Bond Investors: Be a Prudent Pig, not a Yield Hog

There is a certain type of investor, which I’ll call the “Yield Hog,” who prizes income above all else. Fat yields are a siren song he cannot resist. He checks his phone every day to see if bond interest or a stock dividend has posted to his account. The word “buyback” induces indigestion, as he believes companies should send their profits back to shareholders through increased dividends rather than share repurchases. Revenue growth does not excite him. Leverage does not concern him. Crypto makes him cringe. An appetite for Utilities and Energy stocks has made him wealthy and poor over the years. Closed-end funds and REITs have been his undoing more than once. Through it all, he remains steadfast in his pursuit of income.

The past decade has been a trying time for the Yield Hog. Cash has given him nothing, bonds next-to-nothing and dividend stocks have trailed growth stocks by a wide margin. Things were so dire for the Yield Hog that an acronym was invented to describe his plight when searching for income outside the stock market: T.I.N.A. (There Is No Alternative).

But there is good news for the Yield Hog as bonds are back as a source of income and total return. If the Yield Hog can restrain his worst impulses and become instead a Prudent Pig, then 2023 should be a profitable year for our porcine friend. Let’s look at his buffet of options in the current year.

Cash: The Prudent Pig doesn’t overallocate

Cash was king in 2022, not because it made money but because it didn’t lose any. This year will be different as money market yields begin the year near 4% and are poised to go higher. Money market yields closely track the Fed Funds rate set by the Federal Reserve. The Fed’s rapid pace of rate increases caused stocks and bonds to reprice lower last year, but market participants believe the Fed is close to the end of its hiking campaign, with smaller rate increases expected in the first half of 2023 and a terminal rate of 4.90% priced in by the futures market (Figure 1).

Figure 1

Our friend the Yield Hog salivates over 4% T-Bills and compares them to the sub-2% yield on the S&P 500 Index of large-capitalization stocks. He wonders why he should take risk in the stock market and has contemplated selling his stocks and allocating a large chunk of his portfolio to cash.

The Prudent Pig, however, knows that the Fed may need to reverse course as the lagged effects of tighter monetary policy flow through the economy. He knows these cash yields may not last, and that future rate cuts may once again buoy stocks. The Prudent Pig decides to allocate his excess savings to a higher-yielding money market fund but doesn’t change his long-term asset allocation because, over the long term, he expects stocks to outpace bonds and cash.

Credit: The Prudent Pig resists the temptation to load up

The Yield Hog can’t believe what he is seeing in the corporate bond market. Yields are the highest they’ve been in 15 years. Investment grade corporate bonds finished 2022 yielding over 5%; “junk” rated corporates yielded over 9%; and floating-rate leveraged loans yielded over 10% (Figure 2).

Figure 2

The Yield Hog is contemplating selling all his Treasury bonds and loading up on credit. After all, he reasons, these yields promise equity-like returns, and everyone knows bonds are safer than stocks.

The Prudent Pig is equally impressed by the income potential provided by the corporate bond market, but he has learned over the years to look beyond the nominal yields offered by an investment opportunity. He knows that an unusually high yield on a stock can portend a dividend cut, and he knows that the highest-yielding corporate bonds come with higher risk of default.

Also, the Prudent Pig sees rising recession odds and higher borrowing costs as headwinds for highly leveraged companies. He decides to keep his fixed income allocation tilted toward higher-quality bonds. He knows he may not get rich settling for 4%-5% returns, but he owns bonds for stability and income, not growth.

Tax-exempt bonds: The Prudent Pig pays attention to leverage and relative value

While the Yield Hog loves income, he hates paying taxes. Over the years, he has invested his taxable accounts primarily in tax-exempt municipal bonds. It has been a source of frustration for the Yield Hog that high-quality municipal bond yields have spent much of the past decade below the rate of inflation. Now, he is excited by after-tax yields near 4% on investment-grade munis. He is even more excited by municipal closed-end funds, which use leverage to boost returns and offer taxable equivalent yields over 5%. He is contemplating a “diversified” strategy of owning three or four closed-end municipal funds and basking in the warm glow of tax-exempt income.

The Prudent Pig doesn’t like paying taxes either and is also excited about earning a positive real (inflation-adjusted) return on his municipal bonds. Unlike the Yield Hog, however, the Prudent Pig pays attention to leverage and relative value. He knows that when borrowing costs rise, leveraged funds may have to cut their distributions as several closed-end funds have already done in recent months. He also knows that municipal bond valuations are expensive relative to Treasury bonds due to a lack of supply to meet municipal bond demand, as shown in Figure 3.

So, the Prudent Pig treads cautiously when investing in closed-end funds and keeps the bulk of his municipal bond portfolio in high-quality intermediate-term munis, where he is finding nominal tax-exempt yields near 2.5%.

Figure 3

Be a Prudent Pig, not a Yield Hog

Today’s environment is an exciting one for bond investors. Yields on cash, corporate credit, and tax-exempt bonds have not been this high in 10-15 years. The world of T.I.N.A. and trillions of dollars of negative-yielding debt will not be missed by savers and bond investors, and we hope it doesn’t return for a very long time.

But in the excitement, we caution income investors to be more like the Prudent Pig that I have described than the Yield Hog. As always, it’s important to carefully assess today’s opportunity set. Finding attractive yields in fixed income today does not require taking risk in the lower-quality tiers of corporate credit or using leverage to boost returns.

A time will come for greater risk-taking, but already the Prudent Pig is in hog heaven, just knowing that the “income” is back in “fixed income.”

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