- Market Commentary
- By Jack Ablin
- July 1, 2020
Which Risks Are You Willing to Shoulder to Maximize Yield?
Finding acceptable income in today’s low-yield world is an arduous endeavor. That’s because the fixed-income market is the most liquid and efficiently priced market in the world. That means that there are very few “free lunches” to be found, particularly among high-quality, shorter maturities. Yield available in the marketplace is the function of three primary factors: 1) interest rate risk – the risk that higher interest rates disadvantage one’s holdings; 2) credit risk – the chance of issuer default; and 3) illiquidity risk – the substantial penalty for early withdrawal, in effect. Our job at Cresset is to find the highest yield available, subject to each of our clients’ tolerance for each of those three risks. For income investors not willing to shoulder any risk, the “risk-free rate” is the yield available to investors who need daily access to their holdings and require the federal government’s “full faith and credit” guarantee. The risk-free rate in today’s environment is essentially zero, thanks to the Federal Reserve’s desire to encourage risk taking. Relative to inflation, the Fed’s overnight yield is even less compelling: it spent most of the last decade below zero, meaning that the risk-free rate has failed to preserve purchasing power. Generating meaningful yield in today’s environment will require shouldering at least one of the three risks. Let’s examine them in detail.
Interest Rate Risk
Historically, the bond market has offered higher yields to those investors willing to hold bonds with longer maturities. While that phenomenon is still true today, the 10-year Treasury note yield is a scant .51% higher than the 3-month bill yield; that’s about half its historical median .91% yield advantage.
Income investors require a yield premium to extend maturity for two reasons, all other things being equal. The first is reinvestment risk. Shorter-term investors have more opportunities to reinvest in newer bonds as their older bonds mature. They would be better positioned than longer-term holders to reinvest in a higher-yielding new bonds should interest rates rise in the interim. Longer-term holders run the risk of getting stuck with an unattractive yield until maturity. Bond prices fall as rates rise. The degree that higher interest rates hurt a bond’s price can be measured by modified duration. Modified duration measures the interest rate risk of an individual bond or a portfolio of bonds. The higher the modified duration, the greater the interest rate risk and, in a return-for-risk world, the higher the yield bond holders generally require. Before the financial crisis, the relationship between modified duration and yield had been relatively stable. Beginning in 2009 with the Federal Reserve’s unprecedented quantitative easing program, the relationship between interest rate risk and yield skewed because the Fed, the US bond market’s largest buyer, is price insensitive. The Fed’s most recent foray has skewed the relationship between interest rate risk and yield even further, setting up the most unattractive relationship between interest rate risk and return the bond market has ever offered.
Income investors have historically demanded and received higher yields for lending to lower credit quality issuers, since the likelihood of default increases as investors migrate away from the safety of US Treasury bonds. The yield premium, or credit spread, increases or decreases with investors’ perceptions of credit risk. The Bloomberg Barclays Aggregate Bond Index represents the widest swath of the US bond market, comprising government, corporate and mortgage-backed bonds. Notwithstanding its allocation, it remains a high-quality index with nearly 70 per cent of its holdings rated AAA. The index’s yield premium over Treasuries is currently .65 per cent, which is favorable compared to its historical median of .52 per cent. Its yield premium spiked to 1.24 per cent last March is response to the initial COVID-19 market panic.
Lower credit quality bonds offer income investors a substantial yield premium vs higher-quality issues and compared with their history, thanks to today’s uncertain environment. High-yield bonds currently offer income investors a yield premium in excess of 7 per cent over government securities. High-yield bond buyers should keep in mind two mitigating factors, however. First is Federal Reserve policy. While Chairman Powell has gone a long way to provide bond market liquidity with his willingness to purchase corporate bonds to support market liquidity, his policy largesse does not extend to bonds that were rated below investment grade prior to the pandemic. That doesn’t suggest that the rate premium of high-yield bonds isn’t attractive, it just means there isn’t a price-insensitive purchaser acquiring high-yield bonds in the market.
Thanks to the Fed, US corporations are on track to issue as much as $1 trillion new bonds this year. Current yield spreads do not adequately compensate income investors for the unprecedented supply. Non-financial corporate bonds outstanding is expected to exceed 32 per cent of GDP this year, an all-time high. Yet, corporate bond spreads, which typically track supply, have failed to keep pace with what we would expect based on their historical relationship. For these reasons, we do not believe that credit risk, particularly in the corporate high-yield bond market, adequately compensates income investors for the degree of risk they would have to bear.
We recommend income investors focus on higher-quality credits within the corporate bond space even though yield premiums are currently closer to longer-term medians.
Municipal high-yield bonds currently offer a more compelling yield story than corporate yield. The high-yield municipal market has expanded at an 8.5 per cent annualized rate over the last 10 years, thanks to new issuance and downgrades. Cresset recommends income investors take an active approach to municipal high-yield bonds, since security selection is critical.
This is the most rewarding risk feature in today’s environment for those income investors willing to accept the inability to gain instant access to their income investments. Illiquid investments come in a variety of forms, but the most common are private credit and private real estate. Several factors weigh in favor of private investments, the most important of which today is yield. Depending on their position in the capital structure, private credit strategies offer income investors mid-single digit to low double-digit yields, as a result of both illiquidity risk and credit risk. Because investment terms range from 18 months to five years, interest rate risk is relatively low.
Private real estate is probably among the most attractive income assets in today’s environment. It offers high single-digit yields with an opportunity for upside, thanks in large part to its illiquidity. Institutional investors are increasingly turning to real estate to enhance portfolio income. Unlevered core commercial real estate has historically posted attractive annualized returns at a lower standard deviation than equities. Notwithstanding its impressive return history, real estate is the only major asset class that can offer investors significant income opportunities, with mid to high single-digit cash-on-cash yields while employing modest leverage.
Real estate’s credit quality, depending on the degree of leverage, is strong, thanks to its physical collateral. We recommend relatively low leverage – no more than 60 per cent loan-to-value – to ensure the ability to withstand the cyclical downside of a recession. Thanks to depreciation, a significant portion of investors’ income can be exempt from ordinary income tax, particularly in the early years. Putting it all together, private real estate offers income investors a great opportunity to generate relatively high, predictable income in a low-rate world.