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Last month, bond yields made a comeback and the 10-year Treasury note hit roughly 5%, the highest since 2007. On Wednesday, the yield was near 4.5%.
But those higher yields may not be here forever, says George Bory, the chief investment strategist for fixed income at Allspring. He noted that now is the time for investors to think strategically about their bond allocations.
Allspring Global Investments, a US-based global asset management firm with $551 billion under advisem*nt, has fixed income at the core of its strategy, with the majority — or roughly $415 billion —allocated to the asset class.
"When I talk to investors, I just kind of remind them why you buy a bond in the first place," Bory said. "It's just a cash flow, but it has a definitive start and a definitive end. And so as a result, a bond is very good for funding future liabilities. When yields are high, you don't have to save as much to fund that future liability."
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His firm is in the camp that the worst isn't over yet for the US economy. It is going through a soft landing: growth is slowing, inflation is cooling, and the Fed has effectively put its rate hikes on hold. The slowdown is expected to continue into 2024 when economic growth will hit zero and inflation is likely still trending lower, he said.
"So in simple terms, it would be considered a hard-ish landing rather than a true hard landing," Bory said. The latter would be a deep recession, which is still possible, he noted.
The good news is most bonds, including Treasuries, high-quality corporates, and municipal bonds, tend to do well when the economy slows and inflation comes down.
But unlike equities, where investors are advised to buy index funds and avoid trying to beat the market, bonds aren't as efficiently structured, he said. And so, investors need to have a deeper understanding of the asset class.
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A fixed income strategy
Allspring's portfolio includes Treasuries, municipal bonds, investment grade and high-yield corporate bonds, and asset-backed securities like mortgages.
These different categories can often be overlooked, but fixed-income products with different durations and levels of risk can be combined to create an overall strategy comparable to stocks, he said.
However, the types of risk between stocks and bonds are different. Stocks have no contractual agreements. You're betting on the future of that company's growth, and it may or may not pay a dividend. With bonds, it's contractual, he noted.
On the other end, bond risk comes from the borrower's ability to pay back their obligation. Borrowers have credit ratings determining the likelihood that an entity will pay back their obligations, with AAA (or its equivalents) being the most likely and C being the least likely. The highest-quality issuers are typically called investment grade, with ratings between AAA and BBB-, whereas lower-rated, high-yield, or junk bonds are rated BB+ to C.
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In today's market, investment grade corporate bonds can yield between 4.5 to 7.5%, Bory said. But once ratings drop down between BB and CCC, a fair bit of uncertainty is added. For example, there's roughly a 30% chance that a CCC issuer will default over a five-year period, he noted.
If an investor is willing to take on that higher risk, the market will pay a very high premium at about 8 to 16% yields. However, he noted that these companies have exposure to higher leverage with more volatility.
Today's high interest rates mean debt is expensive. Bory emphasized that the borrowers most at risk of default are the small-to-midsize companies relying heavily on variable interest rate bank loans, meaning they reset with the fed funds rate. This is as opposed to a company that has balance sheet strength through diversified revenue streams.
Bory told Insider that he hedges lower-rated credit risk by buying many of the lower grades. If one of the entities defaults, there's distributed risk across the portfolio. So as you go down in rating, the importance of diversity goes up, he noted. This ensures that no single credit disrupts the overall portfolio
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"When you do it well, you can earn very attractive yields over time that typically beat all other forms of fixed income and often are directly very close to equity-like returns," Bory said.
For investors who want higher income, Bory recommends considering a mutual fund or a commingled fund that provides that diversification. While you may not get the highest yield, you could generate 8 to 12% in today's market.
Popular examples of corporate bond funds include the MainStay MacKay High Yield Corporate Bond Fund (MHCAX), Goldman Sachs High Yield Fund (GSHIX), and High Yield Spectrum Fund (PHSIX). Allspring also has a high-yield bond fund (EKHAX).
In the current economic environment, he likes shorter-duration bonds, less than five years, with an average maturity of a year to a year and a half, with lower quality ratings between BBB and B, but avoiding CCC. This selection offers the best risk-to-return trade off, he said.
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"It's what we would call a pure income strategy," Bory said. "It's just there to generate as much income as possible with a limited amount of default risk in the portfolio."
As for individuals saving for a future expense five to 20 years out, he recommends a laddered bond portfolio made up of municipal bonds with different maturity dates. These bonds aren't federally taxed, and some are exempt at the state level. They have relatively low volatility with very certain cash flows, he said. It's a very popular strategy that's becoming even more widespread as yields go up, he added.
Below is a list of Morningstar analysts' favorite high-yield bond funds that have the highest "Gold Medalist" rating. The Medalist system is based on a five-level, forward-looking scoring system that combines the fund's ability to outperform similar funds and its benchmark on a risk-adjusted basis.
PIA High Yield (MACS) Mgd Acct Cmpltn (PIAMX). It has a one-year total return of 11.82%.
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T. Rowe Price Global High Income Bd (RPIHX). It has a one-year total return of 9.95%.
T. Rowe Price Global High Income Bd Adv (PAIHX). It has a one-year total return of 9.72%.
Thrivent High Yield S (LBHIX). It has a one-year total return of 7.14%
