By Scott Welch, CIMA ®
Chief Investment Officer – Model Portfolios
Head of Fixed Income Strategy
Follow Kevin Flanagan @KevinFlanaganWT
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We last visited the topic of generating yield in an evolving market back in October, and it certainly is time to visit it again. We are sailing through volatile market seas these days, with rates rising, inflation fears mounting and geopolitical tensions as high as they have been in many years. How can investors continue to generate risk-controlled yield in this current environment?
First, let’s look at rates, and let’s start with the Treasury yield curve. While we’ve seen a distinct uptick in recent weeks, real Treasury yields remain negative across the entire maturity spectrum with the exception of the 30-year, which just inched into positive territory.
U.S. Treasury Real Yields (%)
While nominal Treasury rates have been volatile, we’ve seen a distinct upward trend, especially in the short end of the curve, as the market reacts to a decidedly more “hawkish” tone from the Fed. We think, with fits and starts, this upward trend will continue (and note the significant “flattening” of the curve, as measured by the 10-Year minus the 2-Year spread).
Speaking of the Fed, the market is now pricing in five rate hikes over the course of 2022, and many believe there may be more, resulting in a Fed Funds Rate well above 1.00% by year-end. Furthermore, the market is assuming an almost 100% probability the Fed will initiate rate hikes at its March meeting, and there is open discussion that 50 bps hikes will be on the table over the course of the year. That is a dramatic shift in sentiment and expectations from even 3–4 months ago.
Interestingly, the credit markets largely have yawned through all this recent uncertainty, suggesting that investors remain comfortable with default risk (although you will note the uptick in the most recent days).
For definitions of terms in the chart, please visit the glossary.
So, What Is a Yield-Seeking Investor to Do?
To summarize the above, we continue to believe that rates will grind higher, and inflation remains the story through at least the first half of 2022. All eyes and ears will be on the Fed as it tries to walk the proverbial tightrope between taming inflation and keeping the economy growing. So, rates are rising, and credit spreads remain tight—not a recipe for a great deal of optimism about risk-controlled total return potential in the fixed income markets.
What about finding yield in the equity markets? Using the information from above, let’s compare current nominal fixed income yields to current equity dividend yields. We see quite a reversal from a year ago, when equity yields were well above fixed income yields.
For definitions of terms in the chart, please visit the glossary.
Investors can now generate a higher level of current income in the bond market than in the equity market (which historically is the more “normal” situation). At the same time, we see increased risk in the fixed income markets and believe that dividends and stock buybacks may represent a more sustainable approach to generating current income.
Our own Model Portfolios remain short in duration and over-weight in credit with an explicit focus on quality security selection relative to the Bloomberg U.S. Aggregate Index (the “Agg”). We definitely are not looking to take excessive risk in our fixed income portfolios in a “reach for yield.”
That said, here are some ideas and solutions that may be of interest.
Fixed Income Strategy Ideas
Obviously, the investment landscape within the fixed income arena is certainly a challenging one. The combination of Fed rate hikes and continued elevated inflation requires a proactive approach to navigate what ultimately lies ahead for the bond investor.
A time-tested approach for a rising rate environment can center around the barbell strategy, where a core bond holding is complemented by a “zero-duration” solution. WisdomTree offers three unique approaches to the “zero-duration” or rate-mitigating strategy portion of the barbell:
- A U.S. government securities-based solution based on floating rate Treasury notes: the WisdomTree Floating Rate Treasury Fund (USFR)
- An investment-grade strategy that combines a long position in bonds representative of the Agg with a short position in Treasury securities to target zero duration: the WisdomTree Interest Rate Hedged U.S. Aggregate Bond Fund (AGZD)
- A “core-plus” approach that combines bonds representative of the WisdomTree U.S. High Yield Corporate Bond Fund and a short position in Treasury securities to target zero duration: the WisdomTree Interest Rate Hedged High Yield Bond Fund (HYZD)
Investors seeking additional yield opportunities may want to consider the WisdomTree Alternative Income Fund (HYIN). HYIN is an alternative credit vehicle that allows investors to “tap” into an asset class to which it has been difficult to gain broad-based exposure. In addition, alternative credit has exhibited less sensitivity to changes in interest rates.
Model Portfolio Ideas
WisdomTree manages three specific Model Portfolios that are yield- and income-oriented—our Siegel-WisdomTree Longevity, Global Dividend and Global Multi-Asset Income Model Portfolios.
These Model Portfolios focus on generating all or the majority of the current yield out of the equity allocations versus the fixed income allocations.
Let’s look at the current yield of these Model Portfolios (as of December 31, 2021).
“Current Yield/Income” refers to the most recently posted 12-month dividend yield as indicated here.
Now, let’s combine all of this into hypothetical “typical” client portfolios.
Today’s market environment is fraught with risks for fixed income investors. Despite the pickup in nominal yields, we continue to believe that taking excessive risk in the fixed income market is not a prudent approach. We believe a more appropriate approach is to focus on the global equity markets to generate yield while still maintaining an appropriate fixed income allocation, both for income generation and as a hedge to equity beta risk.
Today’s yield environment is in a state of flux, and things are likely to get more unclear before they get better. But in today’s yield-starved world, we believe you can still build intelligent portfolios that may potentially generate an optimal level of yield without taking excessive risk.
Originally published by WisdomTree on February 10, 2022.
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