Adam Kramer: Clearing and clouds for income investors
A multi-asset approach may help you face uncertainty in the second half of 2021.
- Multi-asset income strategies may help investors meet their needs for income in the second half of 2021, despite interest rate uncertainty and the high prices of many stocks.
- In exchange for higher income, some of the assets these strategies invest in may exhibit more volatility than traditional income investments. In an inflationary environment, however, strategies that can invest in a variety of income-oriented assets may offer both higher income and better capital preservation than traditional fixed income investments.
- High-yield bonds, floating rate loans, dividend-paying U.S. and international value stocks (including energy and gold producers) and real estate investment trusts (REITs) are among the investments that may offer income opportunities in the second half of 2021.
- Professional investment managers may find opportunities when markets misprice these assets due to excessive pessimism about the future.
With the economy growing, unemployment falling and stock prices rising, many growth-oriented investors are enjoying what feels like a sunny day at the beach. But for those who focus on earning dividend and interest income from their portfolios, the forecast remains as cloudy this summer as it was during the winter and spring. Interest rates are still near record lows, and there may appear to be few viable alternatives to pricey and potentially volatile stocks. Further complicating things is the return of inflation, after a decades-long nap, and growing uncertainty about whether higher consumer prices will force interest rates upward and hurt the prices of many assets.
The good news is that opportunities do exist for those who know where to look – and how to manage the risks. In today's environment, a professionally managed approach to income investing that can seek opportunities in a variety of asset classes may help investors achieve their income goals.
The forces that drive markets are always in motion, and because market conditions constantly change, the investments that deliver the highest returns today may not be the ones that do so next month or next year. That means that diversification, research and risk management matter. That’s also why strategies that can invest across a wide variety of asset classes may be able to deliver more consistent returns and a better balance between risk and return than those with fewer options to choose from.
Scanning the horizon for income opportunities
Inflation is one of the clouds that income-seeking investors have watched grow bigger and darker since the start of the year, and that change in the weather is affecting opportunities in several popular income-producing asset classes. Inflation is a concern for fixed income investors in particular, because it may lead to higher interest rates, which in turn cause the prices of existing bonds to fall. It’s unclear whether the current rise in inflation is merely a passing phase or something that will be with us for a while, but rising consumer prices increase the possibility that interest rates may also rise, and that corporate earnings may fall, during the second half of 2021. Against this backdrop, it's important to determine which income-oriented asset classes may be able to withstand the effects of inflation, and which companies may be best able to maintain earnings.
Even with yields near record lows, high-yield bonds continue to offer higher interest payments than those offered by Treasuries or investment-grade bonds, and their valuations remain relatively reasonable. Of course, their higher interest payments reflect their lower credit ratings, and imply a higher volatility and risk of default. But the credit quality of the overall high-yield market is actually higher than it was a year ago, now that many profitable and well-managed companies, such as Ford and Kraft, have seen their credit ratings lowered into high-yield territory.
High-yield bonds do pose somewhat more default risk than other types of bonds, but they are less exposed to the risk that rising interest rates will reduce bond prices. However, that’s not the same thing as being entirely immune to the risks from an unexpected rate rise. You can understand how vulnerable a bond is to rate risk by looking at its duration, a measure of how likely its price is to change in response to interest rate moves. Currently, duration in the high-yield market averages 3.9 years. That contrasts with less than six months in the floating rate debt market.
For those worried about higher rates, floating rate secured term bank loans may offer an attractive alternative to bonds with similarly high yields in the second half of 2021. That's partly because, unlike bonds, which pay fixed rates of interest, the amount of income an investor receives from these loans rises when interest rates go up. This feature makes floating rate debt attractive to investors at times when rates are rising, and offers a favourable contrast to bonds whose prices drop when rates rise. Remember, though, that floating rate loans, like high-yield bonds, are sub-investment-grade assets that may be more volatile and present higher credit risk than investment-grade corporate and government bonds.
Dividend-paying value stocks from Europe, Japan, Canada and the U.S. are another potential source of income in the second half of 2021. Attractive opportunities may exist in the stocks of companies that include oil and gold producers, clean energy yieldcos, banks (as well as non-bank financial firms such as asset managers) and industrial companies. These stocks are paying healthy dividends and may be less potentially volatile than other stocks, although significantly more volatile than corporate or Treasury bonds. They’re also inexpensive by historical standards, because investors have been focused on growth stocks and have been willing to pay a premium for growth. Many stocks of non-U.S. companies offer both relatively high dividend yields and low valuations that reflect the slower pace of the COVID-19 economic recovery outside the U.S. Countries such as Canada, for example, are only starting to reopen their economies.
Real estate investment trusts in the U.S. and Canada may also offer attractive and steady (or even rising) dividends, plus the potential for capital appreciation as more people return to offices, stores and leisure activities. REITs can grow their earnings by raising rents, and they pay dividends that are higher than the yields of both the S&P 500 Index and investment-grade bonds. Despite their improving fundamentals, some REITs are still being underpriced by the market, and that is creating opportunities for skilled managers who practise careful security selection.