The U.S. investment-grade bond market has offered a sub-3%
yield for 14 consecutive quarters, as measured by the Barclay's
Aggregate bond index. No wonder investors have lost interest in
traditional higher-rated bonds.
What has caught their attention instead? Asset class
At a time of ultra-low bond yields and more compressed
expected equity returns, and while stocks are typically more
volatile than bonds, investors are increasingly opting for stocks
that are behaving "bond-like" to generate income as well as
riskier bonds, which have the side effect of building equity-like
exposure - and risk -in their bond portfolio. This approach,
however understandable, comes with its own hazards. Here's
Certain income stocks are looking expensive.
When it comes to generating income with stocks, many investors
have pursued equity sectors that may offer high dividend yields
and potentially less price swings than the overall market. Think
real estate, telecoms, utilities and consumer staples.
But while many bond proxies, such as utilities and real
estate, have outperformed in 2014 given the renewed move lower in
interest rates, these historically higher dividend yielding
sectors have underperformed the overall market since 2011 amid
improving economic activity. In addition, while some of the
valuation premium of the bond proxy equity sectors has come off
in recent years, they are still somewhat expensive relative to
recent history. For example, relative price-to-forward earnings
ratios for utilities are at the upper end of their historical
Riskier bonds can limit diversification and look
Meanwhile in the bond market, investors have traded interest rate
risk for credit risk during the past few years (and they've been
amply rewarded for doing so).
While this strategy may limit losses when rates rise again,
investors have essentially "doubled up" their equity market risk
as they raise allocations to high yield bonds. As my colleague
Del Stafford recently wrote,
the high yield bond market has a correlation of roughly .74 to
. If high yield has similar risks to stocks, investors are
surrendering the value of diversification and potentially taking
the same bet twice.
Although attractive in a "lower for longer" rate environment,
these cross-dressing asset classes are also relatively expensive.
And if interest rates eventually do resume their move higher, as
I expect, I would be leery of segments of the market that require
low yields to justify their valuations. Here are five investing
ideas I would focus on instead:
Pursue international and global dividend
While I'd be wary of seeking income at all costs (i.e. don't be
agnostic to valuations), that's not to say there aren't certain
market segments that are worth pursuing, especially given that
equities continue to look cheaper than bonds.
One segment I believe investors should consider is
international and global dividend funds, rather than funds
focused exclusively on U.S. dividends. The reason: U.S. dividend
funds look the most expensive, and dividend yields in the United
States are low compared to those in the rest of the world (stay
tuned for more on this potential opportunity in an upcoming
post). In addition,
I also like the global financials and technology
for their cyclical exposure and relatively inexpensive
valuations, and dividends have grown especially fast in these
sectors as well in recent years.
Harvest capital gains:
If it's income you're after, what better way to generate income
than to harvest long-term capital gains in high yield bonds? The
resulting potential "income" stream would accrue more favorable
tax treatment than interest and would lock in gains at expensive
levels. The alternative - letting your winners ride at a below 6%
yield - seems like a risky proposition.
Rebuild your bond ballast:
With yields on high yield bonds south of the 6% mark, I believe
investors are no longer being sufficiently compensated for the
risk they're taking and I see limited opportunity for high yield
price appreciation. While I remain neutral high yield, for
investors concerned about "cracks in the foundation" or "the next
shoe to drop," now may be a good time to trim exposure and
replace it with bond ballast, such as municipal bonds.
If higher interest rates were to undermine stocks, correlations
between stocks and bonds would likely rise. With U.S. stocks
fully valued and high yield bonds offering little value, liquid
alternative structures that enable investors to go long and short
a specific market, such as within equity and credit markets,
would have the potential to outperform. Read more on this
in BlackRock's latest market outlook
, and remember that while long/short strategies can be risky,
they can also potentially offer a differentiated source of return
in a well-rounded portfolio.
With volatility as low as it is today, now would be a good time
for investors to consider purchasing insurance in the event of a
Federal Reserve (Fed)-induced market correction,
I suggested in a recent post
Eventually, the Fed will normalize policy and the allure of
using stocks as bonds and vice versa will fade. Until then,
you'll want to make sure you look under the hood - there may be a
wolf disguised as grandma.
Sources: Linked to throughout Post, BlackRock research
Russ Koesterich, CFA, is the Chief Investment Strategist
for BlackRock and iShares Chief Global Investment Strategist.
He is a regular contributor to
and you can find more of his posts
Kurt Reiman is a Global Investment Strategist at BlackRock
who works directly with Russ Koesterich. He contributed to this
post by providing research and investment insights.
Past performance does not guarantee future results.
Diversification and asset allocation may not protect against
market risk or loss of principal.
Fixed income risks include interest-rate and credit risk.
Typically, when interest rates rise, there is a corresponding
decline in bond values. Credit risk refers to the possibility
that the bond issuer will not be able to make principal and
interest payments. Non-investment-grade debt securities
(high-yield/junk bonds) may be subject to greater market
fluctuations, risk of default or loss of income and principal
than higher-rated securities.
International investing involves risks, including risks
related to foreign currency, limited liquidity, less government
regulation and the possibility of substantial volatility due to
adverse political, economic or other developments. These risks
often are heightened for investments in emerging/ developing
markets or in concentrations of single countries. There is no
guarantee that dividends will be paid.
Investing in alternative strategies such as a long/short
strategy, presents the opportunity for losses which exceed the
principal amount invested. Securities based on volatility are
subject to greater risks than traditional securities and may not
be suitable for all investors.
The information provided is not intended to be tax
advice. Investors should be urged to consult their tax
professionals or financial advisors for more information
regarding their specific tax situations.
This material represents an assessment of the market
environment at a specific time and is not intended to be a
forecast of future events or a guarantee of future results. The
strategies discussed are strictly for illustrative and
educational purposes and should not be construed as a
recommendation to purchase or sell, or an offer to sell or a
solicitation of an offer to buy any security. There is no
guarantee that any strategies discussed will be effective.