- Income generation in today’s low yield environment remains a challenge – especially on an after-tax basis
- Investors could consider diversifying sources of risk with emerging market debt (currency risk), senior loans (credit risk), and preferreds (hybrid of equity and rate risk) to seek higher pre-tax yields – and adding municipals to pursue higher after-tax yields.
The amount of global debt trading below a 1% yield now outpaces the entire market capitalization of the S&P 500.1 That’s a problem as one of the primary functions of bonds in a portfolio is to generate income. In fact, with no major developed nation’s sovereign debt currently yielding above 1.4%,2 the promise of income from bonds has been, to a degree, broken – leaving just bonds’ potential benefit of diversification.
That is not the worst news, though. If we look at yields beyond the macro level and consider the actual income paid out to investors after taxes, the search for income becomes much more challenging.
One for you, nineteen for me
When yields on the Bloomberg Barclays US Aggregate Bond Index (US Agg) were 3.6% back in 2018, the after-tax yield was 2.27%.3 That was above the average rate of inflation4 and more than equities on a pre-tax basis,5 along with 80% lesser volatility.6 However, current yields on the US Agg are 1.2% pre-tax and 0.76% post-tax.7 On a global basis it’s even worse, with the Global Agg yielding 0.91% pre-tax and 0.57%8 post-tax.
Such low levels mean the standard 60/40 portfolio of global stocks and global bonds now yields the lowest amount on record on an assumed after-tax basis, as shown below. At less than 1%, the yield is below the current rate of inflation (1.4%),9 as well as the inflation expectations over the next three, five and 10 years.10 The same calculus holds if you change the bond side to include more than just investment-grade (IG) rated debt,11 also shown below. Swapping in this 95% IG/5% high yield mix for the 40% of the bond allocation, the entire mix also yields less than 1%, a level still well below inflation expectations. Adding in non-IG bonds in this fashion to a 60/40 allocation increases the after-tax yield by just 4 basis points. That’s a problem.
1 The total market capitalization of bonds with a yield below 1% in the Bloomberg Barclays Global Aggregate Bond Index is 44.6 trillion while the market capitalization of the S&P 500 Index is $32.6 trillion based on data from Bloomberg Finance L.P. as of February 5, 2021
2 Bloomberg Finance L.P. as of February 5, 2021
3 After tax yield is based on the yield-to-worst and applying the highest marginal federal income tax rate of 37%. This may differ for actual investors based on their tax bracket and it is meant to be an illustration of the impact on taxes in a such low rate environment. It does not account for state taxes or net investment income taxes. Actual results may differ.
4 Average rate of inflation from 2000 to 2020 was 2.1% per Bloomberg Finance L.P. data as of February 5, 2021
5 Current yield on the MSCI ACWI Index is 1.74% per Bloomberg Finance L.P. data as of February 5, 2021
6 FactSet as of January 31, 2021 based on the monthly returns of the Bloomberg Barclays Global Aggregate Bond Index and the MSCI ACWI Index from January 2001 to January 2021
7 Bloomberg Finance L.P. data as of February 4, 2021
8 Bloomberg Finance L.P. data as of February 4, 2021 based on the Bloomberg Barclays Global Aggregate Bond Index
9 CPI as of February 10, 2021 is 1.4% per Bloomberg Finance L.P. data
10 Based on breakeven rates, inflation expectations are 2.4%, 2.3%, and 2.19% for the next three, five, and ten years, respectively per Bloomberg Finance L.P. as of February 5, 2021
11Based on the Bloomberg Barclays Multiverse Index and the MSCI ACWI Index. The Bloomberg Barclays Multiverse Index has a 5% below investment grade allocation per Bloomberg Finance L.P. as of February 5, 2021
Originally Posted on February 17, 2021 – Income Generation Is a Problem – Plus, The Taxman Clips Your Coupon
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