So far in 2021, the fixed income market certainly hasn’t been very fixed—instead posting negative returns—nor has it offered much income, with yields of just over 1%. U.S. equity and bond indices both posted strong performance in 2020, driving up asset class correlations and dropping yields to new lows. So, when the 10-year U.S. Treasury Bond traded above 1% in January 2021 (incidentally the first time since March 2020), the stock and bond markets both fell, disappointing investors looking to the bond market for portfolio diversification and consistent income stream.
Looking at what is on the menu for yield-focused market participants, options appear limited. Government bonds, while negatively correlated to stocks, tend to have low yield. Credit markets tend to have higher income potential but present additional risks, such as default risk, interest rate risk, and higher correlation to equities.
Analyzing each of these risks, along with their potential rewards, is the key to revealing potential opportunity. For example, the S&P U.S. Investment Grade Corporate Bond Index and S&P U.S. High Yield Corporate Bond Index, which seek to measure the broad U.S.-dollar corporate bond market, have current yields of 1.75% and 4.99%, respectively. Investment-grade bond indices are more credit worthy, but they also carry higher interest rate risk (as measured by the weighted average maturity [WAM] as shown in Exhibit 2). When yields rose in January 2021, the S&P U.S. Investment Grade Corporate Bond Index fell the most among fixed income sectors.
Senior loans don’t have nearly the same degree of sensitivity to rising rates as corporate bonds.1 Because loan rates reset quarterly or semiannually, yields keep pace with changes in prevailing interest rates. Constituents of the S&P/LSTA U.S. Leveraged Loan 100 Index, comprising the largest loans in the market, may not all carry the investment-grade ratings but may benefit from their senior secured status. According to S&P Global’s latest recovery study, bank loan recoveries averaged 79% compared with just 47% for bonds.
The S&P U.S. Preferred Stock QDI Index, comprising preferred stocks whose dividends may be taxed at long-term capital gains rather than punitive ordinary income rates, currently yields 5.66%. Preferred stocks typically do not mature and therefore are less sensitive to interest rates. However, they do have higher correlation to stocks as well as higher volatility relative to bank loans and investment-grade debt. Beyond the tax advantage of these stocks, the index outperformed the broad-based S&P U.S. Preferred Stock Index by 3.5% per year on an annualized basis.
Hunting for income in a yield-starved world comes with many challenges for market participants. By measuring the risk/return profile of various fixed income market segments, yield-hungry market participants will be able to make informed decisions.
1 The degree of sensitivity to rising rates is measured by the weighted average life (WAL) of the S&P/LSTA U.S. Leveraged Loan 100 Index.The posts on this blog are opinions, not advice. Please read our Disclaimers.