Record lows in fixed income yields are forcing income investors to contend with a challenging market. High-quality fixed income offers little more than cash, but taking on more risk before the upcoming election may not be worth the added return, either.
To get an inside look at the search for income today, we spoke with Michael Fredericks, head of income investing for BlackRock’s multiasset strategies team and portfolio manager of the BlackRock Multiasset Income Fund (ticker: BAICX). Here are edited excerpts from that interview.
What are your thoughts on fixed income markets today?
The story is supply and demand: There is tremendous demand for income, but the supply of bonds that pay a coupon over, say, 2%, has fallen dramatically. Central banks around the world aggressively lowered interest rates this year to stimulate economies struggling with the impact of the pandemic. The U.S. 10-year Treasury bond yields less than 1%, though that’s substantially higher than the 10-year government bond in Germany (-0.5%) or Japan (0.0%). It’s important to remember that the need for income is global, with demand from individual and institutional investors looking for the best risk/reward.
The Federal Reserve has essentially told us that it will probably not raise short-term interest rates until sometime after 2023. While the Fed controls the short end of the yield curve, it has less influence on longer-term interest rates. Depending on the outcome of the election we could see a meaningful pick up in Treasury issuance to fund bigger deficits, which would likely put upward pressure on long-term interest rates. In our funds, we have put on hedges to protect against a backup in rates at the back end of the yield curve.
With Treasury yields this low, the hedging benefits from owning government bonds (Treasury bonds typically rally when stocks fall) is much more limited. We don’t think the Fed will resort to negative interest rates, so at these current levels, yields can’t go much lower.
Given yields are so low, how should advisors be thinking about risk-return in fixed income today?
Yields are certainly at very low levels today; this is a very tough backdrop for investors who need income. The yield on cash is essentially zero and 10-year U.S. government bond yields are below 1%. The yield on the Barclays Aggregate Bond Index is near all-time lows at 1.2% today. We don’t see much value in these parts of the bond market. The upside is limited, though in fairness there’s probably not much downside either as the Fed would likely return to buying bonds if there was a meaningful pullback.
Over the last several weeks we have been selling our short-term, investment-grade bonds as well as our agency-backed mortgages. With those proceeds, we took up our cash position and added to high-yield bonds in the U.S. as well as high-quality, dividend-paying stocks. Although there is no yield in cash, we like sitting on some dry powder as we get closer to the election. I think everyone expects increased volatility, especially in equities, as we get closer to the election, but high yield could also sell off a bit. Over the last week, we added to high yield and, in equities, to dividend growers. We’re looking to add more to those positions if we get a sell-off due to election-related volatility.
With respect to risk-return in fixed income, the highest quality parts of the market like Treasurys, agency mortgages, and investment-grade offer little more yield than cash with low diversification benefits. I’m not suggesting risk-adjusted returns will be unattractive; the returns will likely be very low, but so will the risk. I certainly don’t suggest that investors sell all their low-risk bonds, but they should think about adding higher-yielding securities. Stock market returns have really been dominated this year by the fastest growth companies in the U.S., namely the FAANG stocks.
Dividend-paying stocks have lagged this year and at this point, you can find many companies whose dividend yield is well in excess of the bond yield. It’s an oversimplification, but dividend-payers fall into two camps: companies with competitive business models and a history of solid earnings growth and steady increases in dividends; and companies with broken or highly challenged business models with weak or declining earnings. We expect that companies in the first camp, those dividend-growers, will be increasingly in focus. Owning a portfolio of high-quality companies that pay about 3% dividend yields is really attractive versus prevailing bond yields, especially when you consider that the stream of dividend will likely increase over time.
What are your predictions for the rest of the year and into 2021 in terms of economic recovery?
We are cautiously optimistic that the (impacts from the pandemic) will be much less of a threat by the middle of next year. That’s a long way off for companies in the hardest-hit sectors of the economy like travel and restaurants, but the rest of the economy has proven to be very resilient. The housing sector is benefiting from low interest rates and demand for single-family homes. Overall inventory levels are quite low, and that should be a tailwind for growth as companies restock.
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