Income is powerful. Compounded income is even more powerful over time. For example, take the Bloomberg US Aggregate Bond Index where income has been a significant driver of its overall total return since inception (see Exhibit 1). While some investors tend to get hung-up on the threat of rising interest rates, the cumulative price return is dwarfed by the cumulative total return. Why? Income.
Despite recent upside volatility, bond yields have trended lower over recent years and many investors have looked to higher-yielding asset classes for additional income. But we think that reaching for yield in today’s environment with stretched valuations may do more harm than good.
What might be a more sensible approach to balancing income and risk? We can think of three:
Don't shun core bonds. Interest rate exposure can help mitigate downside risk. This is why high-quality bonds have such an important role to play in a well-diversified portfolio. Exposure to high-quality fixed income offers relative stability when markets become volatile, and liquidity that can help investors reposition portfolios when risk assets become volatile. Yes, yields today are low by historic standards, and forward returns are likely to be muted. It’s a similar story for stocks, too. Shortening duration may be enticing today, but shorter duration bonds pack less of punch when risk increases in markets.
Don’t forget that the Bloomberg US Aggregate Bond Index—a common proxy for core bonds—has put in only four years of negative calendar year returns since its inception in 1976. This happened in 1994, 1999, 2013, and 2021 when the index returned -2.9%, -0.8%, -2.0%, and -1.5%, respectively. Since its inception 46 years ago, the “Agg” has offered positive returns in 90% of rolling one-year periods1. While the last few months have been challenging for high quality core fixed income - remember higher yields mean more income and better potential returns going forward.
Consider municipal bonds. If taxes matter to you, the after-tax income potential that municipal bonds offer should too. This is especially so when it comes to medium-grade and lower-rated municipal credit. If the highest marginal tax rate were to increase, the tax benefit of owning municipal bonds is likely to increase as well. What’s more, municipal bonds have benefitted from a strong US economic recovery. Tax revenues have swelled, leading to improved overall credit health for municipal issuers. For example, state rainy day fund balances reached $113 billion in fiscal year 2021 – a new record level – on the heels of stronger than forecasted tax receipts2.
With AAA-rated municipal yields low, we think it may make sense for investors to seek opportunities in mid-grade muni credit and even select exposure to high-yield munis. Strong state tax revenues suggest to us that investors are being reasonably compensated for the added risk. For example, on a taxable-equivalent basis, high-yield municipals offer a yield advantage relative to high-yield corporates. BBB-rated municipals offer a similar advantage on comparably rated corporate debt. And here’s the kicker: Municipals have historically offered a much better historical default experience than corporate bonds, especially in the speculative grade part of the market and better diversification against equity volatility than corporate bonds, too3.
Consider casting a wider net. There may be income to be had beyond traditional core bonds and high-yield corporate debt. That’s why we think it may make sense for investors to widen the opportunity set by selectively integrating less traditional income generators, or so-called “satellite” asset classes. We’re talking about bank loans, emerging-market debt, and several equity sectors (EAFE, infrastructure, real estate). The reference yield for these asset classes is generally on par with or in excess of that available within both traditional investment grade “core fixed income” and high yield corporate debt. For example, nearly 50% of stocks in the S&P 500 yield more than 10-year Treasuries4.
We think many of these “satellites” may stand to benefit from market trends that appear to be gaining momentum. For example, EAFE equities and EM debt would likely do well if the US dollar weakens; infrastructure investment and a move toward clean energy should benefit infrastructure equities; higher inflation would burnish the appeal of real estate equities. This ties into our notion of seeking sustainable yield, rather than “stretching for yield.” In the lower return/higher volatility world we foresee, one way to potentially improve investor outcomes may be to incorporate a diverse basket of these higher-yield “satellites” into a diversified portfolio.
We believe the stability of an investor’s total returns can be enhanced by increasing the component coming from income, which tends to be more reliable than price appreciation.
1 Source: Barclays Live. As of 1/31/2022. 2 Source: National Association of State Budget Officers. Fiscal 2021 are preliminary actual figures. 3 Source: Moody’s Investors Service. US municipal bond defaults and recoveries report. As of 7/9 2021. 4 Source: FactSet. As of 12/31/2021.
About the Authors
Tim Ramsey, Equity Strategist, Goldman Sachs Asset Management
Matthew Wrzesniewsky, Fixed Income Strategist, Goldman Sachs Asset Management