Too many fixed income investors surprisingly do not pay close enough attention to their fixed income portfolios, mostly because they think their investments are safe and they think they have few other options for a safe portfolio. While fixed income yields are currently near record lows, investors can do far better with a mix of carefully selected fixed income securities. This choice could potentially more than double the yield as compared to a ‘traditional’ fixed income portfolio. At ACM, we construct such differentiated fixed income portfolios. Investors should not underestimate the impact of just an additional 1% on their fixed income portfolios. To give you some context, a 1% return will yield 10.5% profit over 10 years’ time while a 2% return will yield 21.9%. On a $300,000 initial investment that is an additional $34,300, which is not exactly a ‘sleepy’ amount of money. If an investor has a larger account or a longer time horizon, the impact of an additional 1% becomes even more significant.
Before I discuss the problems causing investors to ignore their fixed income, investors should refresh on the current fixed income market. Yields in fixed income have been extremely volatile over the past twelve months. While the 10-year Treasury yield is down more than 50% since the end of 2019, since August 2020 the yield has actually doubled. Correspondingly, the average investment grade bond is down over 1.75% in 2021 (based on Bloomberg Barclays US Corporate Bond Index). As a reminder, the average investment grade bond matures in over 12 years, yields around 1.9% and has a duration of 8.7 years. This is a substantial amount of interest rate risk for such a low yield. This year (so far), the entire year’s income has nearly been 100% offset by the loss in bond value.
Please see the table which illustrates the current and historical yields across a range of 5-year investment grade bonds. Please remember these are average yields for illustrative purposes.
Source: Bloomberg. LLC.
Note: Please note we quote benchmark yields which are a based on a large basket of bonds and not necessarily indicative of the yield of our strategies.
First, fixed income typically fails to get the attention it deserves in portfolios because of all the noise / distractions. Investors are easily distracted by equities, for example, by the short squeeze in GameStop. Did you read about GameStop and did you miss the decline in bond prices over that period? Also, fixed income also fails to attract attention because many investors own a balanced portfolio that shows all their equities and fixed income combined in one statement. This typically fails to highlight fixed income returns as the equity volatility will drive the vast majority of any increases or decreases in your account value.
Second, fixed income also gets neglected because of investors’ lack of familiarity with key concepts such as duration, coupons, and yields, which can be confusing. The most common confusion in the current environment is investors not understanding the difference between a security’s coupon and yield. For example, many investors look at the coupon or bond prices and think they are winning. For example, many investors may think a 4% bond trading at $112 maturing in 4 years is yielding just under 4% rather than the reality of yielding less than 1%. Please see the appendix of this commentary for a simple explanation. An investor, who thinks he is earning 4% when he is truly earning 1%, will falsely feel a sense of confidence that the fixed income portfolio is doing exceptionally well. Investors must remember as maturity approaches bond prices will go to par (100). Given the dramatic decline in yields over the past few years, over 95% of Investment Grade bonds currently trade above par (100), so investors will be seeing price declines over the next few years. That does not mean a security is not compelling, but you should be careful not to overestimate your yield.
Third, fixed income does not get the attention it deserves because investors think there is a lack of options. Investors dramatically underestimate the differentiation possible when constructing a fixed income portfolio. The obvious choice of investment grade versus high yield is just one major consideration. Even one investment grade portfolio can be extremely different from another. Variations include either selecting the highest quality bonds, which provide incremental safety but a very low yield, versus taking limited incremental credit risk for a much higher yield. An investment grade portfolio could be composed of all bonds or, alternatively, a combination of bonds and preferreds. A portfolio can include short, intermediate, or long-dated bonds. A portfolio may be actively managed or passively managed, and a passively managed portfolio will be less opportunistic as market conditions change. Finally, many investors only buy “brand name” bonds. These are the bonds issued by the most well-known companies and typically provide a much lower yield than alternatives that require more research, but provide incremental yield as a reward for the research done. In investment grade portfolios, the yield difference among the various options is often at least 1% even if the average duration is the same.
Investors can make their bond portfolios work harder on their behalf and respond to changing market conditions so by adjusting their portfolios to improve their yields. The decision to adjust your portfolio could potentially more than double the yield as compared to a ‘traditional’ fixed income portfolio that is simply held to maturity. At ACM, we construct differentiated fixed income portfolios using single securities to include mix of bonds and preferreds because we know an extra 1% yield will dramatically impact our clients’ portfolios over time.
Yield versus coupon – they should not be confused!
Investors who fail to recognize that yield and coupon are different are dramatically overestimating their yield. Yield is the annual income a bondholder is estimated to earn between now and when the bond is sold, redeemed, or matures. This reflects the coupon and any change in the price of the bond (as bonds mature at par =$100). The coupon is the stated annual interest payment the company agrees to pay to bondholders until the bond matures. The coupon rate does not change as the value of the bond increases or decreases, since the coupon is set when the company issued the bond. The yield is determined by the price other investors will pay the current bondholder to purchase that bond.
Example: Suppose a bond that matures in one year with a 4% coupon is currently trading at a price of $103 (par =$100). Every day you own the bond, you are earning the 4% coupon, but also suffering an erosion in value as the bond’s price declines towards par. A bond with a market price above par must suffer a price decline since the company has agreed to return exactly the principal, which is based on par value. So, if you choose not to sell it, you are accepting the return associated with buying it today at $103 and seeing its price drop to $100 when it matures.
By continuing to hold the bond for the year, you will receive $4 of interest (the coupon for one year) and $100 (par) at maturity for a total of $104 versus receiving $103 today by selling the bond. If you instead choose to sell the bond, you could then go reinvest the $103 of sale proceeds in another bond with a higher yield. By not selling, you are settling for a $1 profit for the next year ($104 of total proceeds in one year versus $103 today, $104-$103=$1 profit for one year). In this example, the coupon is 4%, but the yield is barely 1%. Your yield is NOT 4%! This misunderstanding has resulted in some investors failing to realize that they are now barely earning 1% on a traditional investment grade bond portfolio.