A Ray of Light Amid Treasury Turmoil

Since the Federal Reserve began raising interest rates last year, rising yields have been accompanied by falling prices for Treasury bonds that were already in the market. Because bond yields and prices move in opposite directions, the ongoing decline in prices hasn't been a surprise. As the slump in prices continues, though, it's created a surge in headlines that proclaim a bond market "rout" or "meltdown."

While those words may sound alarming, Adam Kramer who manages Fidelity Advisor Multi-Asset Income (FAYZX), believes they are signs of opportunity for investors who have the ability to take advantage of them. Unlike managers of strategies that only invest in a few types of assets, even if those may not present the most attractive opportunities, Kramer looks for high-quality assets whose prices have been temporarily pushed down by investors overreacting to uncertainty about factors unrelated to the ability of the assets to deliver yield. Given widespread uncertainty about where interest rates and the economy may be headed, that may be an especially useful approach to take now.

Finding opportunities in US Treasury bonds

Bonds issued by the US Treasury are among the least risky and most widely held and traded securities on earth, and right now Treasurys may offer a rare and attractive opportunity for those willing to think differently about them.

Over the past year, many big investors have been selling Treasurys from their portfolios based on concerns that interest rates will remain relatively high for longer than many had previously expected. That has pushed Treasury yields up and prices down dramatically. Meanwhile, the Treasury has been issuing lots of new bonds that pay higher interest rates.

But while some see bad news, Kramer sees opportunity in these 5-, 7-, 10-, and 20-year Treasurys. "These longer-maturity Treasurys are offering a very rare opportunity to 'do more with less'", he says. "There's a lot of bad news about 'higher for longer,' but also a higher term premium, and little risk of a typical deflationary recession being priced into these bonds. They can offer downside protection and could potentially generate total returns in the high single digits if the economy takes a downturn." As of October 16, 2023, 20-year Treasurys, are currently offering a 5.25% current yield. Even if interest rates move higher and prices come down, these bonds are paying enough interest to offset that decline. Says Kramer: "If you want the yield, liquidity, and low default risk of Treasurys plus the potential for rising prices when rates fall in the future, this may be a good time to get those things at attractive prices."

Opportunities beyond Treasurys

While Treasurys may present a unique opportunity right now, Kramer also invests in a wide variety of income-oriented assets that he believes may deliver stock-like returns with less potential volatility than stocks. He says, "I think of it as doing more with less. That means more stock-like returns, with less stocks and less volatility."

Opportunities to do more with less are not secrets but not all investment managers focus their attention on finding them. "Every manager's looking at stocks and investment-grade bonds," says Kramer. "Not as many are doing the work on other securities, but if we do the research, we can find opportunities."

One opportunity that Fidelity's research is finding right now is preferred stocks. Despite their name, preferred stocks are actually hybrid securities that in some ways resemble bonds but also represent equity shares in the companies that issue them.

Kramer likes preferred stocks of big US banks, particularly those whose interest rates are either rising now or are scheduled to do so in 2024. "I think that those are great ways to earn high, single-digit yields now while you wait for their prices to rise. Right now, you can buy them for less than their face value and their issuers can choose to buy them back from you for face value. If they don't choose to do that, the interest rates that they pay may increase and you'll still get a higher return that way. If you're looking for income, you'd probably rather collect an 8% or 9% current yield on these fixed-to-floating preferreds than a 3% dividend yield from the stocks of these same companies."

Opportunities in short-maturity, high-yield corporate bonds

Another group of income-producing assets offering attractive returns are bonds issued by companies whose credit ratings are below investment grade.

Kramer says that short-maturity, high-yield bonds issued by these companies can provide an attractive alternative to owning those companies' stocks, especially if the economy slows and enters a recession. In past recessions, bond prices have historically risen while stock prices have fallen. Right now, the interest payments—known as coupons—on many investment-grade bonds are also higher than they have been in recent years. Those coupon payments, as well as their prices in the marketplace, contribute to the total return of these bonds.

Kramer explains, "I feel like you're getting a bigger bang for your buck in high-yield bonds than in stocks of the same companies. If earnings decline, high-yield bond prices are likely to be less volatile than stock prices. High-yield is also attractive because more than 50% of the market is currently rated just below investment-grade and presents relatively little credit risk. It's unusual in a good way that there are no sectors of the high-yield market that have higher levels of risk right now. Even if the economy gets worse, you could still earn close to 10% on high-yield with much less volatility than stocks. While a potential economic slowdown might seem to raise risks that non-investment-grade bonds could default, Kramer says high-yield bonds are available that offer current yields in the high single digits without excessive risk. In a diversified portfolio, those high yields could potentially offset declines in asset prices that often accompany economic slowdowns.

Keep in mind, though, that the bond universe is a far more vast and variegated place than the stock market and not all bonds perform equally well during recessions.

Opportunities in loans

Kramer is also finding opportunities in floating-rate loans that banks make to high-quality companies and then sell to investors.

Floating-rate loans not only offer potential inflation protection, they are also a hedge against rising interest rates. That's because, unlike most bonds, the interest rates on floating-rate loans adjust upward along with rises in key consumer interest rates. That means loans are less likely than most fixed income investments to lose value when inflation and interest rates rise. While past performance is no guarantee of future results, loans historically have performed better than longer-duration fixed income bonds in rising-rate environments. From August 2022 to August 2023, for example, leveraged loans returned 11.22% on a total return basis, compared to investment-grade bonds' -0.23%.

"If you're getting a 9% current yield on a loan to a company such as Uber or Four Seasons Hotels or Bass Pro Shops, it really doesn't matter what's going to happen with the short-term market prices of these securities," says Kramer. "This is the pure-play example of doing more with less. You're getting paid while you wait for the price of these investments to eventually rise."

Securities issued by master limited partnerships (MLPs) that own and operate oil and natural gas pipelines are another place where one can find 8% to 9% yields. "In the past, master limited partnerships were shunned because everybody was down on energy pipelines and production, but we do need oil and gas," says Kramer. "These companies have been reducing their capital spending and acquisitions and their free cashflow yield is expanding as a result. This is a situation where the payout ratios have been dropping into the 50s, which is quite attractive for something that has a 9% dividend yield."

Kramer also sees another income opportunity from the unpopular energy industry: Dividend-paying stocks of oil and product tanker companies. "Oil tanker companies pay out a large percentage of their income in the form of dividends, which is why they fit into a multi-asset income strategy," he says. "Having enough oil has become a national security priority and because of geopolitics, tankers have to travel longer routes to move oil around the world. I think the setup for tankers is going to be very constructive over the next 2 or 3 years."

Another dividend income opportunity may come from companies that mine gold. Gold has long been popular with investors who are concerned about the power of inflation to reduce the value of cash and other investments, but owning it also comes with risks. Gold mining companies may give investors a less risky way to benefit from rising gold demand as they typically distribute a significant portion of their earnings to shareholders in the form of dividends. Like other stocks, dividend-paying value stocks of gold-mining companies have been affected by higher interest rates, but unlike common stocks, Kramer believes that both rates and a potential economic slowdown have already been priced in. Plus, gold miners now offer sustainable dividend payments of 4% to 5% as well as attractive prices.