The U.S. investment-grade bond market has offered a sub-3% yield for 14 consecutive quarters, as measured by the Barclay’s Aggregate bond index. No wonder investors have lost interest in traditional higher-rated bonds.

What has caught their attention instead? Asset class “cross-dressing.”

At a time of ultra-low bond yields and more compressed expected equity returns, and while stocks are typically more volatile than bonds, investors are increasingly opting for stocks that are behaving “bond-like” to generate income as well as riskier bonds, which have the side effect of building equity-like exposure – and risk –in their bond portfolio. This approach, however understandable, comes with its own hazards. Here’s why.

Certain income stocks are looking expensive. When it comes to generating income with stocks, many investors have pursued equity sectors that may offer high dividend yields and potentially less price swings than the overall market. Think real estate, telecoms, utilities and consumer staples.

But while many bond proxies, such as utilities and real estate, have outperformed in 2014 given the renewed move lower in interest rates, these historically higher dividend yielding sectors have underperformed the overall market since 2011 amid improving economic activity. In addition, while some of the valuation premium of the bond proxy equity sectors has come off in recent years, they are still somewhat expensive relative to recent history. For example, relative price-to-forward earnings ratios for utilities are at the upper end of their historical range.

Riskier bonds can limit diversification and look expensive too. Meanwhile in the bond market, investors have traded interest rate risk for credit risk during the past few years (and they’ve been amply rewarded for doing so).

While this strategy may limit losses when rates rise again, investors have essentially “doubled up” their equity market risk as they raise allocations to high yield bonds. As my colleague Del Stafford recently wrote, the high yield bond market has a correlation of roughly .74 to stocks. If high yield has similar risks to stocks, investors are surrendering the value of diversification and potentially taking the same bet twice.

Although attractive in a “lower for longer” rate environment, these cross-dressing asset classes are also relatively expensive. And if interest rates eventually do resume their move higher, as I expect, I would be leery of segments of the market that require low yields to justify their valuations. Here are five investing ideas I would focus on instead:

Pursue international and global dividend opportunities. While I’d be wary of seeking income at all costs (i.e. don’t be agnostic to valuations), that’s not to say there aren’t certain market segments that are worth pursuing, especially given that equities continue to look cheaper than bonds.

One segment I believe investors should consider is international and global dividend funds, rather than funds focused exclusively on U.S. dividends. The reason: U.S. dividend funds look the most expensive, and dividend yields in the United States are low compared to those in the rest of the world (stay tuned for more on this potential opportunity in an upcoming post). In addition, I also like the global financials and technology sectors for their cyclical exposure and relatively inexpensive valuations, and dividends have grown especially fast in these sectors as well in recent years.

Harvest capital gains: If it’s income you’re after, what better way to generate income than to harvest long-term capital gains in high yield bonds? The resulting potential “income” stream would accrue more favorable tax treatment than interest and would lock in gains at expensive levels. The alternative – letting your winners ride at a below 6% yield – seems like a risky proposition.

Rebuild your bond ballast: With yields on high yield bonds south of the 6% mark, I believe investors are no longer being sufficiently compensated for the risk they’re taking and I see limited opportunity for high yield price appreciation. While I remain neutral high yield, for investors concerned about “cracks in the foundation” or “the next shoe to drop,” now may be a good time to trim exposure and replace it with bond ballast, such as municipal bonds.

Employ alternatives: If higher interest rates were to undermine stocks, correlations between stocks and bonds would likely rise. With U.S. stocks fully valued and high yield bonds offering little value, liquid alternative structures that enable investors to go long and short a specific market, such as within equity and credit markets, would have the potential to outperform. Read more on this in BlackRock’s latest market outlook, and remember that while long/short strategies can be risky, they can also potentially offer a differentiated source of return in a well-rounded portfolio.

Buy volatility. With volatility as low as it is today, now would be a good time for investors to consider purchasing insurance in the event of a Federal Reserve (Fed)-induced market correction, as I suggested in a recent post.

Eventually, the Fed will normalize policy and the allure of using stocks as bonds and vice versa will fade. Until then, you’ll want to make sure you look under the hood – there may be a wolf disguised as grandma.

 

Sources: Linked to throughout Post, BlackRock research

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Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist. He is a regular contributor to The Blog and you can find more of his posts here.

Kurt Reiman is a Global Investment Strategist at BlackRock who works directly with Russ Koesterich. He contributed to this post by providing research and investment insights.

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Past performance does not guarantee future results. Diversification and asset allocation may not protect against market risk or loss of principal.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.  Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/ developing markets or in concentrations of single countries. There is no guarantee that dividends will be paid.

Investing in alternative strategies such as a long/short strategy, presents the opportunity for losses which exceed the principal amount invested. Securities based on volatility are subject to greater risks than traditional securities and may not be suitable for all investors.

The information provided is not intended to be tax advice.  Investors should be urged to consult their tax professionals or financial advisors for more information regarding their specific tax situations.

This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective.

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