Fixed income investors, including retirees, are dealing with a variety of headwinds this year. For example, yields on conservative bond segments, namely Treasuries and municipal bonds, are so low, it’s relevant to ask if those areas are even worth the trouble.
Predictably, yields on short-term bonds and the related funds are exceptionally low. Problem is, investors aren’t getting much in the way of compensation for taking on more duration. Typically, as interest rate risk increases, investors are compensated in a somewhat notable fashion for that risk. That’s not happening this year.
“As of August 2021, the average short-term bond fund had an SEC yield of 0.95% and a duration of 2.2 years. Meanwhile, the average core bond fund had a yield of 1.21% and a duration of 5.9 years. This means that investors pick up only 26 basis points of expected yield while almost tripling the risk associated with rising interest rates,” says Morningstar analyst Brian Moriarty.
Making matters worse for bond investors is that credit spreads are narrow, meaning that the compensation investors expected to earn for opting for corporate debt, including junk bonds, over Treasuries isn’t all that great this year. Even core bond funds that feature corporate debt and junk issues aren’t sporting exceptional yields.
“The average core-plus bond fund had an SEC yield of 1.70% and a duration of 5.7 years. So, the average yield pickup was 49 basis points over core bond funds, while interest-rate sensitivity was just marginally lower. The differences here are driven by the categories’ different exposures to junk-rated debt, with core bond funds limited to 5% max while core-plus bond funds can range from 5% to 25%,” notes Moriarty.
Even multi-sector bond funds are only providing minimal perks this year and that comes with elevated risk, but these funds aren’t perfect.
“Multisector funds will certainly lag the other three categories during credit crises. During the COVID-19 panic in early 2020, the average multisector fund lost 14.1%, more than double the average loss of core-plus funds. While the average SEC yield on multisector funds is about 100 basis points higher than the yield on core-plus funds, investors need to decide if that compensates for potential double-digit losses,” adds Moriarty.
This year, investors don’t have a lot of choices when it comes to generating income with fixed income. Taking on lower rate risk either means accepting less yield or elevated credit risk. If there’s a silver lining, it’s that defaults are low this year, perhaps indicating yield is worth reaching for with credit.
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