Key Takeaways

Traditional Income Portfolios are Failing Investors

In this extended low interest rate environment, advisors and investors are faced with major challenges in finding meaningful income generation from traditional investments. As bond yields have fallen, coupon payments have fallen in both nominal and real terms i.e. there is simply less cash flow available per dollar invested to meet investors’ income needs. Today, it is impossible to reach the same level of income as investors earned holding bonds in the 90s. Practically, this  means that in order for investors to receive the same amount of income as they received in prior decades, investors either have to (i) allocate a greater portion of their portfolio to fixed income, (ii) take on more risk or (iii) look for alternative sources of income.  This problem is further exacerbated when inflation is taken into account - in real terms, yields on most traditional assets are effectively zero, or even negative - meaning investors are losing purchasing power by holding traditional fixed income. So where can investors find meaningful income today? First, let’s dive deeper into the problem.

A brief history of income...

As you can see below, the average yield on US treasuries has fallen dramatically over the last several decades.

US 10 Year Rates

Source: Refinitiv US 10 Year and US 10 Year - 10 Year BEI

When inflation is taken into account, the fall in “real” coupon payments  is even more dramatic, with yields in today’s markets not even breaking even for bond holders  at approximately ~1.2% (see the chart below).  

This means that, for investors sticking to traditional sources, in order to ensure the same level of income, they have had to allocate an increasing portion of their portfolios to bonds. For example, in order to achieve the same amount of income as an investor in the 80s an investor today would need to allocate 2.5x more dollars (in other words a 60/40 portfolio would have to turn into 60/100...which doesn’t really work)  When inflation is taken into account, solving this equation becomes even more daunting.

Bond Allocation Needed (as % of Portfolio) to Reach Same Coupon Payouts as Historic 70/30 (Avg of 1980s)

Source: Refinitiv public markets data (S&P 500 and 10 Year US Treasuries) as of 9/15/22.

Stepping back, this is a continuation of the trend of the last 20 years, where bond coupons drove only about half of bond holders’ returns and a large portion of returns were driven by price appreciation (driven by falling interest rates). This spells bad news for today’s fixed income investors - with interests rates already near zero, there is little upside left from price changes due to falling interest rates 

Examining a Broader Universe of Options

If investors expand their options beyond treasuries, there is a wide range of income-generating assets from lower yielding public assets to higher yielding private ones including: 

• Corporate Bonds - Corporate debt is typically the top choice for investors looking to move out the risk curve to boost their income portfolios, because corporate bonds have fixed payments and are liquid. There are two main types - investment grade, which is less risky and lower yield, and high yield, which is riskier and higher returning.

• Municipal Bonds - Municipal bonds also generally have fixed coupons, but offer a higher yield than US treasuries because they are backed by local governments.  Because of this, munis may also offer additional tax benefits to certain investors. 

• High Dividend Stocks - While they clearly carry more risk than debt-based fixed income instruments, many investors turn to high dividend stocks (including vehicles such as REITs or BDCs) as another source of income for their portfolios.  These can range from the more mature “blue chip” companies that tend to orient their businesses around paying stable dividends to pass-through vehicles likes REITs and BDCs that offer direct exposure to income oriented assets (real estate and private debt, respectively) and are required to distribute the vast majority of their income to maintain favorable tax status (i.e. avoiding double taxation).  It’s important to note that unlike with bonds, companies pay out coupons as a percentage of their earnings (which are variable). However, these companies are incentivized to keep the share of earnings they pay as dividends stable, if possible, because of the signaling power it possesses about the financial strength of the company, though dramatic changes to earnings can lead to dividend cuts (like a default, a recession, etc).

• Leveraged Loans - Leveraged loans are senior loans to risky companies (which are either debt-ridden or have poor credit history), made by banks and re-structured for investors to purchase. These are floating rate loans which yield a spread above LIBOR, and are often higher yielding than corporate debt or municipal bonds. Most investors access these illiquid assets via liquid vehicles, like ETFs. These assets can be quite volatile because of their liquid exposure to high risk, illiquid assets, but they can provide higher coupon, regular payments to investors.

• Private Debt - For investors who do not need immediate liquidity, private debt may offer additional income opportunities outside traditional sources.  Private debt investments span the risk spectrum from loans to distressed companies, to mortgages for safer real estate assets and relatively secure asset-backed loans to more developed companies. Private debt investments may also focus on more niche markets and smaller or non-investment grade companies, which traditional financial institutions have trouble servicing. For these reasons, private debt tends to offer higher yields and, because of their illiquid nature, may be less volatile than other options.

Which Alternatives Provide the Best Hope for Income Portfolios?

For investors looking for the stability of traditional fixed income, private debt assets are likely the only bond-like assets which can produce higher yields with lower volatility. Compared to higher yield, liquid assets such as investment grade corporate debt, high yield corporate debt or high yield stocks, the income opportunity in private debt remains very attractive. In real terms, investment-grade corporate bonds even have a negative real yield. As you can see below, the only other asset offering anywhere close to the yields on private debts are BDCs (a type of high yield stock). 

Yields Across Assets Today

Sources: Refinitiv public markets data - FTSE US REITs, S&P LSTA Leveraged Loans, Wilshire BDC Index, S&P High Dividend Stock Index. *Private debt is sourced from the Lincoln Senior Debt Index Q222. Private debt yields are historically not transparent, but this index captures data from direct lending to middle-market companies - this is the least risky private debt strategy so likely understates the yields investors can earn. As of 9/15/22.

It’s not only along this metric that private debt is a compelling addition to an income portfolio. Their returns are relatively low volatility. And compared to the only true high-yield comparison, BDCs, they’re much less volatile, and a bit more diversifying to equity exposures. Below you can see how private debt compares along these metrics across income alternatives. 

A Comparison Across Income Alternatives

Source: Refinitiv public markets data - FTSE US REIT, S&P LSTA Leveraged Loans Index, Wilshire BDC Index, S&P High Dividend Index; Private debt is Lincoln Senior Debt Index Q222 which likely understates the true yield on private debt available to investors because it only captures yields on the less risky strategies. Methodology: Correlations are calculated quarterly for apples:apples comparison. Private debt correlation uses Burgiss time series. As of 9/15/22