In today’s low yield environment, fixed income investors face a stark choice: accept lower income or take on additional risk to generate incremental yield.
In assessing these two options, investors must start with their own tolerance for risk and investment objectives. For those willing to take on additional risk, I continue to advocate reducing duration risk, for which investors are not being adequately compensated, and modestly increasing exposure to spread products.
I currently see opportunities in three fixed income asset classes, as I highlight in my recent Market Perspectives paper: investment grade US corporate debt, emerging market bonds and high grade municipals. I’ve already written a lot recently about the case for high quality municipals. So I’m focusing this post on the other two sectors, which were punished during last year’s extreme risk-off environment and haven’t benefitted from this year’s ‘risk-on” trade. As a result, they offer attractive yields with reasonable risk/reward balances.
Investment Grade US Corporate Debt: Certain segments of the investment grade space, particularly the lower strata, look like good relative values right now when compared to high yield and to US government debt. For instance, with the Baa segment (based on Moody’s Baa Corporate Bond Index) of investment grade, investors have an opportunity to pick up roughly 300 basis points over a 10-year Treasury. Not only is this spread high by historical standards, but it’s available at a time when government credit quality is deteriorating and corporate balance sheets have rarely looked better.
In addition, current spreads in the Baa sector look too wide compared to their own history and after taking the economic environment into account. As such, I continue to advocate overweighting investment grade credit through vehicles such as the iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSEARCA:LQD). Investors should be aware that the Baa segment of the investment grade universe is currently dominated by financial companies. Though the financial sector has stabilized, the performance of these issues is tied to the financial sector and financial market stability.
Emerging Market Bonds: There are several reasons why investors should consider adding emerging market debt to their portfolios at a benchmark weight through vehicles such as the iShares JPMorgan USD Emerging Markets Bond Fund (NYSEARCA:EMB) and the iShares Emerging Markets Local Currency Bond Fund (NYSEARCA:LEMB). First, macro volatility has historically been the major driver of financial asset volatility. With emerging markets now less volatile relative to developed markets, emerging market stocks and bonds should be less volatile relative to their developed world equivalents.
Second, emerging market countries exited the financial crisis in far better fiscal positions than their developed market counterparts. Third, inflation appears to be a fading risk in most of the large emerging market countries.
Despite these improving fundamentals, emerging market bonds are offering a significant and historically high premium over most developed market debt. Currently, emerging market bonds are yielding roughly 350 bps over the 10-year Treasury, close to a record high. Finally, emerging market bonds add diversification to a portfolio and a way to hedge an eroding dollar. Of course, investors need to keep in mind that emerging market bonds are still more volatile than domestic alternatives and currency exposure can add even more volatility.
In short, these two fixed income segments appear reasonably priced and have solid fundamentals. The risk is that both are, to varying degrees, vulnerable to another bout of intense risk aversion. But under that scenario, as last summer demonstrated, there is little to do other than follow the Fed and load up on Treasuries, at any price.
Disclosure: Author is long LQD and EMB
Disclaimer: Bonds and bond funds will decrease in value as interest rates rise. In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.