Investors seeking income in their portfolios are faced with three distinct challenges:

  1. The current real (inflation-adjusted) yields of U.S. Government-related bonds are only modestly positive.
  2. U.S. Government and related bonds, with yields near record-low levels, cannot mathematically produce the same returns as they have over the past three and a half decades.
  3. Low-coupon, long-duration bonds are particularly vulnerable to a rise in interest rates.

We believe income-focused investors have not yet responded to these challenges in their portfolios.

Current Positioning Compounds the Challenge

According to Morningstar, investors currently allocate more than 70% of their income portfolios in U.S. Government bonds and investment-grade corporate bonds, with a smattering of other income-generating assets comprising the remainder of their portfolios.

 

The results are income allocations within portfolios that we believe are more suited for the past than the present.

 

Investors do have options, however, in today’s fixed income and alternatives world in the form of asset classes that focus on areas beyond the Bloomberg Barclays U.S. Aggregate Bond Index. In our view, such assets as high-yield bonds, international bonds, senior loans, and specialized alternatives (e.g., event-linked bonds, dividend-paying equities, preferred stock, and master limited partnerships) can all compliment a core bond allocation and help investors who are seeking to generate income.

Building Solutions

Our recent white paper offer three portfolio suggestions for different yield objectives based on a Black-Litterman Optimization framework. The targets for yield are 3%, 4%, and 5%. The goals of the optimizations are to provide guideposts for investors as they seek to build new income portfolios out of asset classes beyond the Bloomberg Barclays U.S. Aggregate Bond Index. This framework helps with evaluating how many different asset classes could fit together without over-allocating to specific risks.

 

The paper features the optimization results and explains how investors seeking income can develop new portfolio construction approaches for today’s market environment.

 

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