“Deadly Charybdis—can’t I possibly cut and run from her
And still fight Scylla off when Scylla strikes my men?”
─ the Odyssey, as spoken by Odysseus
In Homer’s legendary epic, the Odyssey, Odysseus is forced to navigate his ship through a treacherous passage with legendary sea monsters, Scylla and Charybdis, threatening his crew on both sides. He tries his best, keeping the ship slightly closer to Scylla, which he deems to be less threatening than Charybdis. In the end, his ship makes it through the strait, but not without losing six men to Scylla.
Today, investors are being forced to navigate through a treacherous strait in the market, with bonds generating near-zero income yields on one side and stocks with increasing volatility on the other side. Making it past the strait, where financial markets return to some semblance of normalcy, will be difficult and filled with challenging trade-offs. The fact that this hazardous journey will likely last for years makes it all the more perilous.
The Low Bond Yield Conundrum
The traditional retirement portfolio has always included a mix of both stock and bonds. When investors are young, they are advised to own far more stocks than bonds because stocks tend to generate higher returns but with more price volatility. Young investors have a long time horizon in which to invest, which allows them to be patient as their portfolio recovers from market-driven drawdowns in value. As investors age and approach retirement, the proportion of stocks should decrease while the proportion of bonds should increase. Bonds are less volatile than stocks, and it makes sense to reduce risk as your investment time horizon shrinks. In addition, bonds historically have paid a higher level of income than stocks, and retirees are more often than not dependent on generating investment income to fund their living expenses.
Unfortunately, the bond market has become almost uninvestable. The 10-year Treasury’s yield-to-maturity is currently 1.1%, which is more than it was in August 2020 when it touched an all-time low of 0.5%, but this paltry yield is still nowhere close to compensating investors for future inflation. Put differently, the real (i.e., inflation-adjusted) interest rate on 10-year U.S. Treasury bonds is currently below 0%. While these yields are pitifully low, they stand well above the negative interest rates available from European and Japanese government bonds. The chart below shows 10-year Treasury yields dating back to 1965.
Moreover, the problem of bond yields being too low is not limited to the Treasury market. As Treasury yields have declined, so too have municipal bond yields and corporate bond yields. As recently as 15 years ago, we regularly purchased high quality, investment-grade corporate bonds for clients that yielded 5.5% or more until maturity without too much difficulty. Today, most investment-grade corporate bonds offer yields of just 1.5% until maturity or less. Currently, 75% of the global bond market pays a yield of less than 1%, while only 10% of the global bond market pays a yield of more than 3%.[1] Unsurprisingly, those bonds that pay a yield of more than 3% today are generally classified as either 1) “deep junk” bonds, issued by companies with weak balance sheets and significant credit risk or 2) have maturities that force the owners to bear material interest rate risk. In fact, a record amount of global bonds trade with a negative yield, about $17 trillion in total value, which means that holders are certain to receive a negative return from holding their bonds to maturity.
Making matters worse, we expect that bond yields could remain this low for years. The Debt/GDP ratio for the United States and the world is currently at a record high level. As a result, if the 10-Year Treasury bond yield were to rise to just 4%, it would create enormous problems for the U.S. economy, as debt service costs would skyrocket for consumers, corporations, and governments alike. The result would likely be a ballooning Federal deficit, widespread debt defaults, a housing crash, and a market crash. Knowing this, the Federal Reserve printed more than $10 trillion in 2020 to purchase U.S. Treasury bonds, keeping Treasury yields low and providing financing for record-breaking U.S. deficits. As long as the Debt/GDP ratio remains high, the Federal Reserve will likely continue printing money to keep bond yields as low as possible.
As a result, our base case expectation is that investors in U.S. Treasuries, investment-grade municipal bonds, and investment grade corporate bonds are likely to generate negative real (inflation-adjusted) returns for years, resulting in wealth transfers from lenders (creditors) to borrowers (debtors).
Bond Alternatives
We have historically owned bonds in client portfolios for two reasons. First, bonds have provided an attractive fixed income return for our clients. Second, bond prices are less volatile and tend to be uncorrelated to stock prices, so clients realize a diversification benefit from owning bonds and stocks together in a balanced portfolio.
Even with uncommonly low bond yields, owning bonds can still provide a portfolio diversification benefit. However, without enough yield, it is difficult for us to recommend as meaningful of an allocation to investment grade bonds because the expected return is simply too low. Instead of bonds, we are looking at a wide range of bond substitutes, none of which are perfect, but all of which offer certain advantages over investment-grade corporate, municipal, and Treasury bonds today. Of course, there is no free lunch in investing; these substitutes also have their own disadvantages relative to bonds.
- Equity-like Substitutes for U.S. Corporate, Municipal, and Treasury bonds:
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- Dividend paying stocks: Most publicly traded stocks pay a dividend and, depending on the company and the industry, certain stocks offer investors an attractive dividend yield. The stock market is richly valued primarily because technology stocks are especially expensive, and most technology stocks do not pay a large dividend. However, blue-chip companies outside of the technology industry are not as richly valued, and many of them pay an attractive dividend to investors. For example, Verizon’s dividend yield currently stands at 4.5%.
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- Advantages vs. bonds: Better tax treatment on dividend payments, higher yields, potential for capital appreciation
- Disadvantages vs. bonds: Price volatility, potential for capital loss
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- Real estate: Real estate investments generate cash flow from rental income and generally pay out that cash flow to investors. While certain real estate sectors, such as office real estate, are currently too risky due to coronavirus-related uncertainty, other real estate market subsectors are not. For example, the fundamentals of industrial real estate and multi-family real estate are currently attractive, depending on the location and valuation. Most private real estate funds target an internal rate of return of more than 10% after fees and benefit from being able to finance their acquisitions at an exceedingly low-interest rate.
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- Advantages vs. bonds: Higher yields, potential for capital appreciation –
- Disadvantages vs. bonds: Illiquidity, potential for capital loss, available only to accredited investors
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- Business development companies: Business development companies (“BDCs”) are investment companies that buy leveraged loans and pay out all of their earnings to investors. Leveraged loans are generally issued by companies that do not have a strong balance sheet, so the interest rate is well above the interest rates offered by investment-grade bonds. If a company goes bankrupt, leveraged loans receive the first priority in the capital stack, ahead of bonds, which means that leveraged loans generally recover more than bonds do in a bankruptcy.
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- Advantages vs. bonds: Better yield, potential for capital gain –
- Disadvantages vs. bonds: Price volatility, potential for capital loss
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- Master limited partnerships: Some dividend-paying stocks are organized as master limited partnerships (“MLPs”) and distribute nearly 100% of their earnings as dividends. For example, Enterprise Products Partners’ dividend yield is 8% currently. MLPs, which are limited to the real estate and natural resource sectors, combine the tax benefits of a private partnership with the liquidity of a publicly traded company.
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- Advantages vs. bonds: Better yield, potential for capital gain –
- Disadvantages vs. bonds: Price volatility, potential for capital loss, K-1 tax return filings
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- Mortgage REITs: Mortgage real estate investment trusts (REITs) are investment companies that buy mortgage-backed securities using leverage and, like BDCs and MLPs, distribute nearly all of their income to investors as dividends. The safety of these investments typically depends on the investment strategy. Some REIT managers pursue a more aggressive approach by purchasing junk-rated mortgage-backed securities, while others only buy the highest quality issues.
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- Advantages vs. bonds: Better yield, potential for capital gain –
- Disadvantages vs. bonds: Price volatility, potential for capital loss
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- Bond-like Substitutes for U.S. Corporate, Municipal, and Treasury bonds
–- Closed-end bond funds: Closed-end bond funds are pooled investment funds that are deployed in a specific bond strategy. As “closed-end” funds, their shares can be purchased throughout the trading day, and the price of those shares could trade at a premium or a discount to the net asset value of the underlying assets. In some instances, we can find closed-end bond funds that are trading at substantial discounts to net asset values, allowing us to indirectly purchase bond portfolios that offer investors a better yield than buying investment grade fixed income securities.
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- Advantages vs. bonds: Better yield –
- Disadvantages vs. bonds: Price volatility, liquidity.
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- Preferred stocks: Preferred stocks are fixed-income issues of companies that receive a lower priority than bonds in the capital stack. A wide variety of companies issue preferred stock, but financial services companies tend to issue preferred stock more than the companies from other industries. Because preferred stocks are riskier than straight bond issues, the yield is typically far higher. Most preferred stocks do not mature for years, which means that the price of preferred stock issues will decline should interest rates rise significantly.
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- Advantages vs. bonds: Better yield, sometimes better tax treatment –
- Disadvantages vs. bonds: Price volatility, potential for greater capital loss in a bankruptcy
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- Inflation protected bonds: Many kinds of inflation-protected bonds exist, but the most common are Treasury Inflation-Protected Securities (“TIPS”). The par value of these bonds step up with the Consumer Price Index, which provides some inflation protection for investors. Inflation protected bonds perform best when inflation expectations are rising quickly, and they perform worst when inflation expectations are falling quickly.
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- Advantages vs. bonds: Potential for capital appreciation –
- Disadvantages vs. bonds: Price volatility, lower yield
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- Emerging market debt: Emerging market debt is issued by emerging market sovereign governments or companies and is denominated in foreign currency. Emerging market debt typically pays a somewhat attractive yield because investors need to be paid for the currency risk and credit risk of owning such bonds. Emerging market debt can be an attractive asset class to own when the dollar is depreciating but an unattractive asset class to own when the dollar is appreciating against various emerging market currencies.
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- Advantages vs. bonds: More yield, potential for capital appreciation –
- Disadvantages vs. bonds: More volatility, potential for capital losses
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- Other Substitutes for U.S. Corporate, Municipal, and Treasury bonds
–- Precious metals: Gold is also a worthwhile bond alternative. It does not pay investors any income, but bonds do not pay investors much income anymore either. Unlike U.S. dollar-denominated bonds, however, gold can appreciate in price as the dollar depreciates. Gold also tends to rise in price when real bond yields are negative, as they are today. Moreover, the gold price is uncorrelated to stocks. It can provide significant diversification benefits to a portfolio, which is an important consideration for investors who own stocks and are reducing their fixed income exposure. For example, between February and March of last year, the S&P 500 Index declined by 33.9%, while gold only declined by 2.8%.
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- Advantages vs. bonds: Potential for capital appreciation, hedge against inflation. –
- Disadvantages vs. bonds: No yield.
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- Cash: Put simply, cash is cash. It yields nothing currently, but it is safe and has no volatility. Moreover, cash is the very definition of what it means to be liquid. As a short-term store of value, cash still works perfectly well as a bond substitute.
- Precious metals: Gold is also a worthwhile bond alternative. It does not pay investors any income, but bonds do not pay investors much income anymore either. Unlike U.S. dollar-denominated bonds, however, gold can appreciate in price as the dollar depreciates. Gold also tends to rise in price when real bond yields are negative, as they are today. Moreover, the gold price is uncorrelated to stocks. It can provide significant diversification benefits to a portfolio, which is an important consideration for investors who own stocks and are reducing their fixed income exposure. For example, between February and March of last year, the S&P 500 Index declined by 33.9%, while gold only declined by 2.8%.
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- Advantages vs. bonds: No price volatility, more liquidity –
- Disadvantages vs. bonds: Lower yield
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Portfolio Construction
Each of these bond substitutes acts somewhat differently, with varying volatility, yield, liquidity, and diversification parameters along with unique advantages and disadvantages versus bonds. Unfortunately, there is no single perfect replacement for corporate, municipal, and government bonds. Our general approach is to employ a mix of substitutes in client portfolios while also continuing to invest in straight corporate and municipal bonds, albeit with a lower allocation given the uncommonly low-interest-rate environment.
Our goal in making these adjustments is to generate more income than you would otherwise earn with a straight bond portfolio while managing the additional volatility that comes with some of these alternative securities. Navigating between the bond market Scylla of low rates and the stock market Charibdys of increased volatility requires thoughtfulness, prudence, and an intense focus on investment ideas that maintain or increase the inflation-adjusted value of your retirement savings. We would be inclined to be more aggressive in our approach to purchasing bond alternatives for those clients who can take more risk. For other clients with a more compressed investing time horizon, an elevated spending rate, or a low tolerance for risk, we will likely use bond substitutes only minimally.
If you have concerns about the bond portion of your investment portfolio, please do not hesitate to reach out to your portfolio manager to engage in a conversation about strategies we are employing to increase income using bond substitutes.
We wish you and your families a happy, healthy, and prosperous 2021. Thank you again for your trust in our firm’s ability to navigate your retirement savings through this uncertain time.
Sincerely,
Pekin Hardy Strauss Wealth Management
[1] Source: Deutsche Bank.
This commentary is prepared by Pekin Hardy Strauss, Inc. (dba Pekin Hardy Strauss Wealth Management, “Pekin Hardy”) for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any security. The information contained herein is neither investment advice nor a legal opinion. The views expressed are those of the authors as of the date of publication of this report, and are subject to change at any time due to changes in market or economic conditions. Although information has been obtained from and is based upon sources Pekin Hardy believes to be reliable, we do not guarantee its accuracy. There are no assurances that any predicted results will actually occur. Past performance is no guarantee of future results. The S&P 500 Index includes a representative sample of 500 hundred companies in leading industries of the U.S. economy, focusing on the large-cap segment of the market. The Consumer Price Index (CPI) is an unmanaged index representing the rate of the inflation of U.S. consumer prices as determined by the U.S. Department of Labor Statistics.
