As the calendar year approaches its end, investors are faced with the compelling need to reevaluate their equity exposure in light of substantial stock market performances. Following the federal election, major stock indexes have soared, culminating in a staggering 26.7% total return for the S&P 500 in 2024. Fueled by expectations of lower corporate taxes, deregulation, and a focus on domestic agendas, investor enthusiasm remains palpable. However, this exuberance also necessitates a more prudent approach, particularly for those with balanced portfolios. Many will likely engage in rebalancing their investments, aiming to secure some equity market gains while redirecting funds into bonds, which have underperformed significantly, evidenced by a meager 1.59% total return for the iShares Core Aggregate Bond ETF so far this year.
While it is common for investors to transition from equities to traditional bond indices, such a strategy might not be prudent given current market conditions. With corporate bond spreads at historically tight levels and the potential for re-accelerating inflation alongside a strengthening economy, it is possible that long-term interest rates will not decline substantially. Hence, merely shifting towards traditional fixed-rate bonds may not yield the desired risk-adjusted returns. Nevertheless, there exist opportunities within the fixed-income spectrum that can produce attractive yields with manageable interest rate risk. This analysis will explore three alternative fixed-income assets that investors should consider as they approach year-end.
One of the compelling alternatives is bank loan ETFs, which can provide investors with a floating-rate investment option amidst concerns over interest rate movements. Despite recent interest rate cuts by the Federal Reserve, some economists predict that proposed tax cuts and tariffs could prevent inflation from dropping significantly, limiting future cuts. In this environment, bank loans—floating-rate debt instruments utilized by corporations—offer yields that notably surpass cash or Treasury bonds. Typically rated BB or lower, these loans carry yields that can reach around 8.25%, making them a relatively less risky option compared to high-yield fixed-rate debt. Investors can access bank loans through ETFs like Invesco’s Senior Loan ETF (BKLN), which boasts a 7.5% distribution rate and a low expense ratio, offering an attractive vehicle for those concerned about the volatility associated with equities while maintaining a reasonable yield.
Another noteworthy fixed-income option is AAA-rated Collateralized Loan Obligations (CLOs), which have expanded their appeal to retail investors through various ETFs, such as the Janus Henderson AAA CLO ETF (JAAA). CLOs are structured pools of diversified bank loans, providing investors with exposure to tranches that vary in risk and return. Currently, most AAA-rated CLOs offer yields approximately 1.2% higher than three-month Treasury bills, presenting a favorable alternative to holding cash. While CLOs are typically low-loss investments, they are not devoid of risk. They can experience notable volatility, especially during financial stress periods. For instance, JAAA has seen a maximum drawdown of 4% since its inception, underscoring the need for investors to carefully consider risk factors even in seemingly secure assets.
Actively managed income-focused bond funds represent another viable option, responding dynamically to prevailing interest rate environments. Such funds are adept at navigating through various segments of the fixed-income market to capture yield opportunities effectively. One prominent example is the PIMCO Total Return Fund, which allocates assets across a diverse range of bonds, including Treasuries, corporate debt, and mortgage-backed securities. These funds can better adapt to ongoing shifts in market conditions compared to passive bond strategies. PIMCO’s fund currently offers a 6.2% dividend yield—attractive compared to traditional Treasury bonds—while maintaining effective maturity management. By leveraging actively managed portfolios, investors seeking income without excessive exposure to interest rate risk can find a suitable pathway.
Analyzing past performance supports the case for alternative fixed-income strategies. According to Portfolio Visualizer, a portfolio diversified in bank loans, AAA-rated CLOs, and actively managed mutual funds (such as JAAA, BKLN, and PIMIX) has outshone traditional passive portfolios of Treasuries and corporate bonds over the past four years, returning 3.7% versus a -2.2% return for the popular AGG benchmark. This alternative strategy exhibited notably lower volatility and maximum drawdown levels, indicating it provides a more stable investment alternative during periods of market fluctuation.
In conclusion, as year-end approaches, the rationale for rebalancing investment portfolios toward bonds in light of the stock market’s robust performance is well-founded. However, investors should be discerning about their choices in bonds. Traditional allocations may not suffice for robust returns, particularly given the current economic landscape. By considering alternatives such as bank loans, AAA-rated CLOs, and actively managed bond funds, investors can strike a balance between yield and risk without venturing excessively into traditional bond territory fraught with potential underperformance. Embracing this diversified approach can empower investors to navigate the evolving market dynamics effectively, ensuring they capitalize on opportunities while tempering their overall risk exposure.