In today’s challenging environment, it can be difficult to find the right type of yield, according to a portfolio manager with Los Angeles–based DoubleLine Capital.
“We all know that yield matters,” said Samuel Lau. “By ‘right type of yield,’ I’m talking about making sure that you’re getting compensated in exchange for the amount of risk that you’re taking.”
When it comes to fixed income, Lau said there are two primary risks to consider: credit risk and interest rate risk. In the current economic environment, Lau sees interest rates as the bigger risk over the next few quarters for a couple of reasons.
The past 18 months have been marked by accommodative fiscal, monetary and credit conditions, which “has allowed companies to recapitalize their balance sheets, leaving most of these companies in stronger credit positions,” said Lau, whose firm manages the Renaissance Flexible Yield Fund.
For this reason, at least at this point in time, Lau sees credit risk as more “benign.”
However, accommodative policies also come at a cost.
“We’re seeing some of those symptoms today with the backdrop of rising rates due to the amount of increased debt that was needed to fund some of these stimulus programs,” Lau said.
The result is higher interest rates and signs of higher inflation, which, according to Lau, is a concern for bond investors.
“Rates moving up means prices moving down,” he said, “which can be a drag on your overall return from your fixed income portfolio.”
Looking forward, he said managing the duration of fixed income portfolios is going to be key in the coming months, especially if earning income is the objective.
So where can investors find good risk-adjusted yield?
To start, Lau does not suggest turning to a broad index such as the Bloomberg U.S. Aggregate Bond index, as it would mean taking on almost seven years of interest rate risk for a yield of only 1.6%. Broad corporate bond indexes offer a bit more yield, “but those yields also come with a relatively high level of duration,” he said.
“It’s not a very attractive reward-to-risk setup,” Lau said. “So not a very attractive proposition for those who are seeking to capture income.”
He said he prefers to look outside the traditional sectors of the fixed income market — such as Treasuries, investment-grade corporate credit and agency mortgage-backed securities — in favour of non-traditional sectors.
For example, Lau said he looks to the investment-grade asset-backed securities market, which generally offers a 1% pickup in yield over investment-grade corporate credit, resulting in a yield of around 3.3%. Collateral loan obligations (CLO) and commercial mortgage-backed securities with BBB ratings are still investment-grade and offer yields above 4%, he said.
“Again, the key is making sure that you’re getting paid for the risk that you’re taking,” Lau said.
There are also attractive yields in emerging market debt for investors who can take some international exposure, he said.
“We particularly like CLO in bank loans today because they are floating rate,” Lau said. “If the short end of the curve starts to move up, then these should benefit from and participate in that in a positive way.”
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