Stock market indexes are at near record highs following the federal election. With a 26.7% total return for the S&P 500 in 2024, investor enthusiasm for additional gains is running high with the possibility of lower corporate taxes, less regulation, and a domestic-focused agenda.
Many balanced portfolio investors will look to rebalance their holdings at the end of the year, given the strong outperformance of stocks compared to bonds. Rebalancing would mean locking in some of the gains in the equity market and reallocating to the bond market, where returns were much lower—the year-to-date total return for the $119 billion iShares Core Aggregate Bond ETF is just 1.59%.
Rebalancing out of equities, though, should not mean an automatic allocation to traditional bond indexes dominated by fixed-rate mortgages, corporate credit, and Treasury bonds. Corporate bond spreads are at record tight levels, and reaccelerating inflation and a strengthening economy may prevent long-term interest rates from falling much further.
Fortunately, there are corners of the fixed-income market where investors can earn attractive yields without taking on much interest rate risk. Here are three alternative fixed-income investments that warrant consideration:
Bank Loan ETFs
The path of interest rates is a legitimate concern for investors following the election. True, the Federal Reserve lowered rates another 0.25% this month. Still, some economists predict that President-Elect Trump’s proposed tax cuts and blanket tariffs on imported goods will stop the fall in inflation. If inflation stalls at current levels and the economy picks up steam again, additional rate cuts may be limited.
“The economy is not sending any signals that we need to be in a hurry to lower rates,” said Fed chair Powell at an event in Dallas on November 14th. If the Fed is not going to cut rates aggressively, then floating-rate bonds tied to short-term interest rates would be an excellent place to invest. Bank loans are one option.
Bank loans are floating-rate debt instruments issued by corporations to fund their operations or finance acquisitions. They are usually rated BB or below by large credit agencies and have yields significantly above cash or Treasury Bills.
A typical bank loan may yield 8.25%, equivalent to a spread of 3.75% over three-month Treasury Bills. Bank loans are often considered a less risky, better-rated alternative to fixed-rate high-yield debt.
Investors can access the bank loans market using ETFs or mutual funds. One example is Invesco’s Senior Loan ETF, BKLN. The ETF tracks the Morningstar LSTA U.S. Leveraged Loan 100 Index, which includes the 100 largest and most liquid senior secured loans within the broader universe. BKLN has a distribution rate of 7.5% and a net expense ratio of 0.65%.
Bank loans and bank loan ETFs are not considered as risky as equities, but they can be volatile in times of financial market stress. They would be a good choice for investors who believe the stock market will have a hard time sustaining the type of returns it has delivered over the last two years but don’t think the economy is about to enter a severe recession in which large companies begin to default on their debts.
Given that dividends from bank loan ETFs are classified as ordinary income, it is better to hold these securities in a tax-advantaged account, such as a traditional or Roth IRA, if possible.
AAA CLO ETFs
Collateralized Loan Obligations are floating-rate securities made up of a pool of diversified bank loans issued by large U.S. corporations. A CLO bundles many corporate loans together and divides them into risk levels, or tranches, for investors to buy. Investors in the safer tranches get paid first when companies repay their loans, while those in riskier tranches potentially earn higher returns but face greater risk if some companies default.
As one might expect, the highest-rated CLOs have a lower yield than the lowest-rated CLOs. Similar to bank loans, the yield of a CLO is linked to short-term interest rates. At the moment, most AAA-rated CLOs have a yield roughly 1.2% higher than the 4.5% current yield on 3-month U.S. Treasury bills.
CLOs, once a niche market dominated by institutional investors, have become widely available to retail investors in recent years via several ETFs. One example is the Janus Henderson AAA CLO ETF, JAAA. With more than $15 billion in assets and a 0.21% expense ratio, the ETF owns a diversified pool of AAA-rated CLOs from various issuers. After the latest 0.25% cut in policy rates, JAAA’s expected dividend yield is around 5.75%, making it an attractive alternative to holding just cash.
However, the additional yield from a CLO is not risk-free. While a AAA-rated CLO has never realized a loss from a credit default, they have experienced times of high volatility. During times of stress, investors demand more compensation or spread from credit instruments like CLOs. The maximum drawdown for JAAA since its inception four years ago is 4%, which occurred during the 2022 monetary tightening that saw most risk assets fall significantly in price.
Actively Managed Income-Focused Bond Funds
Diversified, actively managed bond funds can provide consistent income generation through interest rate cycles. These funds have the ability to go in and out of corners of the fixed-income market to take advantage of yield opportunities. These funds can own Treasuries, investment-grade corporate bonds, high-yield debt and bank loans, private label and Agency mortgage-backed securities, and virtually any other type of bond. An astute manager can allocate to sectors of the market that may be considered inexpensive and trim holdings in areas with richer valuations.
One example is the $167 billion PIMCO Total Return Fund, PIMIX. The fund currently has a large allocation to mortgage bonds, which are relatively cheap to Treasury bonds and corporate bonds. PIMCO’s Income Fund has a current dividend of 6.2% and an effective duration of 4.2 years, significantly more than the 4.3% yield of a 4-year government bond.
Diversified, actively managed, income-focused funds can be a good alternative to Treasury bills or passive bond index funds without taking on a lot of incremental duration or interest rate risk. However, investors should examine the fund’s holdings before jumping in to make sure the income is generated from a variety of sources, not just from high-yield corporate bonds, for example.
Alternative Fixed-Income Historical Performance
In recent years, a portfolio of alternative fixed-income exposure via a selection of bank loans, AAA-rated CLOs, and income-oriented mutual funds has outperformed a traditional passive portfolio of Agency mortgages, Treasuries, and corporate bonds.
According to Portfolio Visualizer, the trailing 4-year return of an alternative portfolio with a 33.3% allocation to JAAA, 33.3% to BKLN, and 33% to PIMIX is 3.7%. This compares to a -2.2% total return of the popular aggregate benchmark bond ETF, AGG. From a risk perspective, the alternative portfolio had a 3.6% volatility and a 6.1% maximum drawdown compared to AGG’s 7.1% volatility and 17% maximum drawdown.
It’s perfectly rational to rebalance risk as year-end approaches by taking gains on stocks and moving into bonds. And it’s equally logical to put that money into cash or traditional, passive bond ETFs or mutual funds. However, for investors who want to earn a return above the cash without assuming a lot more interest rate risk, some attractive alternatives are currently available.
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