Is It Worth Searching For Yield Beyond 5% Treasury Bills?

I'm not adding credit risk to my portfolio right now, but there's one category that intrigues me.

For all the pain that the 2022 bear market and the Fed’s aggressive rate hiking cycle caused, there is a silver lining. Investors have ample opportunities to capture some juicy yields. Gone are the days of 0% yields on savings accounts, money markets and Treasury bills (well, I suppose savings accounts still have them). Now, income seekers can buy a simple Treasury bill and get a yield of 5% or more.

But the landscape has gotten more complicated. The inverted yield curve means that rates on the long end are actually lower than the short end. The Fed may be done, but Fitch’s downgrade of the U.S. government credit rating and Moody’s credit rating downgrade on a big chunk of the banking sector raises the question of just how safe is fixed income right now.

Personally, I’ve been talking about why investors might be better off just locking in a 5%+ yield on a 1-year T-bill and call it a day. After all, if recessionary conditions are coming, wouldn’t some defensive positioning in your portfolio be more prudent? There are a lot of investors out there, however, that disagree with me feeling that GDP growth is still strong, the labor market is tight and the Fed is likely to stop hiking rates. There’s certainly a case for why risk asset prices could still go higher and getting a little riskier to capture some more yield might be the better option.

There are a lot of fixed income options with varying degrees of yield and risk. Let’s break down the sector to see where yields are currently at across the board and if there are better options than the 5% T-bill yield.

The Current Landscape For Fixed Income Yields

Checking, Savings & CDs

Let’s start at the top with the bank products. Checking and savings accounts are non-starters for yield. CDs may be an option depending on how long you’re willing to lock your money up for and how much you’re looking at invest. The national averages don’t look comparatively attractive, but a lot of banks offer specialty CDs with high yields. BMO, for example, offers a 1-year CD with no minimum with a rate of 5.25% (according to Bankrate). You can find slightly higher rates if you’re willing to meet the minimum of $1000 to $2500. One of the highest rates comes from the 1-year CD at Nexbank. It pays 5.6%, but requires a $25,000 minimum. Either way, the yield is virtually no higher than that of the iShares Treasury Floating Rate Bond ETF (TFLO) and I prefer flexibility.

Ultra Short-Term Bonds

In terms of a pure yield grab, the next best option to T-bills might be corporate floaters, but then you’re introducing credit risk to the equation. The iShares Floating Rate Bond ETF (FLOT) is all investment-grade with nearly 90% of assets invested in securities rated single-A or better, so it’s actually one of the better credit profiles out there outside of government bonds. In my opinion, that makes this the second best option on this list behind TFLO. If economic conditions are deteriorating, which I believe they are despite the latest solid GDP growth readings, I’m not sure I want to be in corporate bonds even if they’re generally pretty high quality.

Junk Bonds

There’s really not much additional yield advantage to be found across the major fixed income categories unless you want to venture out into junk bonds. Yields on this group are around 8%, but most of that high yield comes from a big shift in the yield curve. Credit risk is mostly still not priced in, which means that once conditions turn, yields are likely to take off and total returns could tank. The risk/reward tradeoff in corporate high yielders just isn’t at all attractive right now in my opinion.

Muni Bonds

Unless you’re in an exceptionally high tax bracket, the tax equivalent yields on munis aren’t really any more attractive than what you’ll find in T-bills. In terms of limiting interest rate risk, short-term munis are probably where you’d want to be within this group, but even the VanEck Vectors AMT-Free Short Municipal Index ETF (SMB) pays a taxable equivalent of 4.44% for those in the 32% tax bracket. The high yield option, the VanEck Vectors High Yield Municipal Index ETF (HYD), is at 6.66% in the same tax bracket, but that ETF began to break completely in the early stages of the COVID bear market, so I’m not sure you necessarily want to trust this one in adverse market conditions.

Long Duration Bonds

In terms of purely yield, I’m still choosing either TFLO or the iShares Short Treasury Bond ETF (SHV), which invests in T-bills with a maturity of a year or less. Overall, I don’t think we need to overthink this one. With so much uncertainty around which way the global economy is headed and things beginning to break (Chinese real estate and the banking sector quickly come to mind), I’m not sure excess credit risk should be anywhere on the radar. It’s pretty easy to make the case why the 5% T-bill yield is the way to go here.

The question of duration risk is different though. One thing we’ve seen consistently over the past two years is steadily rising yields, which unfortunately has led to big losses for investments in Treasuries. Most of that has been driven by the Fed, but Fitch’s recent downgrade of the U.S. government’s credit rating added another unexpected catalyst. That’s left precious little upside in long-term Treasury bonds, but they may be about to change.

If Treasuries begin acting like a safety valve for investors again and they begin rotating out of stocks and into bonds, there’s some fairly significant upside potential in long-dated government bonds. If we move closer to recession, the Chinese real estate market begins to implode, bankruptcies start to pick up or we start down the path towards a global credit contraction (keep in mind that there’s evidence that all of these catalysts may have already commenced), the run on T-bonds could begin.

The iShares 20+ Year Treasury Bond ETF (TLT) has a duration of 17 years right now. That means for every 1% decline in interest rates, TLT could be expected to rise in value by 17%. With interest rates already 500 basis points higher than they were just two years ago, there’s a lot of downside for rates (and upside for bond prices) should things go sideways.

Full disclosure: I currently own shares of TLT. It’s one of the many portfolio hedges I own.

Conclusion

If you’re looking to add yield to your portfolio, I’m having difficulty finding a better option that TFLO and SHV given the current environment. With GDP still looking strong and the unemployment rate still near historic lows, there’s a reasonable chance that the rally in risk assets continues for another month or two, which means adding duration or even credit risk might ultimately be the more profitable play.

Personally, I’ll take the 5% yield, lock it in and reassess next summer, but I am hanging on to my position in TLT indefinitely. With the recession getting delayed and delayed, long-term Treasuries haven’t been the winning investment that I thought they’d be at the beginning of the year, but I’m still a believer.