There is a certain type of investor that I call “yield hogs” who value income above all else. Fat Yield is an irresistible siren song. They check their phones daily to see if interest on bonds or dividends on stocks have been posted to their accounts. The word “buyback” induces indigestion. They believe companies should return profits to shareholders through dividend increases rather than share buybacks. Earnings growth doesn’t excite them. Leverage is irrelevant. Ciphers make them sick. The appetite for utilities and energy stocks has created both rich and poor over the years. Closed-end funds and his REITs have been able to undo more than once. Through it all, they remain steadfast in their pursuit of income.
The past decade has been a trying time for Yield Hog. Cash gives them nothing, bonds give them almost nothing, and dividend stocks underperform growth stocks significantly. The situation was so dire for Yield Hog that they invented an acronym for their plight when looking for income outside the stock market: TINA (No Alternatives).
But Yieldhog has good news. Because bonds are back as a source of income and total return. If Yield his Hog can curb his worst impulses and instead become a cautious pig, 2023 should be a profitable year for the pig brood. why? Take a look at his buffet of options.
Cash: Cautious Pigs Don’t Overallocate
Cash is king in 2022 not because it made money, but because it didn’t lose money. But 2023 will be different. Yields in financial markets started at around 4% for him and are poised to go higher. Financial market yields closely track the Fed Funds rates set by the Federal Reserve. Market participants believe the Fed is nearing the end of its rate-hiking campaign after the Fed’s rapid rate hikes drove stock and bond prices down last year. % priced by the futures market.
Our friends Yield Hog salivate over 4% Treasury bills and compare them to the sub-2% yields of the large-cap S&P 500 index. They wondered why they should take risks in the stock market and considered selling stocks and allocating a large portion of their portfolio to cash.
But cautious pigs know that the Fed may need to turn around as the delayed effects of tightening monetary policy are streaming through the economy. They know these cash yields may not last long and future rate cuts could push stocks higher again. but we do not change our long-term asset allocation as we expect equities to outperform bonds and cash over the long term.
Credit: Prudent Pig resists the temptation to load
Yield pigs can’t believe what they’re seeing in the corporate bond market. Yields are the highest in 15 years. In 2022, investment grade corporate bonds yielded over 5%, “junk” rated corporate bonds yielded over 9%, and floating rate leveraged his loans yielded over 10%.
Yieldhog is considering selling all of its Treasury bonds and loading up on credit. After all, these yields promise stock-like returns, and everyone knows that bonds are safer than stocks, they reason.
Thoughtful pigs are equally impressed with the income potential offered by the corporate bond market, but have learned over the years to look beyond the nominal yields that investment opportunities offer. We know that abnormally high yields on stocks can portend dividend cuts, and we know that the highest-yielding corporate bonds carry high default risk.
Cautious pigs also see the rising probability of recession and rising borrowing costs as headwinds for highly leveraged firms. They decided to keep their bond allocation toward higher quality bonds. They know he may not get rich with a 4% to 5% return, but he owns bonds for stability and income, not growth.
Tax-exempt bonds: Cautious pigs pay attention to leverage and relative value
Yieldhogs love their income, but they hate paying taxes. Over the years, they have invested their tax accounts primarily in tax-exempt municipal bonds. Yieldhog’s frustration has been that yields on prime municipal bonds have been below inflation for much of the past decade. Now they are thrilled with an after-tax yield of nearly 4% for investment grade muni. They are even more excited about municipal closed-end funds that use leverage to boost returns and offer tax-equivalent yields of 5% or more, he said. They are considering a “diversified” strategy of owning three or four closed-end municipal funds and bathing in the warm glow of tax-exempt income.
Thoughtful pigs don’t like paying taxes either, and are excited about getting positive real (inflation-adjusted) returns on municipal bonds. However, unlike Yield Hog, Prudent Pig pays attention to leverage and relative value. They know that leveraged funds may have to cut their distributions if borrowing costs rise. They also know that municipal bonds are valued at a premium relative to government bonds because there is a shortage of supply to meet the demand for municipal bonds.
As such, Cautious Pigs are cautious about investing in closed-end funds, holding most of their municipal bond portfolio in high-quality intermediate-term bonds.
Be a cautious pig, not a yield pig
Today’s environment is exciting for fixed income investors. Yields on cash, corporate and tax-exempt bonds haven’t been this high in the last 10-15 years. The world of TINA and trillions of dollars of negative yielding debt cannot be overlooked by savers and bond investors.
But amidst the excitement, income investors warn to be like cautious pigs. As always, it’s important to carefully evaluate today’s opportunity set. You don’t need to risk low-grade corporate credit or use leverage to boost returns to find attractive yields on bonds today.
The time will come for greater risk-taking, but just knowing that the “income” has returned to bonds, the wise hogs are already in pig heaven.