Our Fixed Income Insights on Yield Traps
American Century Investments
May 17, 2012
From a fixed income perspective, we explain why aggressive yield-enhancing strategies—resulting from this extended period of historically low U.S. interest rates and yields—can threaten the potentially valuable long-term portfolio benefits from holding fixed income positions. In particular, chasing yield—and stumbling into “yield traps”—can derail the important volatility reduction and diversification benefits offered by carefully selected and well-managed fixed income holdings.
Approximately three and a half years have passed since the darkest days of the 2008 Financial Crisis. Yet, recession risks—such as the European Sovereign Debt Crisis, the 2013 Fiscal Cliff, and lingering weakness in the U.S. housing and job markets—still threaten the U.S. economy.
As a result, U.S. monetary (interest rate) policy continues to be highly stimulative, with many U.S. interest rates and yields still scraping along at historic lows. As the second quarter of 2012 entered its second month, popular interest rate and yield benchmarks—such as the three-month Treasury bill (T-bill) yield, the 10-year Treasury note yield, and the interest rate for 30-year fixed-rate mortgages—remained at or near their lows.
Demand for Yield Remains High, with Consequences
While yields and interest rates have been mired at low levels, demand for yield remains high. As we wrote in the Weekly Market Update last year (More Focus on Fixed Income, September 20, 2011), volatile market conditions, a boom in the 65+ years population category, and increasingly conservative investment behavior by that age group as it approaches retirement have helped shift investor preferences toward yield, and toward fixed income. Investment flows into fixed income remain strong.
Yield demand and yield-boosting strategies have, unfortunately, created unintended consequences for some fixed income investors. They have experienced investment behavior and results that more closely resemble those from equities than from fixed income, which defeats the strategic diversification purposes of holding fixed income positions.
The Lure of Yield Traps
Yield-enhancing strategies that can result in unexpected, undesired volatility and other negative impacts have been labeled “yield traps” in the financial media. Yield traps are investments that can lure investors with attractive yields that may not be fundamentally sustainable, or that may lead to undesired price volatility. These traps can lurk in both the equity and fixed income markets.
Unfortunately, yield traps can prey on those who can least afford them, including retirement investors looking for increased relative income and stability. Traps can be the steep price paid by those who may have been too focused on their income goals and not enough on portfolio stability.
Familiar Topic, Different Perspective
Yield traps are not a new topic for us, but we’re breaking them down in this article from a different investment discipline perspective than our previous written pieces. Back on March 27 of this year, we published a Weekly Market Update titled Uncovering Equity Yield Traps, written primarily from the viewpoint of our U.S. Value Equity investment team, led by Phil Davidson.
This month’s article is designed to be a companion and complement to that earlier piece, broadening the scope of our yield trap discussions to include fixed income.
Yield Deconstructed, and What It Can Signal
The March 27 piece included a yield definition that’s worth revisiting. In the heat of the chase, investors may forget what high yields can represent or signal.
In its most basic form, an investment yield represents some measure of income earned by the investment, divided by some measure of the investment’s value.
Yield = Income
Analysis of this income/value relationship suggests yields can be boosted in two ways:
- An increase in income earned, or
- A reduction in the value of the investment.
Point 2, in particular, is worth pondering. Sometimes a high yield is nothing more than a reflection of the low value (or high risk premium) that the market has assigned to an investment. (Conversely, more highly valued investments that are perceived to have lower risks, such as U.S. Treasury securities, discussed below, typically have relatively lower yields/lower risk premiums.)
It’s also possible that a higher yield represents investment income that has been temporarily increased in some artificial, unsustainable manner.
Clearly, the old adage, “Look before you leap,” can be applied here—we believe it’s important to understand what any particular investment’s yield actually represents before pursuing it.
The Risk-Return Trade-Off—There’s No Free Lunch
While we’re reviewing investment basics, it’s also worth underscoring another key concept that yields can illustrate—the risk-return trade-off. Typically, the higher the return you potentially want to achieve, the higher the risk you must be willing/able to take/accept.
There’s no free lunch. Unfortunately, there’s really no such thing as a low-risk, high-return investment. Under normal circumstances, if you want more return (in this case, more yield) you have to be willing/able to take/accept more risk, which usually means more price volatility.
Illustrating the Risk-Return Trade-Off in Fixed Income
Fixed income securities are very effective for illustrating the risk-return trade-off. At one end of the fixed income risk spectrum are U.S. T-bills, viewed as the ultimate safe-haven investment by much of the investment world. They have the full faith and credit backing of the U.S. government, plus very short maturities, which greatly limits their risk exposure.
But the price for that safe-haven status is a low rate of return—three-month T-bill yields have hovered mostly under 0.1% since the fourth quarter of 2008. For many investors, that’s acceptable—the relative price stability and sense of security they get from T-bills more than compensates for the low yield.
But others want or need more income than that. Increased risk is the price they must pay. For them, there’s a whole range/spectrum of fixed income securities from which they can select, to meet their goals and risk tolerances. But investors should proceed with caution and a plan, understanding the increased risks they’re facing.
Adding Risk (to Get More Yield) in Fixed Income
There are two traditional, primary ways to add risk and yield in a fixed income portfolio:
1. Establish positions with longer maturities or longer duration (a measure of fixed income price sensitivity to interest rate changes). This increases interest rate risk— the risk of price changes in response to interest rate changes. Typically, the longer the maturity or duration, the greater the interest-rate risk. Yields usually increase as maturities and durations increase, to compensate for both the greater interest-rate and inflation risk (the risk that the purchasing power of interest income will erode significantly over time because of inflation).
2. Step down in credit quality—increase the credit risk (the risk of experiencing a default on interest or principal payments). It’s possible to accomplish this by investing in bond sectors that don’t have the full faith and credit backing of the U.S. government (or any other established government entity). Another way is to invest in non-investment-grade (high-yield) securities rated BB or lower.
The graph below illustrates the potential path to higher yields in fixed income through combinations of longer maturity/duration and/or lower credit quality.
Longer Maturity/Duration Temptations of Today’s Steep Yield Curves
In today’s market environment, investors can potentially add considerable yield by extending the maturities and/or durations of their fixed income portfolios. In the U.S. Treasury market, for example, the yield difference between a three-month T-bill and a 30-year Treasury bond has recently been in the range of 2.8-3.0 percentage points (with 30-year bonds yielding around 3% compared with around just 0.10% for T-bills).
This wide yield differential between fixed income maturities is often called “a steep yield curve.” This refers to the fact that if you were to create a graph of all U.S. Treasury yields at any recent point in time, plotting Treasury maturities of one month to 30 years on the horizontal x-axis and the corresponding Treasury yield levels on the vertical y-axis, you would create a steeply curved upward line of yields.
It’s not just U.S. Treasuries that have recently featured a steep yield curve. The municipal bond yield curve is steep as well, as is the corporate bond curve. The potential reward for venturing further out on these curves is significantly more yield. But the corresponding risk is greater portfolio volatility potential because of increased exposure to interest-rate and inflation risks.
Higher yields can help overcome this potential near-term volatility over time. We believe fixed income investment holding periods are a key element to emphasize when talking about the potential compounding and return-smoothing benefits of higher yields. Longer holding periods are important because yield benefits don’t have sufficient time to compile and compound during shorter holding periods. Meanwhile, short-term volatility because of interest-rate and/or inflation risk might be greater than desired.
Higher Correlations with Equities as Risk Increases
At the opposite end of the fixed income risk spectrum from T-bills are securities that can behave like equities— their performance is more correlated with (tied to) equity market movements.
The most common of these kinds of securities are high-yield corporate bonds. Investors can earn high yields from these bonds, but they also have to accept a higher risk of default, and a relatively high return correlation with stocks, especially during periods of economic and financial duress, as shown in the graph below.
Past performance, of course, is no guarantee of future results. But this graph illustrates how high-yield bond funds tracked by Lipper Inc., compared with Treasury funds, have not only had a higher average correlation with stocks (represented by the S&P 500® Index) during the last 20 years, but that correlation has increased during crisis periods.
During three of the four crisis periods highlighted below, high-yield funds and Treasury funds moved in opposite directions, in terms of their correlations with stocks. We believe many high-yield bond fund investors during those three periods endured yield trap conditions, including increased volatility and losses in value along with their high yields.
We Seek to Apply High Yields Appropriately and Proportionately
Don’t misunderstand us—we like high-yield securities. We’ve managed high-yield portfolios for decades. They can add value to diversified portfolios when applied appropriately (as a potentially value-adding risk position) and proportionately (typically as a non-core holding).
High-yield securities or funds can make sense for adding more income and total return potential to a portfolio as long as they’re used under appropriate circumstances, with full disclosure, understanding, and acceptance of their risks and behavior. They also require specialized portfolio management expertise and experience.
“Appropriate circumstances,” to us, include investor preparation and education. We believe understanding yield, risk-return fundamentals, and yield-enhancing portfolio management tactics for fixed income, as we’ve outlined earlier, are essential for spotting and avoiding potential yield traps.
Tips for Sidestepping Fixed Income Yield Traps
We believe sidestepping fixed income yield traps requires awareness, diligence, expertise, and experience. Many investors choose to seek professional portfolio management assistance, such as ours, to help them navigate through the potential traps in this environment.
Besides working with professional investment managers, here are several tips that we think can help individual investors and/or advisors evaluate current and potential fixed income investments, and side-step possible yield traps:
1. Avoid fixating on maximizing yield, which can introduce a host of possible portfolio risks. John D. Rockefeller supposedly said, “More money has been lost by chasing yield than at gun or knife point.” This is not new advice—Rockefeller died in 1937.
2. We believe in being proactive investment consumers—don’t hesitate to ask questions. A yield that seems unusually high or otherwise out of synch with the yields of other, similar investments should be questioned…how was it achieved? It’s likely that some form of yield enhancement tied to a higher degree of investment risk was involved.
3. Again, past performance is no guarantee of future results, but we think it’s revealing to review investment performance track records. In particular, look at 2008, the year of the Subprime Mortgage Crisis. We believe 2008 served as an effective litmus test for separating the relative performance of risk-taking fixed income portfolios (which behaved more like equity portfolios, as shown in the graph) from those managed to perform more like investment-grade bonds.
4. People sometimes forget that basic, common sense rules, such as “if it seems too good to be true, it probably is,” can also apply to investments.
5. We believe in matching fixed income portfolio durations to goals. We think this can help reduce unwanted portfolio volatility and volatility surprises. For near-term goals in two-to-three years, look for fixed income investments that have maximum two- to three- year durations. Shorter durations like these (or in the three- to five-year range) may also be appropriate for those concerned about rising interest rates and/or inflation in the coming year or two.
6. For longer-term investors, we continue to believe that intermediate-term, core diversified fixed income holdings offer the optimal risk-return trade-off and portfolio diversification benefits, in conjunction with equity holdings.
In Conclusion: Our Investment Philosophy About Yield
There are no knocks intended on yield itself in this article. We’re big fans of yield, conceptually and strategically. Yield is one of the most important components of total return for fixed income—it can provide the income that retirement investors seek, and it can provide a cushion and recovery mechanism for portfolio volatility.
We recognize that yield is an important objective in bond investing; it’s a goal we actively seek. But one of our core, strategic views is that pursuit of yield should not be an “end all” itself.
Total return is our primary focus, not yield. As we’ve seen repeatedly during the past two decades, over-pursuit of yield can lead to equity-like portfolio volatility for bond funds, and excessive correlations with equity performance.
We strive to create and manage fixed income portfolios that behave like bonds, not stocks. That’s one of the core statements in our fixed income philosophy, and it’s a standard that we believe has served our clients well.
American Century Investments® offers a wide variety of stock, bond and asset allocation funds. Visit americancentury.com for more information: U.S Investment Professionals
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Generally, as interest rates rise, bond prices fall. The opposite is true when interest rates decline.
Diversification does not assure a profit, nor does it protect against loss of principal.
Letter ratings indicate the credit worthiness of the underlying bonds in the portfolio, and generally range from AAA (highest) to D (lowest).
The opinions expressed are those of G. David MacEwen and are no guarantee of the future performance of any American Century Investments portfolio. This information is not intended to serve as investment advice; it is for educational purposes only.
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