There is a certain type of investor, which I'll call the "Yield Hog," who prizes income above all else. Fat yields are a siren song they cannot resist; they check their phone every day to see if bond interest or a stock dividend has posted to their account. The word "buyback" induces indigestion, as they believe companies should send their profits back to shareholders through increased dividends rather than share repurchases. Revenue growth does not excite them. Leverage does not concern them. Crypto makes them cringe. An appetite for utilities and energy stocks has made them both wealthy and poor over the years. Closed-end funds and REITs have been their undoing more than once. Through it all, they remain steadfast in their pursuit of income.
The past decade has been a trying time for the Yield Hog. Cash has given them nothing, bonds next-to-nothing and dividend stocks have trailed growth stocks by a wide margin. Things were so dire for the Yield Hog that an acronym was invented to describe their plight when searching for income outside the stock market: TINA (there Is no alternative).
But there is good news for the Yield Hog as bonds are back as a source of income and total return. If Yield Hogs can restrain their worst impulses and become instead a Prudent Pig, then 2023 should be a profitable year for our porcine pal. Why? Let's look at his buffet of options.
Cash: The Prudent Pig doesn't overallocate
Cash was king in 2022, not because it made money but because it didn't lose any. But 2023 is different as money market yields begin the year near 4% and are poised to go higher. Money market yields closely track the Fed funds rate set by the Federal Reserve. The Fed's rapid pace of rate increases caused stocks and bonds to reprice lower last year, but market participants believe the Fed is close to the end of its hiking campaign, with smaller rate increases expected in the first half of 2023 and a terminal rate of 4.90% priced in by the futures market.
Our friend the Yield Hog salivates over 4% T-bills and compares them to the sub-2% yield on the S&P 500 Index of large-capitalization stocks. They wonder why they should take risk in the stock market and have contemplated selling their stocks and allocating a large chunk of their portfolio to cash.
The Prudent Pig, however, knows that the Fed may need to reverse course as the lagged effects of tighter monetary policy flow through the economy. They know these cash yields may not last, and that future rate cuts may once again buoy stocks. The Prudent Pig decides to allocate their excess savings to a higher-yielding money market fund but doesn't change their long-term asset allocation because, over the long term, they expect stocks to outpace bonds and cash.
Credit: The Prudent Pig resists the temptation to load up
The Yield Hog can't believe what they are seeing in the corporate bond market. Yields are the highest they've been in 15 years. Investment grade corporate bonds finished 2022 yielding over 5%, "junk" rated corporates yielded over 9% and floating-rate leveraged loans yielded over 10%.
The Yield Hog is contemplating selling all their Treasury bonds and loading up on credit. After all, they reason, these yields promise equity-like returns, and everyone knows bonds are safer than stocks.
The Prudent Pig is equally impressed by the income potential provided by the corporate bond market, but they have learned over the years to look beyond the nominal yields offered by an investment opportunity. They know that an unusually high yield on a stock can portend a dividend cut, and they know that the highest-yielding corporate bonds come with higher risk of default.
Also, the Prudent Pig sees rising recession odds and higher borrowing costs as headwinds for highly leveraged companies. They decide to keep their fixed income allocation tilted toward higher-quality bonds. They know they may not get rich settling for 4% to 5% returns, but they own bonds for stability and income, not growth.
Tax-exempt bonds: The Prudent Pig pays attention to leverage and relative value
While the Yield Hog loves income, they hate paying taxes. Over the years, they have invested their taxable accounts primarily in tax-exempt municipal bonds. It has been a source of frustration for the Yield Hog that high-quality municipal bond yields have spent much of the past decade below the rate of inflation. Now, they are excited by after-tax yields near 4% on investment-grade munis. They are even more excited by municipal closed-end funds, which use leverage to boost returns and offer taxable equivalent yields over 5%. They are contemplating a "diversified" strategy of owning three or four closed-end municipal funds and basking in the warm glow of tax-exempt income.
The Prudent Pig doesn't like paying taxes either and is also excited about earning a positive real (inflation-adjusted) return on their municipal bonds. Unlike the Yield Hog, however, the Prudent Pig pays attention to leverage and relative value. They know that when borrowing costs rise, leveraged funds may have to cut their distributions as several closed-end funds have already done in recent months. They also know that municipal bond valuations are expensive relative to Treasury bonds due to a lack of supply to meet municipal bond demand.
So, the Prudent Pig treads cautiously when investing in closed-end funds and keeps the bulk of his municipal bond portfolio in high-quality intermediate-term munis, where they are finding nominal tax-exempt yields near 2.5%.
Be a Prudent Pig, not a Yield Hog
Today's environment is an exciting one for bond investors. Yields on cash, corporate credit, and tax-exempt bonds have not been this high in 10 to 15 years. The world of TINA and trillions of dollars of negative-yielding debt will not be missed by savers and bond investors, and we hope it doesn't return for a very long time.
But in the excitement, we caution income investors to be more like the Prudent Pig. As always, it's important to carefully assess today's opportunity set. Finding attractive yields in fixed income today does not require taking risk in the lower-quality tiers of corporate credit or using leverage to boost returns.
A time will come for greater risk-taking, but already the Prudent Pig is in hog heaven, just knowing that the "income" is back in fixed income.
