DAVID BAILIN, CHIEF INVESTMENT OFFICER
KRIS XIPPOLITOS, GLOBAL HEAD OF FIXED INCOME STRATEGY
Holding excess cash is a costly strategy in today’s ultra-low interest rate world. Instead, we see various opportunities to put cash to work and seek yield, while also diversifying portfolio risks.
KEY MESSAGES
In past times of market turmoil, it was often said that “cash is king”
Cash served not only to dampen portfolio volatility, but also often acted as a steady source of modestly positive returns
Cash currently offers no yield, little diversification value, and is likely to be the largest drag on portfolio returns
In this environment, we want to focus you upon opportunities for generating better returns from bonds
In past times of market turmoil, people often said that “cash is king.” Cash served not only to dampen portfolio volatility, but also often acted as a steady source of modestly positive returns. Let us be honest, it also always “felt good” to see something constant when markets tumbled. Today, this is no longer the case. In response to the COVID-19 pandemic’s financial fallout, the US Federal Reserve lowered its policy rate to 0.0-0.25%. As a result, cash currently offers no yield, little value in the way of diversification, and is likely to be the largest drag on portfolio returns.
Our strategic asset allocation methodology now estimates an annualized return before inflation of just 0.6% over the coming decade – see Major changes to our Strategic Return Estimates. In this environment, we want to focus you upon opportunities for generating better returns from bonds, while holding modest cash balances sufficient to cover real expenditures for a reasonable period. Here are several fixed income options:
Investment-grade corporates
For a brief period in April, US IG corporate bond yield curves were near their flattest since 2009. However, the bounce-back in global risk assets has driven curves sharply steeper, with short-term yields falling. This presents an opportunity to extend duration modestly beyond cash and cash alternatives. For example, yields on US IG corporates maturing in three to five years is near 2.0% or 50 basis points (bp) more than similar bonds maturing between one and three years.
Although adding a small amount of interest rate risk to portfolios, this is the largest yield pick-up on this part of the IG curve in over two years.
US municipals
For US investors, tax-exempt municipal bonds may provide compelling opportunities. While yields on high quality munis have fallen sharply, lingering market uncertainties have left some lower-rated IG issuers behind. Looking at index levels, moving from AA-rated to A-rated quality municipals can fetch an additional 100bp in yield.
Moving down to BBB-rated garners you another 150bp. This is the largest yield-pick up between these ratings buckets since 2013. Moving down in credit rating requires a more selective approach. Finding value in lower quality bonds should be approached on a case-by-case basis. Depending on an individual’s tax status, particular short-term bonds whose issuer is considered “high quality” by Moody’s can offer tax-free yields above 4.0%. This implies a taxable equivalent yield near 7.0%, or higher depending on state tax exemptions. Of course, not all bonds with these types of yields should be considered equal.
High yield and emerging markets
For those who cannot take advantage of the tax benefits in US munis, taxable high yield and emerging markets bonds can also introduce some opportunities. We would prefer to keep an “up in quality” bias, with a focus on BB-rated issuers. In the case of US HY bonds, yields of 5.4% are 250bp higher than BBB-rated IG. This “crossover” yield pick-up of 150bp is 100bp greater its 10-year average. It goes without saying that these securities come with greater credit risk. However, SREs of 5.9% and 6.2% are much higher than any other fixed income asset class.
While allocations in balanced portfolios may be limited to avoid duplicating equity risk, we would consider overweight positions for fixed income only investors.
Preferred securities
Although longer in duration, preferred stocks or capital securities can produce some compelling yields, without incurring a significant amount of credit risk.* Although junior in capital structure, these securities are primarily issued by wellcapitalized financial institutions in the US and Europe. Some of the larger US banks have particular securities whose yields can exceed 5%. True, these assets can be more volatile during periods of equity pullbacks. However, during the previous zero-rate era between 2010 and 2015, preferreds’ average annual return was 9%. At the same time, the average annual return for cash was 5bp.
Structured credit
Finally, high quality, short-term asset-backed securities (ABS) or structured credit can also offer some cash alternatives, but without much underlying default risk. Supported by the Federal Reserve Term Asset-Backed Loan Facility (TALF), 3-year AAA-rated credit card or auto loan ABS offer yields at LIBOR +70-100bp. Based on current LIBOR rates, this would equate to an all-in yield of 1.0-1.3%.
Despite today’s ultra-low interest rate environment, therefore, plenty of opportunities still exist seeking for yield. While they involve taking some risk, we believe their overall portfolio contribution more than justifies this. Putting cash to work is now king.
*Preferred securities can be called prior to maturity, which may reduce yield if purchased at a premium. Preferred securities may be subject to other call features or corporate restrictions that may have an effect similar to a call. Prices may fluctuate, reflecting market interest rates and the issuer’s credit status.