If debt lights the fire of every financial crisis, as author Andrew Ross Sorkin once observed, then we might have a problem brewing. Companies have racked up a record amount of debt in recent years, thanks in part to rock-bottom interest rates. Most market watchers do not expect the accumulation to trigger an impending credit catastrophe. Nevertheless, investors should be aware of the risks that accumulate and choose carefully when investing in bonds or stocks.
Build a kernel. A well-balanced portfolio needs a core bond fund for weighting. A true core bond fund holds primarily A-rated debt securities and no more than 5% of high-yield bond assets. The managers at Baird Global Bond Fund (symbol BAGSX, expense ratio 0.55%) only buy high quality bonds. More than half of the fund’s assets are made up of triple-A-rated debt securities, including government-backed treasury bills and mortgage-backed securities. The rest of the fund’s holdings include high-quality corporate bonds (40%) and other asset-backed securities (8%). The fund yields 2.09%, which may not impress income seekers, but its main role is to hold its own in tough times. Think of it as an insurance policy against a recession.
Reinforce your safe havens with other government bonds. Agency mortgage-backed securities carry the same collateral as treasury bills and a slightly higher yield. Stable interest rates should keep prepayments, a risk associated with mortgage debt, at bay. Vanguard mortgage-backed securities comes in an exchange-traded fund stock category (VMBS, 0.05%, share price $53) and a mutual fund category (VMBSX, 0.07%). Both hold only triple-A rated mortgage bonds. The ETF yields 2.55% and the mutual fund yields 2.53%, slightly more than the typical core bond fund.
Rise as a business. Everything worked out in the fixed income markets last year. Take profits on junkier debt and build your exposure to higher quality bonds. IShares AAA-A Rated Corporate Bond ETF (QLTA, 0.15%, $55) offers exposure to the highest rated corporate IOUs and yields 2.42%.
Try emerging market bonds for extra income. It is no longer the risky sector it once was. Today, more than half of the emerging market bond universe is investment grade. The dollar is no longer as strong as it was in late 2017 and early 2018. In fact, it was relatively stable in 2019 against a basket of foreign currencies. And many analysts expect it to weaken this year. “Dollar weakness is positive for emerging assets because governments and corporations have a lot of dollar-denominated debt. When the dollar goes up, it’s like a tax,” says Alec Young, managing director of global markets research at FTSE Russell. And when it falters, it’s like a discount.
See also: Contrarian Funds: Charting Their Own Path
Be prepared for volatility. The ride with emerging market bonds is twice as bumpy as the typical core bond fund. But securities in this sector earn on average twice as much. ETF iShares JP Morgan USD Emerging Markets Bond (EMB, 0.39%, $115) returns 4.31%. This ETF avoids the impact of currency fluctuations by buying bonds denominated in dollars. To increase your income, you can pair your dollar-based ETF with the version that invests in local currency IOUs, iShares JP Morgan EM Local Currency Bond ETF (LEMB, 0.30%, $44), which is 5.50%.
See what’s supporting your dividends. Avoid highly indebted companies. Professional stock (and bond) pickers look at balance sheets and tax returns to find out if a company can afford to pay its debts, because whether the choice is between repaying debt or paying a dividend , the first will always win. “Understanding what a company intends to do with its debt and how it intends to repay it is critical to what we do,” says David Bradin of Capital Group, investment specialist at American Funds.
Consider two automakers, Ford Motor and Daimler AG. Both offer similar dividend yields: Ford, 6.37%; Daimler, 6.46%. But Ford has a triple B credit rating and Daimler is A rated. Additionally, Daimler generates enough annual operating revenue to pay 13 times its annual interest expense. Ford throws away enough to pay three years of interest payments. “Investors can jump to the conclusion that two companies in a similar industry with similar returns are the same,” says Capital Group’s Hanks. “But one has more risk than the other, and its dividend could be reduced. You might want to ask yourself, Am I paid for the risk I take? »
Choose a dividend pro. AT Vanguard Equity-Revenue (VEIPX, 0.27%), two companies manage the fund but work separately, focusing on large, high-quality companies with above-average returns. The fund yields 2.70%. Schwab US Dividend Equity ETF (SCHD, 0.06%, $58) is not actively managed, but the companies in the index it tracks must meet several criteria. Companies must have paid dividends for at least 10 consecutive years, to begin with. And only companies with the best relative financial strength, marked by their ratio of cash flow to total debt and their return on equity (a measure of profitability), make the final cut. The ETF returns 3.11%. Pioneering dividend growth (VDIGX, 0.22%) returns just 1.84%, but manager Donald Kilbride focuses on cash-rich, low-leverage companies that can increase dividends over time. Morningstar analyst Alec Lucas says the fund is “a standout when markets shake”.
Add a touch of high quality. A strong, low-leverage balance sheet is a key characteristic of a high-quality business. It’s right up there with smart executives at the helm and a strong market niche in its industry.
Double the quality with iShares Edge MSCI USA ETF Quality Factor (QUAL, 0.15%, $101). The ETF invests in a diverse group of 125 large and medium-sized companies with low leverage, stable annual earnings growth and high return on equity. Johnson & Johnson, Pepsico and Facebook are among its top holdings. BlackRock has an international equity version of this ETF, iShares Edge MSCI International Quality Factor ETF (IQLT, 0.30%, $32), which held up better than the MSCI ACWI ex USA Foreign-Stock Index during the 2018 correction. The ETF yields 2.31% and top stocks include Nestle and the pharmaceutical company Roche Holding.
To go abroad. Companies in the rest of the world are less leveraged, on average, than US companies Better still, if you focus on the best foreign players, you could beat the US stock market, says Robert Lovelace of Capital Group. “The majority of the best performing stocks over the past 10 years were companies based outside of the United States”
AT Fidelity’s international growth (FIGFX, 0.99%), manager Jed Weiss focuses on companies with a competitive advantage. If a company can raise prices for its products without a drop in demand, Weiss is happy. It’s a trait that can sustain a business through tough times.
WisdomTree Global ex-US Quality Dividend Growth (DNL, 0.58%, $66) invests in 300 dividend-paying companies in developed and emerging foreign countries. The fund yields 2.6%. Companies must meet certain quality and growth standards, including return on equity and return on assets (another measure of profitability), to be included in the fund. As a result, the portfolio has an average debt-to-capital ratio of 29, lower than the ratio of 34 for the MSCI ACWI ex USA index (and 44 for the S&P 500). The UK, Japan and Denmark are its biggest domestic bets.