Income Investing: How Much Extra Risk Will You Need To Take To Maintain Portfolio Yields?

Let's look at 7 popular bond ETFs and what would be the next step up in risk for each.

Oct 03, 2024

With the Fed finally launching its long-awaited rate cutting cycle, it’s time for fixed income investors to begin rethinking their situations. As rates likely continue moving lower over the next 12-18 months, yields will be harder to come by. What’s working right now might not work even a few months from now.

The good news is that you don’t need to make any wholesale portfolio changes yet. Yields are on the move, but they haven’t moved so significantly that it requires alterations yet.

We’re seeing the biggest changes so far in short-term and ultra short-term Treasury ETFs. For example, the iShares 1-3 Year Treasury Bond ETF (SHY) has a yield of 4.7% back on June 30th. Today, the yield is 3.6%. Other areas of the bond market, including corporate bonds and those less directly impacted by the Fed’s rate changes, are holding up much better. The iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) has only seen its yield slip from 5.3% to 4.7%. The iShares Treasury Floating Rate Bond ETF (TFLO) has gone from 5.3% to 5.0%.

If you’re invested in bond ETFs currently, you’ve likely already seen your income drop, but it’s only going to get worse. The Fed has already cut the Fed Funds rate by a half-point, but the market is expecting it to go much lower before all is said and done.

The 2-year Treasury yield is the generally accepted benchmark for where yields could be headed in the next 12-24 months. As you can see, it generally moves ahead of when the Fed actually cuts rates, so it does have some predictive power.

Right now, the 2-year yield is a full 1.1% below the Fed Funds rate. That implies the market currently expects more than 100 basis points of rate cuts ahead. The Fed Funds futures market is taking it even further, currently pricing in about 175 basis points of cuts by the end of 2025.

Either way, the days of 5% risk-free yields are over and it won’t be long before even 4% looks like a gift.

How To Improve Portfolio Yield While Managing Risk

There are two ways of lifting the yield on your bond investments - add duration or reduce credit quality.

Going from investment-grade bonds to junk bonds, for example, would take your yield from 4.7% to about 6.7% right now. Of course, you’d be exposing yourself to a lot more credit risk, downside risk and volatility by doing that.

Going from shorter-term bonds to longer-term bonds of comparable quality may actually reduce your yield in the current environment depending on where you’re going from and to.

The highest yields on the Treasury curve still exist with T-bills. From a standpoint of purely yield, there’s no benefit to adding duration. The yield curve, however, has been normalizing over the past several months and it’s likely to return to its traditional upward-sloping curve eventually.

The bottom line is that you’ve got a target yield you’re looking for your portfolio to generate, your asset allocation is going to need to shift if you want to achieve it. You’re going to need to take more risk.

While the inclination may be to make a bigger shift in order to generate more yield, sometimes minor changes to yield better results. It’s generally better to add risk incrementally in smaller pieces to see how it affects your portfolio and your risk tolerance before taking it up another notch.

That’s the premise of what I want to talk about today. If you own a specific bond ETF, what would be the next step up the risk ladder that would, in theory (or normal times), allow you to improve your portfolio’s yield while only slightly tilting your risk profile more aggressively.

Bond ETF Yield & Risk Upgrades

For this exercise, I want to look at a handful of popular bond ETFs and their respective “upgrades”. In reality, you can use them as proxies for other similar ETFs for other fund families too. They’re just designed to give you a sense of how much more risk you might need to accept in order to capture that step-up in yield.

Some will be minor steps. Some are a little more major. But they all represent logical next steps for income seekers.

iShares Short Treasury Bond ETF (SHV) to iShares 1-3 Year Treasury Bond ETF (SHY)

This is basically stepping up from 0-1 year Treasuries (i.e. T-bills) to those with a 1-3 year maturity. If you look at volatility levels, SHY is technically 6 times more volatile than SHV, which sounds like a lot, but in reality it’s going from virtually zero risk to very little risk.

If you want to get into downside risk, the biggest drawdown SHV ever experienced was 1% during the COVID recession. SHY experienced three “major” drawdowns over its lifetime. It was down about 4% during the financial crisis, 3% from 2016-2018 when the Fed was trying to normalize rates and 7% during the COVID recession. Under normal conditions, share price fluctuation is relatively minimal, but it is a different risk profile and can experience some volatility during more extreme conditions.

iShares AAA-A Rated Corporate Bond ETF (QLTA) to iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD)

QLTA is one my favorite bond ETFs because of its focus on quality. But as yields fall, you’re probably going to need to at least consider accepting a little more risk in order to improve income prospects. Durations between these two funds are relatively comparable, so this is mostly a play on increasing yield through added credit risk.

LQD is still entirely investment-grade, but it has 45% of assets in the BBB category, whereas QLTA has none. Today, the risk premium of LQD is actually pretty minimal, about 10% higher than QLTA. In the past, it’s gotten up to around 25%, so be aware if conditions in the credit markets start to get worse. The yield boost from QLTA to LQD is 0.37% right now, which is about in range of what you might expect given the higher risk level.

iShares Core U.S. Aggregate Bond ETF (AGG) to Fidelity Total Bond ETF (FBND)

AGG is about 2/3 government securities and 1/3 investment-grade corporate bonds. FBND introduces junk bonds into the mix. Its allocation is a little more than 60% in AAA-rated bonds, around 30% in investment-grade corporate bonds and 10% in junk bonds. It’s perhaps the smallest step possible to lower overall credit quality in the pursuit of higher yield.

Historically, risk levels between AGG and FBND have proven to be incredibly similar. FBND is usually slightly more volatile, but it’s actually managed to be less volatile than AGG in recent days. The yield advantage, however, has been noticeable. Over the past year or so, FBND’s yield has been about a full 1% higher than AGG’s. If credit conditions worsen, expect FBND to potentially get hit harder, but that yield bonus is a nice cushion.

iShares Floating Rate Bond ETF (FLOT) to iShares 1-5 Year Investment Grade Corporate Bond ETF (IGSB)

Floating rate bonds can be expected to see their yields adjust pretty quickly to changes in interest rates. The fixed rate nature of IGSB’s bonds will adjust over time as bonds mature and get replaced in the portfolio, but it should adjust much more slowly. If you think rates are going down, it’s perhaps better to lock in higher yields today while you can.

“Lock in” is a relative term because you’re never really “locking in” a yield like you would with a CD. Staying with the shorter-term investment-grade notes of IGSB helps minimize the additional risk, which is about triple that of FLOT, but still less than half that of a broad Treasury bond ETF. FLOT is still yielding more than 1% more than IGSB, so now wouldn’t be the time to make that move just yet.

iShares U.S. Treasury Bond ETF (GOVT) to iShares 10-20 Year Treasury Bond ETF (TLH) or iShares 20+ Year Treasury Bond ETF (TLT)

GOVT, as a broad Treasury bond ETF, has a duration of around 6 years. Both TLH (with a duration of 12 years) and TLT (with a duration of 17 years) will nearly double and triple your interest rate exposure, respectively, so this would be a bigger jump in risk.

If you think Treasury yields are going down, however, moving to TLH or TLT could be the home run swing since you’d experience much more share price upside. You can get a 30-35 basis point yield improvement by moving out onto the longer end of the yield curve currently, but the doubling of volatility may not be worth it for some.

iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) to BondBloxx BBB Rated 5-10 Year Corporate Bond ETF (BBBI)

Just like moving from QLTA to LQD was to add lower-rated BBBs to a higher quality bond portfolio, moving from LQD to BBBI would be moving ENTIRELY to BBB-rated bonds. Many investment-grade bond ETFs have half or more of their assets in BBBs because of the added yield, so this wouldn’t necessarily be a unique tradeoff, but it would be pushing all of your bond exposure right to the edge of the junk category.

BBBI actually rates as about as risky as GOVT and significantly less risky than LQD. The reason is that LQD holds longer-term bonds, which means the added duration risk outweighs the comparatively lower credit risk. BBBI has a modest 0.15% higher yield at the moment, but the higher yield & lower risk nature of pivoting to BBBI could be quite attractive.

iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) to iShares 0-5 Year High Yield Corporate Bond ETF (SHYG)

And this would be a comparable move from investment-grade over the line and into junk bonds. Again, SHYG focuses on shorter-term bonds, which helps offset the added credit risk. That actually makes it significantly lower risk than both GOVT and LQD.

SHYG’s yield is currently more than 2% higher than LQD’s, which is significant. Again, if credit conditions deteriorate, SHYG is likely to get harder, but this is a nice yield/risk improvement as it stands.