Income! It is by far the most common topic of conversation when I am speaking with investors. Given the low level of U.S. bond yields, people are struggling with how to generate income. Stick with Treasuries and accept low yields? Move into longer maturity bonds and take on more interest rate risk? Reach for yield in junk bonds and take on default risk? What is the right answer? Let’s sort through some of these issues so you have a better framework for navigating fixed income markets.

Written by Matthew Tucker, CFA

See the chart below for the current yields available from different fixed income asset classes as of 31 October 2016. I am using Bloomberg Barclay’s index yields here to keep the conversation simple. The blue dotted line shows the 1.5% rate of inflation as measured by Consumer Price Index (CPI, as of 10/31/2016).

The first thing that jumps off the chart for me is that Treasuries don’t offer a lot of yield right now. This isn’t new information, but it is the root of the problem. Most other bond sectors are priced off of Treasuries. If Treasury rates are low, this often brings down the yields of other asset classes as well. Also, the yield on Treasuries is below the current level of inflation. When the return on an investment is less than the inflation rate, purchasing power is actually declining over time.

Moving from left to right on the chart, we see that the broad investment grade aggregate index is yielding just around 2%, and mortgage-backed securities are a touch higher at 2.27%. Surprisingly, we find that 20+ maturity Treasuries only yield 2.52%. That isn’t a lot of yield considering the high level of interest rate sensitivity that long maturity bonds carry. If interest rates do rise, it is the bonds with the most interest rate sensitivity that will likely fall the most in price.

The last three asset classes are the ones that have been getting a lot of investor attention lately: investment grade credit, emerging market (EM) debt and high yield credit. Investment grade credit offers a yield of 2.95%, with an interest rate sensitivity that is close to that of the aggregate and Treasury sectors. The high yield and EM sectors offer yields of around 5% or above, a heady figure in this yield environment. Of course, they also come with higher amounts of credit risk, the risk that a bond issuer will default on their coupon or principal payments.

Interest rate risk or credit risk

In the bond market, interest rate risk and credit risk are the two biggest risk factors that investors face. When an investor buys a bond investment, they take on some interest rate risk and some credit risk, and exactly how much of each risk factor they take on will determine how much yield their investment offers. Nothing is ever free; if an investor wants more yield, they need to take on some kind of risk. Interest rate movements historically have had a low correlation with equity market movements, and so adding interest rate risk to a portfolio can help balance out equity returns. However, adding interest rate risk doesn’t generate a lot of yield in today’s market, as we saw with the Bloomberg Barclays US Treasury 20+ Year Index above. Credit risk can be a place to potentially source income, but keep in mind that in a market where corporate bonds struggle, equity investments are likely to struggle too. For this reason, credit risk does not provide the same diversification benefits to a broad portfolio as interest rate risk does.

What is the income solution?

Ultimately, today’s investors get paid more for taking on credit risk than interest rate risk. If an investor tries to build income by just adding longer duration bonds, they won’t be able to get very far. Almost any income solution will probably need to involve corporate or EM bonds. As always, diversification is important. It is helpful to have both interest risk and credit risk in a bond portfolio. A broad Bloomberg Barclays US Aggregate Bond Index fund such as the iShares Core US Aggregate Bond ETF (AGG ) is made up mostly of interest rate risk, it can potentially make a nice pairing with a historically higher yielding and more credit risk-sensitive asset class like the high yield corporate bonds found in a fund like the iShares iBoxx $ High Yield Corporate Bond ETF (HYG).

Keep in mind that this analysis does not take taxes into consideration; in a taxable account, you may have different preferences...