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Paul Yeung/Bloomberg
These are the golden days of money. Money market funds and treasury bills offer returns of around 5% with virtually no credit or interest rate risk. Longer-term Treasuries yield less than short-term ones, a condition known as an inverted yield curve, so there’s no immediate benefit to venturing into later maturities. Moreover, an inverted yield curve is a remarkably prescient harbinger of a future recession, making corporate bonds unattractive.
But while cash may seem perfect now, it carries longer-term risks. Michael Arone, investment strategist at State Street Global Advisors, raises the specter of reinvestment risk, or the danger that when rates eventually drop, cash investors will have to reinvest at lower rates. He recommends a barbell approach, overweighting cash on one side and higher-quality, longer-duration securities on the other. “Now you are able to acquire higher quality assets with a significant return to offset some of that reinvestment risk,” he says.
Another advantage: when the impact of interest rate hikes by the Federal Reserve inevitably leads to a slowdown in the American economy, yields will fall, and if you hold a few intermediate securities, you could participate in the rise because these securities are appreciate. “If you stay in cash, you’ll miss out on potential bond market rallies next year,” says Dhruv Nagrath, director of fixed income strategy at BlackRock.
This message may be falling on deaf ears right now. Bond prices fell in July as yields rose sharply. The 10-year Treasury bond rose above 4% last Thursday for the first time since March. Inflation remains elevated and another Fed rate hike is expected this month. An exchange-traded fund that tracks a broad bond benchmark,
iShares Core US Aggregate Bond
(ticker: AGG), has fallen around 3% over the past three months.
Nonetheless, long-term investors, especially those in retirement looking for consistent income, should prepare now for a possible spike in yields and add longer-duration securities.
The good news: you can get a little more yield than cash and still stay in high-quality securities if you look in some less obvious corners of the fixed income markets. Preferred shares, often issued by large, well-rated banks, yield around 6%. Similarly, agency mortgage-backed securities pose little credit or prepayment risk, as many homeowners keep their mortgages at 3%.
“Preferreds offer an attractive opportunity in a higher quality asset with yields above 6%,” says Arone. They are also relatively cheap due to the regional banking crisis in March. “There is rarely such a large discount for the privileged,” he notes. State Street’s offer is the
SPDR ICE Preferred Securities
ETF (PSK), which yields 5.72%.
Cliff Corso, chief investment officer at Advisors Asset Management, likes short-term preferred stocks issued by big banks and energy companies. His company
AAM Preferred and low-duration income securities
ETF (PFLD) yields almost 7%.
Nagrath has other high-quality securities on its list, including longer-dated Treasuries. “The recession will creep into the narrative,” he says. “Having longer-duration Treasuries is a prudent thing.” He suggests investors add an ETF that tracks a bond benchmark, like iShares’ Core Bond offering, which has an intermediate duration and a yield of 4.12%.
Inflation-protected Treasuries, agency MBS and local currency emerging market debt are also now part of BlackRock’s fixed income portfolio. Nagrath is less of a fan of preferred stocks due to their exposure to the financial sector. THE
iShares Preferred and Income Securities
The ETF (PFF) offers a yield of 6.62%, but 70% of the assets are in preferred banks. However, it is difficult to oppose a modest allocation to this sector. B
Write to Amey Stone at amey.stone@barrons.com