Today’s podcast features a discussion about income. What it is, where to find it in today’s low-yield world, and how different fixed-income strategies can be used by investors. To discuss, we’re talking with George Bory, Managing Director and Head of Fixed Income Strategy and Product Specialists at Wells Fargo Asset Management.
Laurie King: I’m Laurie King and you are listening to On the Trading Desk®. Today I’ll be talking with George Bory, Managing Director and Head of Fixed Income Strategy and Product Specialists at Wells Fargo Asset Management. George has been a guest on our program several times and today he is launching what we might consider a “series within a series.” It’s called “Income Generator.” Welcome to the program, George.
George Bory: Hi, Laurie. Thanks for having me on.
Laurie: Income Generator is a title, but it sounds like it may be more. Why is it an important title for you? And why do you expect it will resonate with our listeners?
George: So the Income Generator, it’s an idea we hatched a few months ago, and the idea is to connect the fixed-income markets with our products.
It’s intended to provide a regular stream of commentary that focuses on the outlook for different parts of the bond market and how those outlooks connect with our different strategies and products.
Now for some, fixed-income markets tend to be opaque, and if you’re a casual observer, bond markets don’t get nearly as much attention as the equity markets do in the popular press. So what we would like to do is create a lens for our clients and internal partners to observe the big drivers in the bond market and how those drivers can impact their portfolios.
Income Generator, for us, is a product. So we may send out podcasts, write-ups, and maybe even host a webinar to discuss the outlook for fixed-income markets, but all that channeled through the product title of Income Generator should give our clients and our internal partners a point of focus to look for our ideas and themes that cut across fixed income.
Laurie: Well, that sounds very good, looking through the lens. So what are the challenges that investors are facing right now with bond portfolios?
George: Laurie, all fixed-income investors face three major challenges.
The first is liquidity management. The second is income generation, and the third is purchasing power protection.
Earlier this year, many investors were exclusively focused on liquidity management as volatility erupted following the outbreak of the COVID epidemic. Bond markets seized up and trading all but halted. However, the Fed intervened with extraordinary provisions to re-liquefy markets and restore some order to trading. Fortunately, their intervention worked and market activity quickly resumed to pre-COVID levels.
But in some ways, the Fed may have been too successful. Aggressive intervention led to a massive drop in interest rates, and in doing so, yields of most other U.S. dollar-denominated securities fell, as well.
As a result, income generation is getting more and more difficult for investors with each passing day.
What we like to say is it’s good to be a borrower, but it’s very tough to be a saver in today’s world. And so generating adequate income is a big part of our strategy and a big part of our focus.
But lower yields, it’s a double-edged sword. As yields dropped earlier this year, long bond returns—or bond returns in general—moved up considerably. And in fact, those positive returns were the cornerstone of many portfolios as volatility erupted.
But the drop in yields also caused real yields to turn sharply negative. A real yield is the difference between nominal yields and inflation. So while low nominal yields suggests limited future nominal returns, the prospect of locking in a negative return for 10—or as long as 30—years is difficult for many investors to accept.
As such, preserving purchasing power is quickly becoming the focal point for many of the yield-starved investors that we talk to each and every day.
Laurie: Okay, so let’s drill down into the second one: Income. So income can mean many things. To many, their primary income is from their job in the form of wages. Retirees may think of their retirement assets as a source of income. But when you’re talking about diversified sources of income, what do you mean?
George: When we talk about income, we’re talking about income generated by a portfolio of bonds.
It used to be that a long-term saver could safely assume that a well-diversified portfolio of bonds could generate a yield somewhere around 6%. 6% was a nice, steady savings rate. It offset the risk of price volatility in a bond portfolio. It offset credit risk, and it usually was considerably above where inflation might be in the broader market. So we could tick all three of those boxes I mentioned before.
However, as I mentioned before, today’s bond yields are much, much lower. And when we think about it, the cost of retirement, the cost of college, the cost of healthcare that hasn’t gone down. In fact, in many instances, it continues to go up. So what’s an investor to do?
So we need to do a few things. Number one, you need to reduce your expectations for future returns. Low yields tend to translate into low returns. Secondly, you need to increase your savings, but thirdly, and perhaps most importantly, you need to expand the universe of investment you’re willing to consider.
Now we’re not suggesting that you throw caution to the wind and put all of your money into something that’s very risky, but we are suggesting that in today’s yield-starved world, investors need to cast their net very broad to capture all available yields that are in today’s market. That includes looking at high-yield bonds, the municipal bond market, bonds outside the U.S., and then finally, we’ll even look at emerging markets.
So when we talk about diversified sources of income, we want to look at all forms of income and try to build a portfolio that’s well-diversified with relatively low correlations to be able to boost income as much as possible.
Laurie: Well, one strategy for income that I’ve heard you discuss is moving out the yield curve. What exactly does that mean? Can you give us an example?
George: Sure. So moving out the yield curve is the simple exercise of extending the maturity of your bond portfolio.
For example, it’s just simply selling a two-year bond and buying a five-year bond. So the maturity of that bond, you’ve extended by three years.
Now typically, an investor gets paid an additional yield for lending to a borrower for a longer period of time. When this happens, this is called a positively-sloped yield curve. However, the extra yield is not a static amount. It moves around over time as investor preferences change and economic conditions change.
Currently, an investor gets an extra 14 basis points [100 basis points equals 1%] to lend to the U.S. government for five years, rather than two years. Now admittedly, this is not too much of a yield increase in absolute terms. However, when you consider the current yield on the two-year is only 14 basis points, then a three-year extension allows you to double your yield by going from two to five years.
It’s these skinny yield pickups that can amount to substantial gains if a savvy investor picks the right part of the curve.
We try and identify what we would call the steepest part of the curve. That’s where you get the biggest pickup in yield for an incremental increase in maturity by looking at different bonds, different issuers, and different points along the curve.
By extending the duration, assuming yields stay the same, that bond will shorten in maturity as we move through time. What typically occurs is what’s called roll-down and that adds a certain amount of capital appreciation to the portfolio as the price of the bond goes up while yields come down.
So there is a certain amount of technicality there that goes along with the portfolio, but low yields plus roll-down, or the capital appreciation from rolling down the curve, can actually boost the overall total return of a portfolio, and that can really help, especially in an environment where yields are quite low.
Laurie: And that applies to other kinds of credit curves besides just the treasury curve, as well, like for corporate bonds. I’m sure you could point to some instances where there’s unique opportunities there, which brings me to my next question about credit, meaning both investment-grade and high-yield corporate bonds. What about using them as a source of income?
George: Well, corporate credit has become the cornerstone for a lot of portfolios.
If you look at today’s bond market, roughly almost half the bond market is made up of corporate bonds, and that’s up from roughly a third about a decade ago. So the corporate bond market has really expanded in size and is a large percentage of the available investments for bond investors.
Well, when we think about corporate bonds, we like to look at the entire spectrum. We try to identify what is the best relative value across the rating spectrum. And by moving down the rating spectrum, we can increase yield and enhance the running yield of a particular portfolio.
Our philosophy is to build portfolios from the bottom up. We like to focus on security selection. When we identify good credits, good companies that have either stable or improving cash flows, manageable balance sheets, and for the sake of a better term, rational management, those tend to be credits that look pretty attractive for a fixed-income portfolio.
Laurie: Now I know many of our listeners invest in municipal bonds. What opportunities are you seeing there? And how worried should investors be about credit risk given the pandemic’s effect on state and local budgets?
George: So municipals are not immune from the risks of the COVID pandemic.
And as many people have read about in the press, budgets are under pressure. Revenues have come down, but there seems to also be a meaningful redistribution of income as consumer behavior changes and people are changing their personal habits to adapt to this sort of new world we live in with respect to the risks of COVID.
So we do find value in municipal bonds. We have been pretty actively looking at municipals as a way to both diversify and maybe move out of some of the corporate debt into municipal debt.
Now when we look at high-yield, municipal high-yield is different than corporate high-yield. The probability of default within high-yield is limited to very specific components of the municipal market. For a state or a municipality—a taxing entity—to actually default, the probabilities are relatively low. Ratings can go down, but the actual event of default tends to be low. And so we try and segment our portfolio to focus on the issuers that have the most amount of financial flexibility, the least amount of default risk, and, hopefully, the municipalities and states that can adjust their budgets through time to be able to meet the demands of their citizens, as well as to balance the tax revenues that are coming into their funds each and every year.
Laurie: So I’d like to ask a little bit more about diversifying sources of income. And can you explain a little bit more in detail why U.S. investors may want to think about diversifying yield and currency exposure outside the U.S.? I mean, should they be doing that?
George: Diversification really comes down to one basic principle. You’re looking for bonds that have either a low or a negative correlation to your existing portfolio.
So by moving outside the U.S., you pick up a different volatility structure. The price of bonds from countries outside the U.S. are going to move based on different factors than bonds originated here in the U.S.
So there’s an element of currency differential—so the bonds may be denominated in a different currency—and then there’s difference in terms of economic differentials between the two countries or the two regions.
We have been looking for ways to diversify portfolios out of the U.S. into other markets. We look at both developed markets, so this would be places like Japan or Europe, but we also look at developing markets, so Mexico, Brazil, parts of Asia.
To be clear, this is typically a very small portion of a portfolio. We’re looking for incremental components, incremental portions of diversification where we’re getting appropriately paid.
The extra yield you get by going outside the U.S. can be very beneficial to a portfolio, especially when yields are so low.
Now we want to be very cognizant of the risks. We need to analyze the countries, their paying ability, and the economic policies that are underpinning those countries, but again, as we think about generating diversified sources of income, a small allocation to non-dollar bonds can be a nice diversifier to just a traditional dollar-based portfolio.
Laurie: And so George, do you have any last thoughts for our listeners to tie together all the ideas we’ve discussed today?
George: I think we can simple it down to just a few thoughts.
In the age of skinny bond yields, the trend is unlikely to go away. It’s likely to persist for the foreseeable future as monetary policy, fiscal policy, demographics, and political shifts all collide to create a slow-growth world for economic activity and low inflation.
It’s in this environment that bond investors should remain focused on the three principles we mentioned above. They should focus on liquidity management, diversified sources of income, and protecting their purchasing power wherever possible and as much as they possibly can.
Laurie: Well, thanks so much for joining us today, George.
George: Thanks for having me, Laurie. It’s always a pleasure to be on the show.
Laurie: For our listeners, if you’d like to read more market insights and investment perspectives from the fixed-income teams at Wells Fargo Asset Management, you can find them at our AdvantageVoice® blog, as well as on our website at http://on.wf.com/6123GWNbL. Until next time, I’m Laurie King; take care.
Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses.