by Brian Erickson, Vice President of Fixed Income Research and Strategy, Ameriprise Financial
- After a difficult 2018 for bond investors, the market has changed.
- Higher-quality bonds now generate more attractive yields.
- This may be the time to revisit your income portfolio to reshape income portfolios around high quality fixed income.
Rising yields cast a pall over fixed income markets in 2018 as bond prices fell and fixed income returns ended the year in the red. It’s important for bond investors to remember that, in general, as yields rise, the price of bonds fall. Because yields trended higher, the Bloomberg Barclays U.S. Aggregate Bond Index (U.S. Aggregate) produced a -1.8% total return year-to-date through November 2018.
Looking for silver linings
There’s a silver lining, though, for income investors. The yield on the U.S. Aggregate Bond Index, which is backed by high-quality fixed income assets, including U.S. Treasury securities, agency-issued debt and investment grade corporate bonds, rose to 3.5% at the end of November 2018, up from 2.7% at the end of 2017. The good news for investors is that reasonable levels of income have officially returned to the high-quality fixed income market. This translates to greater opportunities to capture attractive yields with less risk.
For most of the past decade, Federal Reserve monetary policy depressed interest rates and made income investing a challenge. Since the end of 2010, the yield on the U.S. Aggregate Index averaged just 2.4%, ranging from a low of 1.6% in 2012 to 3.6% in November 2018. Looking ahead, we believe core bond yields may peak in 2019 or 2020. This could provide a window for income-oriented investors to reinvest in high-quality core fixed income instruments, just as market volatility picks up.
Strategies for bond portfolios in today’s environment
We recommend constructing income portfolios around three types of investments: core fixed income, lower-quality fixed income assets, and dividend-paying equities. Of the three, we believe core fixed income investments serve as the foundation, with the other two elements layered in based on an individual investor’s risk tolerance level.
Though dividend-oriented equities can generate both a stream of income and potential share-price growth, they add a degree of volatility you’d expect in the stock investments. Similarly, while fixed income options such as high yield bonds, senior secured loans, or emerging market bonds typically add higher yield and some diversification, they also come with greater default risk, which can mean the potential for loss of principal. As a result, we believe core fixed income should serve as the foundation; comprising the majority of assets in a conservatively diversified income-generating portfolio.
Time to consider a different approach
Income investing has been difficult over the past decade given the low interest rate (and subsequently, yield) environment. To the extent that investors took on greater risk to meet income objectives by increasing dividend-paying equity allocations, we believe now is the time to reverse course. At the end of 2012, the dividend yield generated by the Standard & Poor’s 500 Index1 stood at 2.2%, exceeding the 1.7% yield on the U.S. Aggregate Bond Index. At the end of November 2018, the yield on the U.S. Aggregate was 3.5%, nearly twice that of the 2% yield of the S&P 500. We recommend returning to core fixed income investments as an anchor for your income-generating allocations.
In addition, where investors took on greater risk when selecting fixed income assets or added leverage to generate greater yield, we believe now may be a prime opportunity to reduce risk in your portfolio. Not only are yields for core fixed income instruments attractive again, but they may also provide greater portfolio stability in what can typically be a volatile investment environment as the economic expansion winds down.
Strategy: Manage bond maturities
When implementing income strategies to weather market environments that may be on the horizon, we recommend considering the term, or maturity, of fixed income investments as well. For example, individual-security investors should consider a laddered strategy that extends 10 years or more to help protect income generation should the Federal Reserve reverse course and begin cutting interest rates again. This involves owning securities across different ranges of the maturity spectrum, from 1-year bonds to 10-year bonds, or even beyond that time horizon. Investors preferring bond funds, on the other hand, should consider core short- and intermediate-term fixed income strategies, layering in long-term fixed income funds once an economic slowdown materializes in the quarters ahead.
Revisit your bond strategy with your advisor
As we approach what we believe could be the peak in U.S. aggregate bond yields over the next two years, now is a good time to sit down with your financial advisor to review your income portfolio. Explore ways to ensure your asset mix is firmly grounded on a foundation of core fixed income to take advantage of the silver lining of today’s higher fixed income yields.