By Scott Welch, CIMA
Chief Investment Officer – Model Portfolios
and
Kevin Flanagan
Head of Fixed Income Strategy
This article is relevant to financial professionals who are considering offering Model Portfolios to their clients. If you are an individual investor interested in WisdomTree ETF Model Portfolios, please inquire with your financial professional. Not all financial professionals have access to these Model Portfolios.
It has been a little more than two months since we last visited the topic of generating yield in a volatile market, but market conditions continue to evolve, so it is time to visit it again. The Fed seemingly remains on its fairly aggressive “rate hike regime” and has now added “quantitative tightening” as it begins to reduce its balance sheet. It will continue to walk a proverbial tightrope as it attempts to balance economic growth against high inflation. Right now, fighting inflation is the primary concern, but the Fed suggests it will be “data dependent” as we move through the summer.
So, with rates and credit spreads volatile and the stock market in a swoon, how best to navigate generating reasonable yield in this environment?
Let’s start with the Treasury yield curve. In the wake of the Fed’s current policy, real Treasury rates have now risen visibly above zero across the entire maturity spectrum. This is meaningful when evaluating fixed income investments—investors are no longer locking in a guaranteed loss of purchasing power if they buy longer-dated Treasuries.
U.S. Treasury Real Yields
Nominal Treasury rates have also been rising, with the short end rising sharply in the face of the Fed’s tightening program. The market got “jittery” in late March when the yield curve inverted for a day or two, and those fears resurfaced over the past week or so as the yield curve flattened again. We think, with fits and starts, this upward rate trend will continue, with the caveat that, should the market perceive the Fed is being too aggressive and is correspondingly shutting down the economy, we may see a new decline. The Fed seemed “locked in” to 50-basis-point (bps) hikes this summer, but the most recent CPI print of 8.6% proved to be the catalyst for a more aggressive stance, pushing fed funds up by a historically high move of 75bp at the June FOMC meeting.
Our “house view” is that (a) inflation may be peaking but likely will be “sticky” for some time to come, and (b) the Fed is somewhat between a rock and a hard place right now but combatting inflation is its primary objective, perhaps even at the expense of economic growth in the second half of the year.
Finally, volatility in credit spreads has increased—a trend we expect to continue as we head into uncertain economic and inflationary times.
For definitions of terms in the table, please visit the glossary.
What Is a Yield-Seeking Investor to Do?
This is not an easy time to find reasonable risk-adjusted yield in the fixed income markets, though pockets of relative opportunity should appear from time to time. At this point, we do not recommend taking on additional duration or credit risk in a “reach” for yield, though our views on duration may evolve as we move through the summer.
What about finding yield in the equity markets? Using the information from above, let’s compare current nominal fixed income yields to current equity dividend yields.
For definitions of terms in the table, please visit the glossary.
We are starting to see more “normalized” fixed income yields, and available data suggest corporate balance sheets are in good shape. So, while the total return picture may not be overly optimistic, “coupon clippers” may find solace in today’s market environment.
Our own fixed income Model Portfolios remain short duration and over-weight in credit, with a focus on quality security selection, compared to the Bloomberg U.S. Aggregate Bond Index (the “AGG”). We are not looking to take excessive risk in our fixed income portfolios in a “reach for yield.”
Here are some other ideas and solutions that may be of interest.
Product/Strategy Ideas
Within the fixed income universe, the rise in yields thus far in 2022 has altered the backdrop for income-focused investors. Questions surrounding duration remain and will more than likely continue for the second half of this year and into 2023.
Given this uncertainty, investors may want to consider a barbell approach to fixed income investing. Our “in-house” barbell consists of the WisdomTree Yield Enhanced U.S. Aggregate Bond Fund (AGGY) at one end and the WisdomTree Floating Rate Treasury Fund (USFR) as the other “weight.” This barbell offers a core strategic solution designed to help fixed income investors navigate the uncharted waters ahead without making a high-conviction bet on where Treasury yields may ultimately be headed.
Model Portfolio Ideas
WisdomTree manages three Model Portfolios that we think fit nicely into today’s yield environment, depending on investor objectives:
- The Global Dividend model is an all-equity model designed specifically to generate optimal yield and current income without taking excessive risk. This can be used as a stand-alone model, but many advisors use it as a complementary sleeve to their existing equity portfolios in an attempt to generate additional income.
- The Global Multi-Asset Income model attempts to optimize risk-controlled current yield and income. In addition to equities, it includes fixed income and other yield-generating strategies (e.g., preferred securities and energy master limited partnerships (MLPs)).
- The Siegel-WisdomTree Longevity model, built and managed in collaboration with our since-inception Strategic Advisor, Professor Jeremy Siegel. This model attempts to “build a better mousetrap” to the traditional “60/40” portfolio by over-weighting in yield and dividend-focused equities (75% allocation) while using the fixed income allocation (25%) as a source of risk-controlled income and a hedge to the equity risk of the overall portfolio.
These three models focus on generating all or much of the current yield from the equity allocations versus the fixed income allocations.
Let’s look at the current yield of these portfolios (as of May 31, 2022). “Current Yield/Income” refers to the most recently posted 12-month dividend yield.
Now let’s examine some hypothetical “typical” client portfolios.
Conclusions
We are approaching a more “normal” market environment, where investors can generate respectable yield out of their fixed income portfolio. While this is a reversal of market conditions in the past two years, it actually represents a more historical environment. There are products and strategies, as discussed above, that have the potential to generate reasonable risk-adjusted yields and performances.
At the same time, we still believe another approach is to focus on the global equity markets to generate yield while still maintaining an adequate fixed income allocation, both for income generation and as a hedge to equity beta risk.
In today’s yield-starved world, we believe you can build intelligent portfolios that generate an acceptable level of risk-adjusted yield without taking excessive risk.
You can get all the details on our individual strategies and our Model Portfolios on the WisdomTree website.
Originally published on WisdomTree on June 16, 2022.
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Important Risks Related to this Article
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The Siegel-WisdomTree Longevity Model Portfolio seeks to address increasing longevity by shifting the focus to potential long-term growth through a higher stock allocation versus more traditional “60/40” portfolios.
AGGY: There are risks associated with investing, including the possible loss of principal. Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline. Investing in mortgage- and asset-backed securities involves interest rate, credit, valuation, extension and liquidity risks and the risk that payments on the underlying assets are delayed, prepaid, subordinated or defaulted on. Due to the investment strategy of the Fund, it may make higher capital gain distributions than other ETFs. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.
USFR: There are risks associated with investing, including the possible loss of principal. Securities with floating rates can be less sensitive to interest rate changes than securities with fixed interest rates, but may decline in value. The issuance of floating rate notes by the U.S. Treasury is new, and the amount of supply will be limited. Fixed income securities will normally decline in value as interest rates rise. The value of an investment in the Fund may change quickly and without warning in response to issuer or counterparty defaults and changes in the credit ratings of the Fund’s portfolio investments. Due to the investment strategy of this Fund, it may make higher capital gain distributions than other ETFs. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.
