Yields Are Low, Get Over It

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Includes: HYG, JNK, MIN
by: Roger Nusbaum

Bill Bernstein was interviewed by Index Universe and had some interesting things to say about fixed income investing. Perhaps the reason they are interesting to me is because they echo what I've said before about fixed income (confirmation bias).

First he says that "I want to take my risk with stocks, not bonds." Relatively high yields are great but too many people do not understand the risk they take when they chase yield. The SPDR High Yield ETF (NYSEARCA:JNK) and the iShares High Yield ETF (NYSEARCA:HYG) both had equity-like declines in 2008.

Another event of the same magnitude is unlikely, but a combination of a normal bear market and widening spreads could lead to another run-in with equity-like declines - but there has not been an equity-like recovery. Since the March 2009 low the S&P 500 is up over 110% while JNK is up 45% but still down from where it was five years ago. The higher the yield relative to "riskless" treasuries the more risk being taken. The variable is when this matters because as we have discussed before it is possible to take a huge risk without ever having to confront the consequence for that risk, but that is a dangerous bet to make.

The other snippet I liked was "get over the low expected returns of fixed-income instruments, because you don't have a choice." Rates are low and are going to stay low for a while (the US ten year is around 1.86% now, even if it went to 2.86% that would still be low).

A couple of paragraphs up I made a reference to so called riskless treasuries and I believe they are riskless in terms of return of principle. There is interest rate risk though. If you buy a ten year treasuries today and rates normalize then you will be sitting on a position that has dropped in value with a below market yield. Rates are close to all time lows and from here can't really go much lower but they could stay where they are for a while or they could start to go higher (intentionally obvious statement).

The road to all time low yields has made treasuries a great performer despite the risk potential--because of the risk potential we have been out of the space for a long time. Our allocation has been a combo of different exposure such that we try to average out to a better yield than nothing but without concentrating risk.

A core holding has been a TIP ETF which has done well but will be vulnerable to rising rates so we will have to swap to a short maturity TIP fund. Another core holding is the Vanguard GNMA Fund (MUTF:VFIIX) which has seen its yield decline since we bought in but the current 2.55% is not nothing. Price-wise the fund has been a snoozer which is a good thing. Another core fund is the MFS Intermediate Income Fund (NYSE:MIN) which goes further up on the volatility scale. It is a closed end fund so it will be volatile but the volatility is not bad compared to other CEFs and obviously there is leverage involved to give it its yield.

Clients also own a couple of investment grade, short dated bonds (individual issues) and here the yield is close to nothing. I would say that there should be a noticeable portion of the portfolio that takes very little interest rate risk. If rates start to go up in a meaningful way it would be nice to not have to turn over the entire portfolio.

We also have several individual foreign issues some with better yields like Australia and New Zealand and some not like Norway. Most clients own one or two individual preferred stocks in small weightings. Here there are 5 and 6% yields available but these have interest rate risk. Interest rate risk is not necessarily bad if you know you're taking it. We would probably want to step away from this space for a while if rates start going up.

Finally we have ETFs covering emerging market bonds (good yield), one of the shorter BulletShares (very little yield) and a corporate bond ETF targeting a sector (this has a middling yield).

Obviously the above is a blend of products (individual issues and funds), quite a few different exposures, different volatility profiles and different interest rate risks. This is not radically different than what we were doing in 2008 and the mix held up pretty well in the face of the market seizing up for a while. Hopefully this type of mix will hold up when rates do start going up but to be clear, I have the expectation of needing to make some changes when/if rates go up.