bonds
In an effort to diversify their funding sources, Duke Energy and several other corporations offer floating-rate notes geared toward retail investors, with higher yields than money-market funds. They generally offer check-writing and liquidity; redemption features vary.
One of the larger programs is Duke Power PremierNotes, now offering a rate of 2.2% for balances of $10,000 or less and 2.4% for $50,000 and above. The minimum investment is $1,000, and the rate floats at a minimum of one-quarter percentage point above the average taxable money fund yield. Duke has more than $1 billion of these notes outstanding. Rate resets tend to occur quarterly or whenever the Fed shifts short rates.
Duke Power’s neighbor, Dominion Energy, rolled out a similar program called Reliability Investment in 2017 and now offers rates as high as 2.7%. It had just $10 million outstanding at the end of last year and appears eager to add assets, given the attractive rate.
As regulated utilities, Duke and Dominion are strong credits, with Duke carrying a single-A rating from Standard & Poor’s, and Dominion, triple-B.
The finance arms of General Motors and Ford Motor (F) offer similar floating-rate notes. The GM Financial Right Notes yield 2.5%, while Ford Interest Advantage paper offers a top yield of 2.4%. The GM program is marketed to employees and retirees, but is open to all investors. While the auto makers are more vulnerable to a weaker economy than utilities, the liquidity feature on the GM and Ford notes should allow investors to get out before big trouble hits.
Amerco (UHAL), the corporate parent of U-Haul, has an unusual program called the U-Haul Investors Club. It offers a range of securities called U-Notes backed by assets such as trucks, trailers, and even dollies. They carry a corporate guarantee, with maturities of two to 30 years and yields as high as 6.5%. Investors may want to stick with the shorter maturities because there is no liquidity feature. A recent two-year dolly-backed U-Note yields 3% and pays off like a mortgage, with investors due to get principal and interest payments over the next 24 months. Amerco’s controlling shareholder, the Shoen family, likes the U-Notes, holding more than a quarter of the $80 million outstanding.
An array of mutual funds and ETFs with yields of 3% to 5% hold these securities. Among them: Pimco Income (PONAX), DoubleLine Total Return Bond (DLTNX), Loomis Sayles Bond (LSBRX), and John Hancock Strategic Income Opportunities (JIPAX).
The two largest bond ETFs, iShares Core U.S. Aggregate Bond (AGG) and Vanguard Total Bond Market (BND), own a mix of Treasury, corporate, and federal agency debt; they yield about 2.7%. Importantly, the ETFs feature rock-bottom expense ratios—0.05% for the iShares and 0.04% for the Vanguard.
Many of the big funds have had a hard time keeping up with the bond market averages because they have been defensive. They’ve been keeping maturities relatively short or have been focusing on mortgage securities, which typically lag behind Treasuries in rising markets.
The giant Pimco Income fund, which oversees $130 billion, has returned 5.3% this year, leaving it well behind the 9% gain in the Bloomberg Barclays U.S. Aggregate Total Return index. The fund is ahead of the index over the past five years.
This go-anywhere fund has a large exposure to mortgage issues that lack federal guarantees. The fund boasts an outsize 5.2% dividend yield, but has been hurt by short positions in negative-yielding Japanese government bonds.
One of the original unconstrained funds, Loomis Sayles Bond, co-headed by 86-year-old Dan Fuss, is positioned defensively, with a shorter-than-usual average maturity of about five years. “We’re in the bottom of the eighth inning of the credit cycle,” Fuss says, expressing concern about an economic downturn. “We’re bringing up the quality of the portfolio,” Fuss adds.
The fund has a small position in AT&T (T) common stock and yields about 3.5%.
John Hancock Strategic Income Opportunities also is investing more defensively. “We’ve upgraded our emerging market and high-yield exposure,” says co-manager Dan Janis. The fund doesn’t own Argentina, among the riskier emerging market issuers, but instead favors Indonesia and the Philippines. The fund is focused on double-B-rated junk—the highest tier—and avoids CCC-rated issues, the basement dwellers.
There isn’t much yield internationally in developed countries. The German 10-year government bond yields negative 0.5%, and the Japan 10-year bond is at negative 0.2%. The iShares Core International Aggregate Bond ETF (IAGG) yields 2%.
Emerging market funds offer comparable yields to corporate bonds. The largest ETF is the iShares JPMorgan USD Emerging Markets Bond (EMB), now yielding 4.3%.
Taxable munis are another alternative to corporate bonds. Barron’s recently highlighted the appeal of “century” taxable munis with maturities of 100 years from issuers including Georgetown University and the University of Pennsylvania. While these yield 3.2% to 3.9%, their ultralong maturities create a lot of interest-rate risk.
California is expected to soon offer a $1 billion–plus taxable bond deal that would benefit in-state holders. While the bonds don’t face California income taxes on interest income, they are subject to federal taxes.
This market has been strong, with returns of 11% this year, and quality has won out. The double-B sector is up 14%, against just 6% for the riskier triple-Cs, as danger-averse investors avoid the most leveraged, economically sensitive companies.
Open-end funds that operate in this market include the low-fee Vanguard High-Yield Corporate (VWEHX) and MainStay MacKay High-Yield Corporate (MHHIX). They have yields in the 5.5% range.
Closed-end junk funds yield more; most offer 7% to 8%. This reflects their use of leverage and pervasive discounts to net asset value averaging 9%. Big high-yield closed-end funds include PGIM Global High Yield (GHY) and BlackRock Corporate High Yield (HYT).
One group of funds focused on leveraged loans faces less rate risk, thanks to floating rates, but boasts less liquidity than public junk debt. Most of the big closed-end leveraged loan funds trade at a nearly 10% discount to NAV, with the Invesco Dynamic Credit Opportunities (VTA) yielding 8%. Leveraged loan funds are less popular now, because yields have declined with the drop in short rates.
Probably the diciest part of the junk market is energy, where investors worry about highly indebted producers and service companies against a backdrop of weak oil and gas prices. Nonetheless, energy debt is an alternative to the sector’s depressed common shares, offering both high yields and price-appreciation potential.
Examples include the Diamond Offshore Drilling 7.875% bonds due in 2025 and yielding 13.5%; Southwestern Energy 7.5% bonds due in 2026, at 10.8%; Transocean (RIG) 6.8% bonds due in 2038, at 13%, and Denbury Resources (DNR) 7.75% bonds due in 2024, at 15.5%.
This market has been on a roll this year, driven by the drop in Treasury yields and strong flows into the dozen or so preferred ETFs. The largest, iShares Preferred & Income Securities (PFF), trades around $37, yields 5%, and has returned 13% this year.
Most preferred shares are perpetual, making them sensitive to rate changes. The problem is that they generally can be redeemed at the issuer’s option five years after issuance. This limits the upside, while exposing investors to a lot of downside if rates rise. “It’s heads you win a little, and tails you lose a lot,” says Fuss, who isn’t enamored of the market. During the bond market selloff in 2018, the prices of some preferreds plunged almost 20%.
Many preferred shares were issued with dividend yields of about 6% and now trade at premiums to their face value, usually $25 a share. Investors should evaluate the yields, based on likely redemptions. Doing so often indicates that the “yield-to-call” is 3% or so.
Banks dominate the market. Big issuers include JPMorgan Chase (JPM), Bank of America (BAC), Wells Fargo (WFC), and Citigroup (C). The decline in yields has prompted several recent new issues with dividend yields of about 5% from Bank of America; Allstate (ALL); Fifth Third Bancorp (FITB), a regional bank; and Public Storage (PSA), a large REIT. The Bank of America 5% preferred (series N) now trades slightly above its offering price of $25 and yields 4.88%.
The sector remains a favorite of individuals, who dominate the market despite ultralow yields.
“If you’re a high-rate taxpayer, munis still make a lot of sense,” says John Loffredo, co-manager of MainStay MacKay Tax Free Bond (MKINX) and MainStay MacKay High Yield Municipal Bond (MMHAX).
Triple-A-rated 10-year munis now yield about 1.35%, or 87% of the Treasury yield—the high end of the range this year after a market pullback in September. Top-rated munis with one- to five-year maturities yield about 1.15%.
“It’s a good time to stick with higher-quality munis because the yield differential versus low-grade munis isn’t wide,” says Alan Schankel, the muni strategist at Janney Montgomery Scott. Money has poured into muni mutual funds, including those focused on the high-yield market.
The largest muni fund, the Vanguard Intermediate-Term Tax-Exempt (VWITX), totals $70 billion after attracting $7.6 billion this year. It yields 2.5%.
The largest high-yield muni fund, Nuveen High Yield Municipal Bond (NHMAX), has topped $21 billion and yields 4%. A broad rally has diminished the appeal of muni closed-end funds, with many returning 20% or more this year.
Most funds still yield more than 4%, reflecting leverage. Big funds in the sector include Nuveen AMT-Free Quality Muni Income (NEA), with a recent share price of $14.30, yielding 4.5% and trading at a 9% discount to NAV; Nuveen California Quality Municipal Income (NAC), at $15, yielding 4.1% and changing hands a 7% discount; Nuveen New York AMT-Free Quality Municipal Income (NRK), at $13.50, with a 4% yield and 10% discount; and BlackRock Municipal 2030 Target Term Trust (BTT) at $24, with a 3% yield and 8% discount. The BlackRock fund is a good alternative to an intermediate-term muni fund, given a wind-up date in 2030 and the discount.
Many investors own laddered muni portfolios with a string of maturities—often one-to-10 or five-to-15 years—that involve the sale or maturity of the shortest rung on the ladder and a reinvestment in longer-dated bonds.
Several firms have created separately managed accounts, or SMAs, based on the strategy, with Eaton Vance, Pimco, and Nuveen being the largest. They offer the advantage of professional management and the ability to source bonds in the often illiquid muni markets.
The $24 billion Eaton Vance program is larger than all but a few muni bond funds and has attracted $6 billion this year. The fee is modest at 0.16% annually, although financial advisors may add on their own management charges. Schwab offers the program with an all-in 0.35% yearly cost. The minimum investment is usually $250,000.
The firm employs the same strategy in several funds, including the Eaton Vance TABS 5-to-15 Year Laddered Municipal Bond fund (EALTX). Its returns in recent years have been comparable to the big Vanguard intermediate-term fund. The $8 billion Pimco muni ladder SMAs have a $150,000 minimum and what the firm said is an annual fee in the midteens of a percentage point—comparable to Eaton Vance.
Many investors still prefer individual bonds, and with interest rates low, there has been no shortage of issuance.
The New York State Thruway Authority, for example, is expected to issue $2.7 billion worth of bonds soon. They should appeal to Empire State residents because of their high credit quality and exemption from federal, state, and local taxes.
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