Over the last several years the bond market has provided investors with a steady flow of generous returns; however, the spigot is drying up and thirsty investors are being forced to rethink their fixed-income allocations.
From January 2007 through September 2010, the Barclays U.S. Corporate High Yield, U.S. Corporate Investment Grade and U.S. Treasury indexes have experienced annualized returns of 7.8%, 7.4%, and 7.3% respectively, compared to the S&P 500's annualized return of -3.6% over the same period.
With GDP growth expected to be negligible for the foreseeable future, and investors clamoring for "safe" investments that provide meaningful yield, advisors need to look past conventional fixed-income products to meet investor needs. As a consultant that meets regularly with wealth managers, this has been a popular topic of discussion.
The bear market of 2008 along with low inflation, weak economic growth, and an aging population hungry for "stable" fixed-income investments has led to massive asset inflows into the fixed-income space. In fact, according to Morningstar, an estimated $214 billion flowed into U.S.-taxable bond mutual funds between Jan. 1 and Oct. 31, 2010, with an additional $33 billion flowing into U.S. municipal bonds over the same period. Applying simple supply and demand principles, this increase in demand is certainly a contributing factor to the steady appreciation of bond prices. The consensus opinion amongst fixed-income managers is that prices are at, or near, a ceiling and that the outsized returns of the past are exactly that, a thing of the past. Certainly, PIMCO's launch of an actively-managed equity fund this past April is testament to this shift in sentiment.
Risk Choice: Lower Quality or Longer Duration
The typical high-net-worth bond investor is concerned with some combination of two things: the income "thrown off" from their investments and the stabilization they provide to a portfolio. In the current low-yield environment, the problem facing investors who rely on income from the bond portion of their portfolio to fund future liabilities becomes the search for additional yield. Many investors have chosen to tackle this problem either by taking on the additional credit risk of lower rated issuances or by stepping out further onto the yield curve.
Bank Loans
If the main concern with longer maturity issues is staying out of the way of a yield curve shift when interests rise—as most analysts predict they will in the intermediate-term future—then a convincing case can be made for the addition of bank loans to a portfolio. Bank loans have floating rates that typically reset every 60 to 90 days and are tied to a major index, such as LIBOR. This floating feature makes bank loans less subject to interest-rate risk. What's more is that the S&P 500/Loan Syndications & Trading Association Index has averaged a 465 basis spread over LIBOR since 1999. Of course, the downside to bank loans is the higher credit risk associated with the borrowing companies; however, this is partially offset by their higher position in the capital structure.
Emerging Markets Debt
