Generating Yield in a Volatile Market

This article is relevant to financial professionals who are considering offering Model Portfolios to their clients. If you are an individual investor interested in WisdomTree ETF Model Portfolios, please inquire with your financial professional. Not all financial professionals have access to these Model Portfolios.

It has only been a little more than a month since we last visited the topic of generating yield in an evolving market, but market conditions have changed so rapidly since then it is time to revisit it, and in fact, this will become a recurring topic. The Fed recently began its “rate hike cycle” as it attempts to balance economic growth against rampant inflation, the stock market has been volatile and geopolitical tensions are as high as they have been in decades.

Let’s begin with rates, starting with the Treasury yield curve. Rates are rising without question as investors anticipate an aggressive Fed rate hike regime, but except for the 30-Year, Treasury real yields remain negative across the entire maturity spectrum.

U.S. Treasury Real Yields (%)

While nominal Treasury rates have also been rising, the real action has been at the short end of the curve, as we now approach a flat and perhaps inverted yield curve structure (we use the 10-Year minus 2-Year Treasury rates as a proxy for the “shape of the curve”). We think, with fits and starts, this upward trend will continue, but should the yield curve invert, we do not necessarily believe that signals an impending recession, as it has many times in the past. What is notable is how aggressively the 2-Year rate has risen in recent months even though the Fed has, thus far, only raised rates once.

Speaking of the Fed, the market is now pricing in at least six rate hikes for the remainder of 2022, meaning at least a 25-basis-point hike in each of the remaining FOMC meetings, resulting in a Fed Funds Rate of at least 2.00% by year-end. There are others, like St. Louis Fed Governor James Bullard and our own Senior Investment Strategy Advisor, Professor Jeremy Siegel, who believe the Fed will have to be even more aggressive than that if it wants to get a handle on inflation.

The Expected Future Path of th Three-Month Average Fed Funds Rate

Finally, credit spreads awakened from their apparent somnambulance and have started to widen.

For definitions of terms in the table, please visit the glossary.

So, What Is a Yield-Seeking Investor to Do?

To summarize the above, we continue to believe rates will grind higher, and inflation remains the story through at least the first half of 2022. Rates are rising, and credit spreads are widening—it’s hard to be optimistic about the total return profile of the broader fixed income markets. We note, however, that corporate balance sheets are in solid shape, so we believe “coupons” (interest payments) have a reduced probability of default.

What about finding yield in the equity markets? Using the information from above, let’s compare current nominal fixed income yields to current equity dividend yields.

For definitions of terms in the table, please visit the glossary.

Investors can generate higher levels of current nominal income in the bond market than in the equity market (which historically is the more “normal” situation). At the same time, we see increased risk in the fixed income markets and believe that dividends and stock buybacks may represent a more sustainable approach to generating current income. 

Our own fixed income Model Portfolios remain short duration and over-weight in credit, with an explicit focus on quality security selection, relative to the Bloomberg U.S. Aggregate Bond Index (the “Agg”). We are not looking to take excessive risk in our fixed income portfolios in a “reach for yield.”

That said, here are some ideas and solutions that may be of interest.

Model Portfolio Ideas

WisdomTree manages four Model Portfolios we think fit nicely into today’s yield environment, depending on investor objectives. From the most straightforward to the more complex, they are:

1. The Short Duration Fixed Income Model Portfolio. In June 2021, we launched our Short Duration Fixed Income Model Portfolio, which is designed specifically to reduce interest rate (duration) risk while not sacrificing too much in terms of yield relative to the “Agg” Index. It can be used as a stand-alone fixed income Model Portfolio or a complementary sleeve to an existing fixed income allocation as a means of reducing duration risk without disrupting existing allocations.
   As we write this blog post (March 25th), the effective duration of the Short Duration Fixed Income Model Portfolio is approximately 2.77 years, and the current yield* is approximately 2.81%. This compares to an effective duration of roughly 5.65 years and a current yield of roughly 3.42% in our core Fixed Income Model Portfolio. So, investors are taking a modest reduction in yield to essentially reduce their duration risk by 50%.
2. The Global Dividend Model Portfolio is an all-equity model designed specifically to generate optimal yield and current income without taking excessive risk. This can be used as a stand-alone Model Portfolio, but many advisors use it as a complementary sleeve to their existing equity portfolios in an attempt to generate additional income.
3. The Global Multi-Asset Income Model Portfolio attempts to optimize risk-controlled current yield and income, but in addition to equities, it includes fixed income and other yield-generating strategies (e.g., preferred securities and energy master limited partnerships (MLPs)). 
4. The Siegel-WisdomTree Longevity Model Portfolio. Built and managed in collaboration with our since-inception Senior Investment Strategy Advisor, Professor Jeremy Siegel, this Model Portfolio attempts to “build a better mousetrap” to the traditional “60/40” portfolio by over-weighting in yield and dividend-focused equities (75% allocation) while using the fixed income allocation (25%) as a source of risk-controlled income and a hedge to the equity risk of the overall portfolio. 

The last three Model Portfolios focus on generating all or much of their current yield from equity allocations versus fixed income allocations. 

Let’s look at the current yield of these Model Portfolios (as of February 28, 2022). 

Now let’s examine some hypothetical “typical” client portfolios.

Conclusions

Today’s market environment is fraught with risks for fixed income investors. Despite the pick-up in nominal yields, we continue to believe that taking excessive risk in the fixed income market is not a prudent approach. We believe a more appropriate approach is to focus on the global equity markets to generate yield while still maintaining an adequate fixed income allocation, both to seek income generation and as a potential hedge to equity beta risk.

In today’s yield-starved world, we believe you can build intelligent portfolios that generate an optimal level of yield without taking excessive risk.

Financial advisors can register with WisdomTree to access fully transparent information (performance, fees, yield, allocations, etc.) via our Model Adoption Center. 

*“Current Yield/Income” refers to the Model Portfolio 12-month dividend yield, which is calculated using the weighted average trailing 12-month distribution yields of the Fund constituents. Funds incepted less than 12 months do not have a trailing 12-month dividend yield.