Last year, the Federal Reserve took interest rates took historic lows in response to the coronavirus pandemic. One of the effects of that response is advisors hearing more and more about difficulties in sourcing adequate income for client portfolios.
If you're an advisor in that boat, take a bow. You have every right to declare “income exasperation.” Trouble is, as evidenced by the most recent batch of meeting minutes from the Federal Open Market Committee (FOMC), U.S. interest rates will be low for some time. Even with the recent rise in Treasury yields, the after-tax yield situation currently facing advisors and clients is ominous.
“When yields on the Bloomberg Barclays US Aggregate Bond Index (US Agg) were 3.6% back in 2018, the after-tax yield was 2.27%,” said Matthew Bartolini, head of SPDR Americas Research, in a recent note. “That was above the average rate of inflation and more than equities on a pre-tax basis, along with 80% lesser volatility. However, current yields on the US Agg are 1.2% pre-tax and 0.76% post-tax. On a global basis it’s even worse, with the Global Agg yielding 0.91% pre-tax and 0.57% post-tax.”
Ex-US sovereign debt has often been a go-to for advisors looking for some added yield for income-starved clients, but that well is running dry, too. As Bartolini points out, the amount of global debt sporting yields of less than 1% is more than the entire market capitalization of the S&P 500. In fact, there isn't a single major developed economy with yields north of 1.42%.
Solutions Abound, Not Much Imagination Required
A traditional approach to coping with low Treasury yields is to run to corporate bonds, including high-yield fare. However, the State Street research indicates even going heavy on junk bonds in a 60/40 portfolio barely moves the after-tax yield needle.
Good news: There are solutions and most don't require an extreme sense of adventure. Preferred stocks, which I discussed earlier this month, are a solid starting point and can be combined with emerging markets debt and senior to generate better after-tax yields.
“Each market carries a current pre-tax yield north of 3.5%. The post-tax yield of a 3.5% rate equates to 2.2% – still low from a historical perspective, but at least above the current rate of inflation,” notes Bartolini.
Emerging markets debt may seem like a risky asset class. At the very least, it appears difficult to explain to clients, but neither needs to be the case. A weak dollar environment, which we're being treated to today, is beneficial to emerging markets assets. That's particularly true of debt denominated in U.S. dollars because the weak greenback means lower financing costs for the issuing country.
Younger, more risk-tolerant clients may be pleased to hear from their advisor that the J.P. Morgan EMBI Global Core Index has 30-day SEC yield of 3.59% and 56% of that index is rated AA, A or BBB.
Another avenue for advisors to consider when it comes to income for retirees or clients close to retirement is high-yield municipal debt.
While the municipal bond universe is vast and a frequent stopping point for conservatively positioned client portfolios, high-yield fare represent a scant percentage of this space. Still, there are admirable income traits to consider.
“The current yield to worst on high-yield municipal bonds is 2.89% while high-yield corporates yield 3.98% pre-tax, but 2.51% post-tax,” says Bartolini. “Not to mention, this income is generated alongside lower volatility than high-yield corporates.”
Additionally, junk munis are great diversification tools with historically low correlations to government debt, corporate bonds and domestic stocks.