For the first time since the financial crisis, playing it safe is paying off for income investors.
After a decade when conservative money market funds and similar short-term investments yielded close to zero, it is now possible to earn about 2 percent and even a bit more.
Vanguard Prime Money Market fund (VMRXX) yields more than 2 percent. A six-month Treasury bill yields 2.4 percent, up from 0.6 percent at the beginning of 2017. Ally Bank (ALLY) pays a 3 percent annual yield on a five-year certificate of deposit, with an early withdrawal fee equal to five months of interest. Goldman Sachs’ (GS) online consumer bank, Marcus, pays 1.95 percent on a savings account.
Money invested in savings and CD bank accounts is guaranteed to hold its value. Money market mutual funds lack an outright guarantee but are designed to deliver the same steady ride. In both instances, you’ve got no downside risk and your upside is the interest you earn.
Lately, pocketing a 2 to 3 percent return owning cash is better than the performance of popular core bond funds that track the Bloomberg Barclays U.S. Aggregate Bond Index.
That’s because bond fund returns have two components: the interest paid by the bonds and changes in bond prices. When interest rates rise, prices fall. A bond statistic called duration estimates a portfolio’s sensitivity to rate changes; the longer a portfolio’s duration, the bigger its price loss when rates rise.
Core bond funds that track the aggregate index have a duration of around six years, considered intermediate-term in bond parlance. That means when interest rates rise one percentage point, the index’s bond prices will fall 6 percent. Over the past year, rising interest rates lifted the yield on core bond funds above 3 percent, but that was not enough income to offset price declines.
The iShares Core U.S. Aggregate Bond ETF (AGG), which tracks the index, is down 1.9 percent over the past 12 months. IShares 0-5 Year Investment Grade Corporate Bond fund ETF (SLQD), with a duration below three years, has a positive return of 0.2 percent.
“The boost in yield you get from owning intermediate- and longer-term bonds is very, very low, and you are taking a lot more risk,” said Michael Fredericks, head of income investing for the BlackRock Multi-Asset Strategies group. That it’s now possible to earn something on shorter-term investments “changes the calculus a lot in the way you think about things,” Fredericks said.
Over the last year, the BlackRock Multi-Asset Income fund (BKMIX), which he helps manage, has shifted the portion of its portfolio that invests in traditional bonds from intermediate-term issues to shorter-term investment-grade bonds and cash. The fund’s average duration is less than three years. That provides a defensive foundation yielding 3 percent or so, as the managers focus most of the $16 billion fund on investments that offer higher yields, such as preferred stocks, high-yield bonds and floating rate loans.
Kathy Jones, chief fixed-income strategist at the Schwab Center for Financial Research, says she is concerned that investors are becoming too defensive. “When I go out and talk to clients, all of a sudden everybody is sitting in T-bills or cash equivalents,” said Jones, referring to short-term Treasury securities and bank investments that mature in less than one year.
Morningstar Direct reports that ultrashort-term bond funds — portfolios with durations below one year — have had the highest net inflows among all types of taxable bond funds for six consecutive months through August.
“Implicitly, that is trying to time the market,” Jones said, and such behavior can hurt investor returns.
Jones pointed out that intermediate-term bonds have historically been the better diversification counterweight when stocks fall. “T-bills will hold their value, but a five-year bond will actually do pretty well” in such a situation, she said.
For example, in the 12 months through February 2009 — the heart of the last stock meltdown — intermediate-term bonds rallied 5 percent and Treasury bills gained 1.3 percent.
Moreover, if you’re worried about a bond bear market, it’s time to check your rearview mirror.
With inflation still in check, expectations are that longer-term interest rates may already be near a peak. The yield on the 10-year Treasury note has risen to 3.1 percent recently from 1.4 percent in July 2016.
That means you and your core bond fund have probably already lived through what passes for a bond bear market in this economic cycle. The aggregate index has lost a grand total of less than two percentage points since July 2016.
Jones says the sweet spot for investors is a fixed-income portfolio with an average duration from two to five years. Yields in that range are about 90 percent of the 10-year Treasury yield, with a lot less downside risk.
If your current fixed-income strategy is simply to own a core bond fund that tracks the aggregate index, you can reduce the duration by adding shorter-term mutual funds or exchange-traded funds, or even cash.
Shifting some money out of a core bond fund can also be an opportunity to add diversification in securities that are not included in the index.
“High-yield bonds, preferred stocks, floating rate debt, emerging markets are opportunities that can increase your fixed-income diversification,” said Terri Spath, chief investment officer at Sierra Investment Management.
Spath says she sees good value in municipal bonds today. New muni bond issuance is down significantly from last year, when there was a big rush to float new bonds at a time of fear that tax reform would strip away the tax deductibility of municipal bond interest. The new tax law did not affect the treatment of muni interest, as it turned out, and Spath now has nearly 30 percent of the Sierra Tactical Core Income Fund (SSIZX) invested in high-yield municipal bonds.
She says that with no recession on the near-term horizon, strong corporate earnings, low unemployment and rising wage growth, she is comfortable seeking the higher yields in lower-rated issues because municipalities are raking in plenty of tax and fee revenue to cover their interest payments. The S&P Municipal Bond High Yield Index has a current yield of 4.3 percent, compared with 2.8 percent for the S&P Municipal Bond Investment Grade Index.
With the same outlook for the economy, Fredericks said he had placed nearly 30 percent of the BlackRock Multi-Asset Income fund’s (BKMIX) assets in high-yield corporate bonds and floating rate loans, which are usually high-yield issues. That said, BlackRock is being careful, he said. “Our focus is on higher-quality high yield. Even if we find ourselves in recession, those companies are better positioned to weather it,” he said.
The resurrection of short-term yields merits two more portfolio considerations.
Anyone who has been using dividend-paying stocks as a bond substitute since the financial crisis might want to revisit that strategy. The 2.4 percent yield of the SPDR S&P Dividend ETF (SDY) is about what you can earn on cash and short-term bonds these days, but the risk of holding stocks is higher, especially in Year 9 of a bull market. “It’s hard for us to envision double-digit returns from dividend-paying stocks, but if there was a growth scare, you could certainly envision double-digit downside,” Fredericks said.
And if you have money parked in a brokerage sweep account, you might want to reconsider how much is sitting there. According to Crane Data, such accounts yield just 0.22 percent, on average, as firms are moving the accounts from higher-yielding money market mutual funds — with an average yield of 1.8 percent — into bank accounts that pay a lot less to investors but generate nice fees for the brokerages.
Once you’ve got your tweaking done, you might relax. “The whole idea of fixed income is you don’t have to worry about it if you have it invested properly,” Jones said.
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