Federal Reserve Chairman Jerome Powell.
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Barron’s used to have a column covering the bond market called Current Yield, which started back in the 1970s, when bonds really had some yield. Now, nearly four decades past their peak—which put risk-free long-term Treasury bonds over 15%—they provide return-free risk, as the column’s originator, James Grant, has famously quipped.
Indeed, U.S. government securities yield less than nothing after taking inflation into account. The real yield on 10-year Treasury inflation-protected securities, or TIPS, is minus 0.84%, before compensation for future inflation. With the regular, or nominal, 10-year note yielding 1.48%, the market effectively sets a “break-even” rate at 2.32%—that is, the anticipated inflation rate at which investors would break even between TIPS and a nominal note.
So, if bond yields rise from their historic low levels, their price declines would swamp the meager interest they pay. That is the opposite of four decades ago, when hefty double-digit interest coupons would cushion the impact of falling bond prices.
Moreover, during the long secular bull market in bonds that ensued, bonds would invariably rally when stocks fell, making fixed income the perfect hedge for an equity portfolio. That symbiotic relationship can’t be counted on if interest rates rise along with inflation in the future, making the traditional 60% stocks/40% portfolio mix less foolproof, as this column has discussed on multiple occasions.
Given there’s no real yield in Treasuries, and riskier fixed-income sectors such as corporate bonds, mortgage-backed securities, and municipals offer the smallest extra fillip of return ever, Mark Grant comes to a similar conclusion as Jim (no relation, however). The chief global strategist for fixed income at B. Riley Securities advises investors to sell their bonds, full stop, whether you consider their absolute or relative value.
That includes bonds that show hefty gains and now trade at big premiums as a result of being purchased when yields were appreciably higher. Those premiums will inevitably narrow once the bond matures at par or, especially in the case of munis, are called before maturity at a small premium above par. Better to sell and take a profit now, says Mark Grant. That’s the case even though the investor would owe capital-gains taxes, he adds.
The question then would be where to reinvest that cash. GMO’s latest seven-year forecast for various asset classes offers little encouragement about other investments. “U.S. stocks’ valuations, by almost any measure we can come up with—backward or forward looking—are at levels that concern us,” comments Peter Chiappinelli of the GMO asset-allocation team.
Those high current valuations translate into annual future real, inflation-adjusted returns of negative 7.8% for large U.S. stocks and negative 8.4% for small U.S. stocks. Only emerging market value stocks look to provide a positive real annual return, by GMO’s reckoning, of 2.7%, which is less than half of the historical 6.5% real return from U.S. equities.
To match the historic real return of U.S. stocks would require a nominal return of 9%, assuming the Federal Reserve achieves its goal of letting inflation hover modestly above its previous 2% target for some period.
That’s all but impossible in current markets. The only investment that generates current income anywhere near that high are closed-end funds, which Mark Grant has been recommending to his institutional clients, which traditionally have shunned the sector. But he also thinks some select CEFs are well-suited to individual investors seeking high current income, such as retirees, to pay bills or to maintain their lifestyles.
Owing to compliance restrictions, Grant can’t name names, but he focuses on CEFs and a few exchange-traded funds that yield upward into double digits, largely by virtue of their leverage. By being able to borrow money at a lower rate and invest the proceeds at higher yields, leverage boosts returns but also increases risks.
Some CEFs take a different tack to generate current income: a portfolio of dividend-paying stocks. Some may use leverage to boost income while others may sell options against their equities, using the options premium to generate current income.
We looked for examples of equity-based CEFs that trade at a discount from their net asset value and pay current yields over 9%. Two are leveraged funds from Clough Capital Partners: Clough Global Equity (ticker: GLQ), which closed Thursday at discount of 7.76% and with a yield of 10.84%, and Clough Global Dividend & Income (GLV), with a 6.99% discount and a 10.76% yield. The latter has a balanced portfolio of stocks and bonds, while the former is equity-based.
Two such CEFs that use options writing are Voya Asia Pacific High Dividend Equity Income (IAE), trading a 6.92% discount and yielding 9.13%, and John Hancock Hedged Equity & Income (HEQ), managed by Wellington Management, trading at a 3.59% discount and yielding 9.01%.
The main attractions of these equity CEFs are income, income, and income, in that order. They don’t come close to delivering the 41.89% 12-month total return of the SPDR S&P 500 ETF (SPY), according to Morningstar data. And they weren’t immune to swoons during the market’s steep selloffs in early 2020, as the pandemic took hold.
But if it’s income you’re after, which is sorely lacking in bonds, these CEFs could play that role.
Write to Randall W. Forsyth at [email protected]
