Generating yield in a world of rising interest rates

Now that the best parts of the bond market rally are behind us, it’s time for advisers to start considering how to position clients for a likely increase in the fed funds rate later this year.
I think the Federal Reserve is probably going to do something in September. It could still move its first rate increase into early 2016, but Fed officials seem anxious to begin raising rates because they perceive that as the U.S. economy begins to accelerate, the probability of creating asset bubbles is increasing.
We’ve taken a historical look at periods following Fed rate increases. The best-performing fixed-income asset class is floating-rate securities, typically led by leveraged loans.
The likelihood we’re going to have some sort of adverse credit event in the next couple of years is very low. The Fed will begin raising rates because the U.S. economy is getting stronger. Strong economies are not associated with increasing default rates and are generally associated with tightening credit spreads. That’s why we see leveraged loans, or bank loans, as one of the most attractive asset classes.
As the Fed begins to raise rates, the yield curve should flatten more. As the curve flattens, long-duration securities don’t have as much room for an increase in rates as short-duration securities do. So that bar-belling of the curve will allow fixed-income investors to participate in the increase in yield on short-term rates, but also will insulate them from the risk of another downward spike in interest rates.
(More: Gross sees Fed hike by September, even as job growth slows)
In the current environment, the surest path to underperformance is to remain anchored to the past. Advisers must develop a new, sustainable, long-term strategy to generate yield for their clients. We believe the solution lies beyond the Barclays U.S. Aggregate Bond Index.
Since its creation in 1986, the Barclays Agg has become the most widely used proxy for the U.S. bond market, with over $2 trillion in fixed-income assets managed to it. The Barclays Agg once was a useful proxy for the universe of fixed-income assets, which primarily consisted of U.S. Treasuries, agency bonds, agency mortgage-backed securities and investment-grade corporate bonds — all of which met the inclusion criteria. However, the fixed-income universe has evolved over the past 30 years with the growth of such sectors as asset-backed securities and municipal bonds.
The historical average yield of the Barclays Agg is 7.1%. Today, the average index yield is approximately 2.1%. With each index subsector yielding less than 4%, investors are facing a scarcity of yield across the fixed-income landscape.
LONG-TERM RISKS
Extending duration or increasing credit risk to meet yield objectives may prove successful in the near term, but utilizing these investment shortcuts carries significant long-term risks.
The traditional core fixed-income strategy is overly confined by a benchmark that no longer accurately reflects the opportunities that exist in the fixed-income landscape today. It does not allow for portfolios shifting toward more attractive opportunities that emerge from changing markets, and perhaps most importantly, it fails to incorporate active duration management, which could result in real losses.
As the chasm between investors’ income targets and obtainable market yields deepens, it is apparent that the traditional view of core fixed-income management requires innovation.
Over the next several years, we believe global central bank easing will continue to support a benign credit environment, but we are intensely focused on how the current accommodative conditions are likely masking a comprehensive, market-wide underappreciation of investment risks.
Advisers must remain vigilant in identifying the risks involved in reaching for incremental yield, since not all yield is created equal. Employing investment shortcuts, such as increased credit or interest-rate risk, solely to generate yield may come at the expense of future performance.
In the short term, advisers could help their clients by considering an increased allocation to floating-rate bonds. In exchange for the higher yield, investors take on elevated credit risk. However, floating-rate bonds generally have low price sensitivity to interest rates, as the bonds are pegged to short-term rates and are reset periodically.
Further, floating rates are positively correlated with inflation. We believe this is a relevant point for advisers and investors as the Federal Reserve looks to raise the fed funds rate for the first time in years.
Scott Minerd is chairman of Guggenheim Investments and global chief investment officer at Guggenheim Partners.