Solving the 6% yield portfolio puzzle

Bottom line up top

Last month’s inflation meets this week’s U.S. Federal Reserve meeting. February data showed the Consumer Price Index (CPI) coming in slightly hotter than expected for the month, largely reflecting higher gasoline prices and sticky shelter costs. Core CPI (excluding food and energy) dipped to 3.8% year-over-year, slightly below January’s print (Figure 1). Nevertheless, it’s clear that consumer inflation isn’t moderating quickly enough for Fed policymakers to begin easing at their next meeting on Wednesday. In fact, we think that the first rate cut is likely to be pushed out from an expected June timeframe to sometime in the second half of the year.

February wholesale inflation as measured by the Producer Price Index (PPI) was also released last week, with the core number rising a bit more than consensus for both the month (+0.3%) and year-over-year (+2.0%). This uptick in wholesale prices further confirms that the battle to bring down inflation is far from over.

Consumers tap the brakes. Retail sales, another key indicator that could impact the trajectory of inflation, fell short of forecasts in February. This could be a sign that spending momentum may be slowing, though it is not collapsing. Preliminary consumer sentiment data for March was essentially flat month-over-month, and modestly lower than expected. Sentiment remains well above 2023 levels and the historic lows hit during 2022’s peak inflation.

Against the backdrop of persistent inflation and higher-for-longer interest rates, many investors are questioning how to adjust their investment strategy to produce attractive income levels that align with their risk appetite.

Portfolio considerations

Mystery fans and movie buffs of a certain age may recall The Seven-Per-Cent Solution, a mid-1970s best-selling Sherlock Holmes novel made into an Academy Award-nominated film. The story, an alternative version of key events chronicled in the official Holmes canon, put a number of long-accepted “truths” about the famous detective under the magnifying glass. Fortunately for investors, uncanny sleuthing skills aren’t required to solve a present-day puzzle: how to build portfolios with a yield target that would have been unheard of only a couple of years ago.

Today’s higher-yield environment has created opportunities to do just that. Below, we present a sample fixed income allocation that would have produced a 6% yield based on February month-end index data — call it The Six-Per-Cent Solution (Figure 2).

• In an environment where we believe inflation will continue to moderate, albeit more slowly than the consensus expects, a 6% yield would have provided a nearly 3% real (after inflation) income return — more than 100 basis points (bps) higher than the broad fixed income market (measured by the Bloomberg U.S. Aggregate Index).
• This sample allocation had a duration of 5.7 years, slightly shorter than the benchmark’s 6.1 years. In our view, this close-to-neutral duration posture could be advantageous, with interest rates likely to decline gradually over 2024.
• Importantly, the reach for higher yield using these diversified sector exposures does not equate to significantly greater realized risk, with volatility (standard deviation) over the past 10 years at 5.15%, versus 4.77% for the benchmark.
• Securitized exposure includes agency and non-agency mortgage-backed securities (MBS) and asset-backed securities (ABS), both of which are supported by strong fundamentals. In addition, MBS spreads are wider than their historical average, while most fixed income sector spreads are relatively tight. Preferred securities, which also offer sound fundamentals, benefit from healthy investor demand given favorable tax treatment of the qualified dividend income that preferreds generate.
• Among non-U.S. categories, emerging markets (EM) corporate bonds are particularly appealing, thanks to solid credit ratings, healthy spreads relative to EM sovereign debt and lower net leverage versus their developed market peers. Notably, EM corporates are predominantly (60%) investment grade yet yield about 8%, with relatively short duration (around four years).
• Lastly, below-investment grade corporate credit has the potential to deliver equity-like returns with lower volatility. High yield bonds are bolstered by healthy interest coverage ratios (4.5x) and benign default rates, which we expect to continue. Floating rate loans may be an effective portfolio diversifier, with low correlations to fixed rate sectors and a shorter duration profile than the broader fixed income market. Moreover, the yields offered by loans are among the highest available in the public fixed income arena. The sample allocation’s below-investment grade exposure favors higher-quality segments and issuers with enterprise revenue business models

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