Q4 Bond Compass: Barbelling Credit and Defensives
As investors head into the fourth quarter and the effects of the coronavirus delta variant linger, bond portfolios face a multitude of variables that may impact their trajectory over the coming months. These issues are set against a backdrop of the recent hawkish tilt from the Federal Reserve (Fed), which said in September that it may start tapering by November, with a potential rate hike next year.1 After the Fed’s September meeting, it was revealed that nine of the 18 Fed officials expect the central bank to begin raising rates next year2 – up from seven at June’s meeting.3
While rate hikes may be off in the future, we do expect long-term rates to rise as the Fed starts to normalize policies and pandemic-related factors such as supply chain disruptions, consumer demand and employee shortages continue fueling inflationary forces, a situation that may be heightened during the holiday shopping season.4 This is why we feel that Treasury Inflation-Protected Securities (TIPS) may be the more attractive defensive treasury position once again next quarter, as opposed to nominals.
Yet rates will still be low relative to historic standards, and on a real basis. Currently, 78 percent of all investment-grade bonds trade below the market’s expectation for inflation over the next 10 years5 (10-year breakeven rates are 2.37 percent).6 As a result, there are not a lot of positive real income opportunities in the largest part of the bond market, exacerbating the challenge of generating income in our low but rising rate environment.
With a significant amount of long-dated issuance coming to market (both corporate and Treasury), duration profiles for investment-grade bonds have become extended. For instance, the duration on the Bloomberg US Aggregate Bond Index (Agg) has increased from six years before the pandemic to 6.6.7 As a result, the yield-per-unit-of-duration profile of the broad Bloomberg US Aggregate Bond Index sits at 0.23 — a level 28 percent below that of the prior three-year average.8 Given our view for an upward bias on rates, taking on any extended duration risks to obtain a diminutive yield may not be a valuable trade-off in this market — from either an income or total return perspective.
In order to achieve higher portfolio yields, investors typically need to accept exposures with increased credit risks that often exhibit higher correlation to the equity market. Credit has benefited from some of the same forces that have propelled equity markets, including still accommodative policies and supportive growth.9
More so, the fears of China credit concerns spilling over into other areas of the global credit markets appear contained, evidenced by the fact that global high yield credit spreads registered an increase of just five basis points in the month of September – compared with the increase of 300 from the China high yield market.10 As a result, we are constructive on credit in this market to potentially produce positive real income and total return opportunities.
For the next quarter, a barbell of defensive real return treasury positions (TIPS) and high-income credit exposures may be a valuable allocation to navigate the low, and still uncertain, return environment, as the Fed starts to taper and the economy continues to reopen.
Focus on loans for real income and less rate risk
Despite taper talks and a more hawkish dot plot view, monetary policies are likely to continue to foster liquidity and the TINA (there is no alternative)-style risk taking that has been a tailwind for credit markets. Positive rating trends offer fundamental support for this outlook on credit, as the ratio of high yield upgrades-to-downgrades is at the highest level ever.11 Return momentum is also in credit’s favor, as below-investment-grade bonds have posted gains in 18 out of the past 20 months, while core global bonds are registering their worst return since 2005 given the rise in rates this year.12
Credit, however, is not immune to duration headwinds, as yield curve changes have subtracted 176 basis points from high yield’s overall 4.54 percent return in 2021.13 And within investment-grade bonds, the impact has been even worse as curve changes have pushed returns negative on the year.14 Senior loans, with their floating rate structure, have been able to sidestep duration-induced price declines while still participating in the credit rally. Yield curve changes so far this year have been negligible for loans, a fact underscored by loans outperforming the more duration-sensitive investment-grade corporate bond market (+580 basis points).15
Looking ahead, senior loans’ floating rate structure may prove to be even more valuable should rate hikes impact the short end of the curve. In addition to mitigating any potential duration-induced return headwinds, loans’ floating rate component increases the potential yield as the securities’ underlying coupons adjust to the prevailing short-term market rate they are tied to (the London Interbank Offered Rate, or LIBOR).
Beyond the potential benefit of limiting rate sensitivity, senior loans might be an effective tool for generating potential real income, as yields are above breakevens and comparable to high yield corporate bonds. Senior loans currently yield 3.71 percent,16 just below high yield corporates’ 4.04 percent, but with far less interest rate risk due to the frequent resetting of loans’ coupon payments. The chart below illustrates senior loans’ strong yield-per-unit-of-duration, underscoring their potential to generate high income while mitigating any duration-induced price impacts.
Additionally, if the credit rally does stall (even though loan defaults are expected to remain near all-time lows through the remainder of 2021 and into 202218) or if macro risks pile up, loans are more senior in their capital structure and historically have witnessed lower relative levels of volatility than fixed-rate high yield (4.67 percent vs. 6.73 percent).19 The downside deviation for loans is also better than high yield (7.53 percent vs. 11.95 percent).20
Overall, loans’ lower volatility profile relative to fixed-rate high yield, potential to generate higher income, and floating rate structure that can reduce the negative impact of higher rates, make loans an integral part of a diversified credit portfolio in this environment.
For an actively managed senior loan exposure that may add more value over an indexed approach through credit selection, consider the SPDR® Blackstone Senior Loan ETF (SRLN).
Preferreds may offer real yield and diversification
With the economic backdrop likely to remain conducive for risk-taking, an overweight to hybrid exposures such as preferred stocks may be warranted for those in search of a real yield that may also provide additional diversification beyond pure credit.
For starters, preferreds currently generate yields higher than inflation expectations (4.64 percent vs. 2.37 percent)21 and are more favorable than high yield bonds, even though they are primarily investment-grade rated.22 As shown below, preferreds out-yield all other traditional and income-sensitive segments. As a result, given the low rates around the world, a potential 4 percent-plus yield for a group of primarily investment-grade-rated securities, and not just junkier credits, is worth considering.
Preferreds may also help to enhance overall portfolio diversification. Due to regulatory and rating agency capital requirements, preferred securities tend to be issued primarily by financial institutions, such as banks and insurance companies. Thus, relative to their credit counterparts, preferreds are heavily allocated toward Financials (73.30 percent),23 which strengthens their credit quality profile. The banking sector is one area that may benefit should rates rise, as bank margins benefit if the long end of the yield curve rises. Outside of financials, preferreds also provide exposure to a variety of other sectors including Utilities (14.04 percent),24 Real Estate (6.88 percent)25 and Communications (4.53 percent).26 Because this differs from their credit counterparts that provide more exposure to the volatile Energy sector,27 adding preferreds to the mix can help to diversify credit sector exposures.
Cross-asset correlation impacts should be on investors’ portfolio construction checklist, especially as we enter the fourth quarter that historically has been a volatile time for markets.28 Preferreds are both bond- and stock-like, and as a result their correlation profile is low relative to both asset classes. Their correlation to basic US Treasuries is very low at 0.04 over the past 15 years (based on monthly returns).29 They also have a 0.42 correlation or less to equity-sensitive high yield bonds and to equities themselves — from all parts of the world.30 Preferreds’ volatility profile (5.78 percent)31 is also lower than that of common stocks (13.21 percent)32 and credit-sensitive high yield bonds (6.73 percent).33
Overall, in a market with low rates and abundant macro risks, preferred security exposures, like the SPDR® ICE Preferred Securities ETF (PSK), could possibly add high income to a bond allocation without outsized volatility and equity risk.
Include TIPS for a defensive ballast in portfolios
Barbelling credit with TIPS could add another real income stream, this time from the defensive side of the bond portfolio. Because TIPS are backed by the full faith and credit of the US government, they have low credit risk and investors can be assured that they will never receive less than the original face value of the bond at maturity, even in the event of deflation during the life of the bond. Adding TIPs to a portfolio also could help counteract some of the equity risk introduced by overweights to credit.
US inflation expectations, as measured by the 10-year breakeven inflation rate, are above the 10-year average. Similarly, personal consumption expenditures, which the Fed uses as its inflation gauge, saw the largest annual increase since 1991.34 US personal spending recently increased 0.8 percent from a month earlier, following a downwardly revised 0.1 percent decline in July.35 Price increases are being felt across many advanced economies because of pandemic-related factors such as supply chain disruption, consumer demand and employee shortages. As a result, so far this year owning TIPS instead of nominals has been a beneficial swap, as TIPS have outperformed nominals by 5.98 percent.36 TIPS have also outperformed the Agg by 4.94 percent,37 even though they have a longer duration (8.4 years versus 6.97).38 Given that inflationary forces will likely remain high (still-accommodative policies even with a taper, plus increased fiscal spending), a TIPS allocation may continue to be rewarded.
As a distinct asset class from Treasuries — and not a component of the widely followed Bloomberg US Aggregate Bond Index — TIPS tend to behave differently from other investments that are commonly found in core bond portfolios. TIPS are not perfectly correlated to common fixed income investments and have a low correlation to equities, making them a valuable portfolio diversifier. Thus, including TIPS may help improve the risk/return profile of a diversified portfolio irrespective of the market’s inflation dynamics.
Investors may want to consider the SPDR® Portfolio TIPS ETF (SPIP) to add a source of real income and diversification for defensive positioning. Because TIPS ETFs pay out all earned income in the portfolio, including the inflation adjustment that is applied to the fund's underlying securities (unlike individual TIPS), a TIPS ETF may be a better source of current real income than owning TIPS outright.
1 Forbes.com, September 22, 2021. “September FOMC Meeting: Tapering ‘May Soon be Warranted.’”
2 Reuters, September 22, 2021. “Fed signals bond-buying taper coming ‘soon,’ rate hike next year.”
3 CNBC, June 16, 2021. “The Federal Reserve now forecasts at least two hikes by the end of 2023.”
4 Bloomberg, October 7, 2021. “Buttigieg Warns Supply Chain Trouble Will Hit Holiday Shopping.”
5 Bloomberg Finance, L.P., as of September 30, 2021. Based on yield-to-maturity of bonds in the Bloomberg US Aggregate Bond Index.
6 Bloomberg Finance, L.P., as of September 30, 2021.
7 Bloomberg Finance, L.P., as of September 30, 2021.
8 Bloomberg Finance, L.P., September 30, 2018 – September 30, 2021.
9 Bloomberg Finance, L.P., August 1, 2001 – September 30, 2021. High yield represented by the Bloomberg Barclays US Corporate High Yield Index.
10 Bloomberg Finance, L.P., as of September 30, 2021, based on the ICE BoFA Global High Yield Index and the Bloomberg Asia Ex-Japan USD Credit China HY Index.
11 Bloomberg Finance, L.P., as of September 30, 2021. Based on S&P ratings.
12 Bloomberg Finance L.P., as of September 30, 2021, based on the Bloomberg Global Aggregate Bond Index and the Bloomberg US High Yield Index.
13 Bloomberg Finance, L.P., as of September 30, 2021. High yield represented by the Bloomberg Barclays US Corporate High Yield Index.
14 Bloomberg Finance, L.P., as of September 30, 2021. IG corporates represented by the Bloomberg US Corporate Investment Grade Index.
15 Bloomberg Finance, L.P., as of September 30, 2021.
16 S&P Dow Jones, as of September 30, 2021. Measured using the S&P LSTA Leveraged Loan 100 Index’s yield-to-maturity.
17 Bloomberg Finance, L.P., as of September 30, 2021. High yield represented by the Bloomberg Corporate US High Yield Bond Index yield-to-worst.
18 Blackstone Credit, as of August 31, 2021.
19 FactSet, September 30, 2011 – September 30, 2021.
20 FactSet, September 30, 2018 – September 30, 2021.
21 Bloomberg Finance, L.P., as of September 30, 2021. Preferreds represented by the ICE BofA hybrid Preferred Securities Index. Inflation represented by the US 10-year breakeven rate.
22 Bloomberg Finance, L.P., as of September 30, 2021. Preferreds represented by the ICE BofA hybrid Preferred Securities Index.
23 Bloomberg Finance, L.P., as of September 30, 2021. Preferreds represented by ICE Exchange-Listed Fixed & Adjustable Rate Preferred Securities Index.
24 Bloomberg Finance, L.P., as of September 30, 2021. Preferreds represented by ICE Exchange-Listed Fixed & Adjustable Rate Preferred Securities Index.
25 Bloomberg Finance, L.P., as of September 30, 2021. Preferreds represented by ICE Exchange-Listed Fixed & Adjustable Rate Preferred Securities Index.
26 Bloomberg Finance, L.P., as of September 30, 2021. Preferreds represented by ICE Exchange-Listed Fixed & Adjustable Rate Preferred Securities Index.
27 Bloomberg Finance, L.P., as of September 30, 2021. High yield represented by the Bloomberg High Yield Corporate Bond Index. Preferreds represented by ICE Exchange-Listed Fixed & Adjustable Rate Preferred Securities Index. The index has a 13.36 percent weight to energy while preferreds have a 0.73 percent exposure to energy.
28 State Street Global Advisors, Bloomberg Finance, L.P., as of September 30, 2021. All three months’ average CBOE VIX Index readings being at or above 20 since 1994, unlike any other quarter.
29 FactSet, as of September 30, 2021. Based on 15-year monthly returns. Preferreds represented by the ICE BofA hybrid Preferred Securities Index.
30 FactSet, as of September 30, 2021. Based on 15-year monthly returns. Preferreds represented by the ICE BofA hybrid Preferred Securities Index.
31 FactSet, September 30, 2011 – September 30, 2021. Preferreds represented by the ICE BofA hybrid Preferred Securities Index. Volatility represented by standard deviation.
32 FactSet, September 30, 2011 – September 30, 2021. Common stocks represented by the S&P 500 Index. Volatility represented by standard deviation.
33 FactSet, September 30, 2011 – September 30, 2021. High yield represented by Bloomberg High Yield Corporate Bond Index. Volatility represented by standard deviation.
34 Bloomberg Finance, L.P., as of August 31, 2021.
35 Bloomberg Finance, L.P., as of August 31, 2021.
36 FactSet, as of September 30, 2021. Based on the Bloomberg US Treasury Index and the Bloomberg US Govt Inflation-Linked All Maturities Index.
37 FactSet, as of September 30, 2021. Based on the Bloomberg US Aggregate Bond Index and the Bloomberg US Govt Inflation-Linked All Maturities Index.
38 Bloomberg Finance, L.P., as of September 30, 2021. Based on the Bloomberg US Aggregate Bond Index and the Bloomberg US Govt Inflation-Linked All Maturities Index.
Glossary
Bloomberg Aggregate Bond Index
A benchmark that provides a measure of the performance of the US dollar-denominated investment-grade bond market. The “Agg” includes investment-grade government bonds, investment-grade corporate bonds, mortgage pass-through securities, commercial mortgage-backed securities and asset-backed securities that are publicly for sale in the US.
High Yield
A company or bond that is rated “BB” or lower is known as junk-grade or high yield, in which case the probability that the company will repay its issued debt is deemed to be speculative.
Investment-Grade Credit
A fixed income security, such as a corporate or municipal bond, that has a relatively low risk of default. Bond-rating firms, such as Standard & Poor’s, use different lettered descriptions to identify a bond’s credit quality. In S&P’s system, investment-grade credits include those with “AAA” or “AA” ratings (high credit quality), as well as “A” and “BBB” (medium credit quality). Anything below this “BBB” rating is considered non-investment-grade.
Senior Loans
Floating-rate debt issued by corporations and backed by collateral, such as real estate or other assets.
Treasuries
The debt obligations of a national government. Also known as “government securities,” Treasuries are backed by the credit and taxing power of a country, and are thus regarded as having relatively little or no risk of default.
Volatility
The tendency of a market index or security to jump around in price. Volatility is typically expressed as the annualized standard deviation of returns. In modern portfolio theory, securities with higher volatility are generally seen as riskier due to higher potential losses.
Yield
The income produced by an investment, typically calculated as the interest received annually divided by the price of the investment. Yield comes from interest-bearing securities, such as bonds and dividend-paying stocks.
Disclosure
Important Risk Discussion
The views expressed in this material are the views of Matthew Bartolini and Emily Theurer through the period ended September 30, 2021, and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
Investing involves risk, including the risk of loss of principal.
Diversification does not ensure a profit or guarantee against loss.
Prior to February 26, 2021, the SPDR Blackstone Senior Loan ETF was known as the SPDR Blackstone/GSO Senior Loan ETF.
Prior to May 1, 2021, the SPDR ICE Preferred Securities ETF was called SPDR Wells Fargo Preferred Stock ETF.
This communication is not intended to be an investment recommendation or investment advice and should not be relied upon as such.
The value of the debt securities may increase or decrease as a result of the following: market fluctuations, increases in interest rates, inability of issuers to repay principal and interest or illiquidity in the debt securities markets; the risk of low rates of return due to reinvestment of securities during periods of falling interest rates or repayment by issuers with higher coupon or interest rates; and/or the risk of low income due to falling interest rates. To the extent that interest rates rise, certain underlying obligations may be paid off substantially more slowly than originally anticipated and the value of those securities may fall sharply. This may result in a reduction in income from debt securities income.
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The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without State Street Global Advisors’ express written consent.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of the information, nor liability for decisions based on such information, and it should not be relied on as such.
Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Investing in high yield fixed income securities, otherwise known as “junk bonds,” is considered speculative and involves greater risk of loss of principal and interest than investing in investment-grade fixed income securities. These lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
Actively managed funds do not seek to replicate the performance of a specified index. An actively managed fund may underperform its benchmarks. An investment in the fund is not appropriate for all investors and is not intended to be a complete investment program. Investing in the fund involves risks, including the risk that investors may receive little or no return on the investment or that investors may lose part or even all of the investment.
Passively managed funds hold a range of securities that, in the aggregate, approximates the full Index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index.
Investments in senior loans are subject to credit risk and general investment risk. Credit risk refers to the possibility that the borrower of a senior loan will be unable and/or unwilling to make timely interest payments and/or repay the principal on its obligation. Default in the payment of interest or principal on a senior loan will result in a reduction in the value of the senior loan and consequently a reduction in the value of the portfolio’s investments and a potential decrease in the net asset value (NAV) of the portfolio. Securities with floating or variable interest rates may decline in value if their coupon rates do not keep pace with comparable market interest rates. Narrowly focused investments typically exhibit higher volatility and are subject to greater geographic or asset class risk. The fund is subject to credit risk, which refers to the possibility that the debt issuers will not be able to make principal.
State Street Global Advisors Funds Distributors, LLC is the distributor for some registered products on behalf of the advisor. SSGA Funds Management has retained Blackstone Liquid Credit Strategies LLC as the sub-advisor. State Street Global Advisors Funds Distributors, LLC is not affiliated with Blackstone Liquid Credit Strategies LLC.
Because of their narrow focus, financial sector funds tend to be more volatile. Preferred securities are subordinated to bonds and other debt instruments, and will be subject to greater credit risk. The municipal market can be affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. The fund may contain interest rate risk (as interest rates rise bond prices usually fall); the risk of issuer default; inflation risk; and issuer call risk. The Fund may invest in US dollar-denominated securities of foreign issuers traded in the United States.
Investments in emerging or developing markets may be more volatile and less liquid than investments in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems that have less stability than those of more developed countries.
Weekly Fixed Income Commentary: Treasury yields decline as growth concerns continue
U.S. Treasury yields fell again last week, supporting core fixed income returns. However credit spreads continued to widen on economic growth concerns.
Weekly Fixed Income Commentary: Treasury yields decline over growth concerns
U.S. Treasury yields declined for the first time in six weeks.
Weekly Fixed Income Commentary: Treasury yields rise as Fed downplays larger rate hikes
U.S. Treasury yields rose again despite last week’s Federal Reserve meeting, at which the central bank hiked rates by 50 basis points.