As interest rates have continued to decline over the past several years, we have more and more clients “seeking income” through a number of alternatives. Investors can achieve income yield through credit worthy investments, however at this stage of the market cycle investors must be much more diligent in selecting bonds and stocks that will perform as expected. We have experienced an extended bull market in bonds as interest rates have declined. Those investors who purchased bonds early in the cycle, might still be enjoying 4% and 5% yields on bond issues. Last week, as the Federal Reserve pointed to improving economic news, they stated they are considering a rate hike in June or July.
The stock market, including common stocks, preferred stocks, publicly traded real estate investment trusts (REIT’s) and master limited partnerships (MLPs), has also enjoyed a bull market that is now in it’s seventh year. When does the stock market move to the next stage We cannot pinpoint with accuracy the timing, however we can start preparing portfolios for the next stage which includes “income oriented” portfolios. The selection of companies, securities and maturity dates for income oriented investments is critical in a rising interest rate environment and/or an economic slowdown.
Let’s review the income alternatives and understand how they tend to behave when rates rise and/or if there is an economic slowdown. We will study the investments in order of priority of payment. By priority of payment we mean what type of security is senior to the others as a corporation pays out their cash flow. This is critical when facing an economic slowdown.
Individual Corporate Bonds:
There are different levels of corporate bonds, however for the sake of expediency we will view them as one in this article. The past few years have been good for bonds of almost all maturities and credit quality. Currently interest rates are at historical lows and spreads between maturities and credit quality have narrowed. Therefore, you do not attain a much higher yield with longer maturities or lower credit quality. If we are entering a cycle of rising interest rates, the market value of bonds will decline as interest rates rise. We are advising clients to acquire individual bonds with investment grade ratings and average maturities of 3 to 5 years. Under this strategy we can expect to attain a yield to maturity of 2% to 3%. The conservative nature of this strategy reduces the risk of loss of principal and then when bonds mature reinvest at the prevailing interest rates. More conservative also means a lower rate of return, though this is an important allocation to any income oriented portfolio. For tax-sensitive investors, this strategy holds true with tax-exempt municipal bonds as well.
Preferred stocks are typically a hybrid between bonds and common stocks. They normally offer a stated dividend payout with yields that are much higher than a bond. There is also a maturity date, unless it is a “perpetual” preferred which often has specific call dates. Each preferred stock offering has unique structural differences that must be well understood before investing in any issue. Investors must first keep in mind that preferred stocks are well below bonds in their priority of payments. They also tend to be issued with maturity dates that can be 30, 40 or even 60 years. The longer the maturity, the greater the fluctuation in price when interest rate rise or fall. Given the order of priority of payment and the longer maturities and unique structure of preferred stocks, we believe it is critical to focus only on high credit quality companies, particularly if we are entering an economic slowdown. That said, preferred stocks can provide an income yield of 4% to 8%. There are preferred stocks with higher income yields but they are typically issued by lower credit quality companies. We do not recommend lower credit quality preferred issuers. Investors should know an allocation to preferred stocks offers higher yield commensurate with a higher level of risk.
Publicly Traded Real Estate Investment Trusts (REITs) and Master Limited Partnerships (MLP’s)
REITs and MLP’s are different types of investments in distinctive sectors of the market but can look and act similarly. The structure of these investments is unique, as they are required to distribute most all of their income to their investors and also have specific tax structures. MLP’s are energy related and, as we experienced in 2015 and into 2016 when energy prices fell, the value of the MLP’s can drop significantly. If an MLP’s income is disrupted, it can also cause a cut in distributions to investors. REIT’s can have similar reactions in the market if the real estate values goes south. Investors should invest in the best operators with proven track records. It is also important for an investor to understand that, although they may pay a high income yield, the prices of REIT’s and MLP’s can fluctuate like common stocks. Attainable yields in REIT’s and MLP’s range from 4% to 8%. Again, higher yield equals higher risk with moderate growth opportunities long term.
Common Stocks with High Dividend Yield and Growing Dividend Yield
For the past few years we have had the unique experience from a historical perspective of being able to attain higher dividend income yield in select common stocks than yields available in most bonds. When looking for yield in common stocks, we recommend focusing on quality companies that have a history of consistent and growing dividend income payments. We can find stocks that provide solid dividend yield in most every sector of the economy. This strategy has proven, over the long term, to provide a growing stream of income and moderate growth. You can attain a dividend income yield of 3% to 6% on select companies. Moderate growth is also achievable, however common stocks have higher risk of losses, particularly if we experience a rise in interest rates and a slowing economy. The focus should be on high credit quality companies offering leading products and services with solid cash flows and profits. Common stocks offer a higher return potential but with a higher level of risk.
If you are considering having an income portfolio designed to provide the level of income you need for your objectives, we advise an allocation to all of the securities outlined above. Given where we are in this market cycle, the portfolio must be designed with a focus on credit quality and securities with short to intermediate maturities. Please contact us if you would like to know more about an “income producing” portfolio.
Robert A. Kincade
President & Portfolio Manager