The right kind of risk
It is possible, however, with diversification and measured risks, for investors to find income without unduly endangering principal.
There are two main avenues to obtain more income. The first is to own longer maturity fixed-income securities which have higher duration. (Duration refers to a debt instrument’s price sensitivity to changes in interest rates – the higher the duration the greater the sensitivity.)
Higher-duration securities typically pay greater yields because they carry more interest rate risk and day-to-day volatility. These are usually bonds with fixed payouts and a long time to maturity, so every change in interest rates significantly impacts their value. They tend to do poorly when interest rates are rising.
Seeking greater yield through duration, however, is not attractive at present as interest rates on long-maturity investments are not significantly higher than interest rates on short-maturity investments, so the opportunity for additional yield is small. This is unlikely to change in the near term with the economy on the mend from the deep recession triggered by the pandemic.
Whether the recovery is a V-shaped, U-shaped or some other shape, the Fed is firmly committed to low rates for at least a few years.
The repercussions are two-fold. First, high-quality government bonds offer scant yield in either short- or long-maturity bonds. Second, interest-rate risks are asymmetric with yields this low. Treasury rates have little room to fall, but plenty of room to rise over the long term and trigger lower bonds prices once the economy heats up and the Fed eventually begins to raise rates.
Another route to generating higher income is to take on credit risk, which carries a higher risk of default and price volatility. Credit risks certainly have risen with the economic slowdown. The recession already has sparked a wave of defaults in lower-quality bonds and leveraged loans.
The key question for investors is whether market pricing and yields already reflect this. We believe they do. Fixed-income markets have priced in an increase in defaults in line with consensus default estimates. The key risk to credit then is if the economy recovers much more slowly than expected.
For income investors, we think the implication is clear – taking diversified and measured risks in mid- to lower-quality securities may offer a better source of income than higher-duration securities. Additionally, it helps to diversify across asset types, such as corporate bonds, emerging markets and securitized assets linked to mortgages or other assets.
Consider short duration bond funds
Currently, most savings and money market accounts offered by banks pay little more than 0%, and most bank certificates of deposit (CDs) offer yields under 1%.
For investors with a longer-term outlook – particularly if you’re willing to take on some credit risk – we believe there may be some appropriate options. For example, the Thrivent Limited Maturity Bond Fund (THLIX) has a very short duration (low interest-rate risk) and has recently offered a yield of 1.55%. The portfolio enhances yield with a diversified portfolio including securitized debt, such as government-guaranteed residential mortgage-backed securities and high-quality structured securities with underlying assets such as corporate and student loans. It also invests in short-term, investment-grade corporate bonds.
The yields for this Fund and the others discussed in this article are based on the distributions paid and the net asset value of the fund. Yields quoted here are “30-day SEC” yields calculated based on the previous 30 calendar days ending June 30, 2020.i For the most recent yields on all Thrivent Mutual Funds fixed-income funds, see: Thrivent Mutual Funds Fixed Income Options.
Seeking higher yields
The same thinking applies to investors who are looking for higher yielding opportunities. One example is the Thrivent Opportunity Income Plus Fund (IIINX). This Fund has relatively short duration (three years) and has recently offered a yield of 2.58%.
A bit more than one-fourth of the Fund is invested in floating-rate leveraged loans, which are bank loans to lower-quality U.S. corporations. They offer a higher yield (currently around 6%) to compensate investors for greater credit risk, such as possible defaults. The Fund also invests in a diversified mix of securitized debt, emerging-markets debt, and corporate bonds, including high yield. Each of these investments carry more credit risk than interest rate risk. We focus on mitigating that risk by conducting extensive research and by diversifying our holdings.
Another approach to balancing interest-rate and credit risk can be seen in the Thrivent Income Fund (LBIIX), which invests primarily in investment-grade corporate bonds. The Fund gets a yield boost by investing in high-yield bonds and other assets classes opportunistically, such as floating-rate leveraged loans and emerging-markets debt. The Fund has less credit risk than Thrivent Opportunity Income Plus Fund but has more than double the duration (seven years). Its recent yield was 2.21%. (See current yield)
Moving along the credit risk spectrum
Further out in the credit risk spectrum would be a high yield-bond fund. The Thrivent High Yield Fund (LBHIX) invests predominantly in high-yield corporate bonds. For that higher credit risk, it has traditionally paid a higher yield than the Thrivent Income Fund (it was recently yielding 5.63%. (See current yield) We prefer the middle area of the high yield market—B rated bonds—over higher risk CCC bonds (as rated by Standard & Poor’s), because we think the risk tradeoff is better.
Alternative income strategies can also enhance yield by carefully choosing credit risk opportunities. The Thrivent Multidimensional Income Fund (TMLDX) invests in a broadly diversified set of higher yielding debt, including preferred securities. ‘Preferreds’ combine features of debt and equity, in that they pay fixed dividends, but can have a higher potential to appreciate in price. The Fund also invests in closed-end funds and convertible bonds (bonds convertible into equity), both of which carry higher equity-like risk and offer higher potential returns than traditional bonds. The Fund has a relatively short duration of more than four years and was recently paying a yield of 4.21% (30-day SEC yield pre-waiver was 3.76%.ii). (See current rate)
Don't forget munis
Finally, if you are in a high tax bracket or live in a high-tax state, you may want to consider a municipal bond fund. Municipal bonds are bonds issued by state and local governments to finance public projects such as roads, bridges, schools, and hospitals. The interest they pay is exempt from federal taxes and, in some cases, from state taxes, although any capital gains distributions, as well as realized capital gains from selling fund shares, may be taxable. For certain investors, their after-tax yields can be significantly higher than for other types of bonds.
For example, the Thrivent Municipal Bond Fund (TMBIX) was recently paying a yield of 1.46%. (See current rate) The tax-equivalent yield can be significantly higher (as compared with taxable bond funds), as the graph below illustrates: