An adaptable approach to seeking income may help during the rest of 2021.
by Adam Kramer, Portfolio Manager, Fixed Income, Fidelity Investments
Key takeaways
- Investing in a wide variety of income-producing assets may help investors meet their needs for income despite economic and interest rate uncertainty.
- In exchange for higher income, some assets that these strategies invest in may experience more volatility than traditional income investments.
- Floating-rate preferred stocks and loans, dividend-paying stocks of energy and gold producers, master limited partnerships (MLPs), clean energy yieldcos, and real estate investment trusts (REITs), are among the investments that may offer income opportunities in the rest of 2021.
- Professional investment managers have the research resources and investment expertise necessary to help them identify mispricing and manage the risks associated with higher-yielding security types.
Not long ago, financial markets were pricing in expectations that the COVID pandemic was on its way out and that pent-up consumer demand would fuel a broad economic recovery as life returned to the way it used to be. Instead, as summer ends, COVID remains with us, the recovery may be slowing, and uncertainty about what's next is growing. Meanwhile, interest rates are still near record lows and even high-flying US stocks have lost some altitude. Further complicating the outlook is higher inflation and uncertainty about when it might force interest rates upward.
The return of clouds to what had been a sunny forecast may be disappointing to income-seeking investors, but there is a silver lining. For professional investors who have the flexibility to choose from among a wide variety of income-producing assets, opportunities do exist. 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. It'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. In today's choppy, murky environment, a professionally managed, tactical approach to income investing that can seek those opportunities may help investors achieve their income goals.
Scanning the horizon for income opportunities
Inflation is one of the clouds that income-seeking investors are watching grow bigger and darker and it is affecting opportunities in popular income-producing asset classes such as investment-grade bonds. Inflation is a concern for fixed income investors in particular because it may lead to higher interest rates, which in turn cause bond prices 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.
That possibility that higher inflation will eventually lead to higher rates is increasing the attractiveness of floating-rate assets including preferred stocks and loans from both the US and Canada. Unlike bonds that pay fixed rates of interest, floating-rate assets pay interest at rates that adjust periodically, based on a publicly available, short-term interest rate. That means floating-rate preferreds and loans are less likely than most fixed income investments to lose value when inflation and interest rates rise. While past performance is no guarantee of future results, floating-rate loans and preferreds historically have performed better than longer-duration fixed income bonds in rising rate environments. Remember though, that floating-rate loans are sub-investment grade assets that may be more volatile and present higher credit risk than investment-grade corporate and government bonds.
Master limited partnership (MLP) and clean energy yieldco dividends are another interesting source of income right now, though investing in them is best left to professional managers. MLPs pay the highest yields of any income-oriented asset class and have historically maintained their value in times of inflation. MLPs operate real properties, mostly oil and gas pipelines, and many also continue to be mispriced by the market. Clean energy yieldcos also operate real properties, mostly solar and wind power projects. Many MLPs have been increasing their free cash flows by cutting their capital spending and paying down debt and offer historically attractive yields, compared to high-yield bonds issued by energy companies. MLPs may also benefit if proposed increases in corporate income tax rates come to pass because as partnerships, rather than corporations, they have tax advantages that would become increasingly valuable in a higher tax environment.
Real estate investment trusts (REITs) in the US and Canada may also offer attractive and steady (or even rising) dividends plus the potential for capital appreciation as more people eventually 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 and investment-grade bonds. Despite their improving fundamentals, some REITs are still being underpriced by the market and that's creating opportunities for skilled managers who practice careful security selection. Some of the concern about the persistence of COVID has been priced into casino and shopping mall REITs.
Dividend-paying value stocks from companies including oil producers and gold miners are another potential souce of income. These stocks are paying healthy dividends and are also inexpensive by historical standards because investors may be pricing in an eventual rise in real yields. Gold miner stocks usually move with real yields which take into account inflation. If inflation rises and real yields move lower, gold miners and gold itself typically move higher. If real yields rise sharply, then gold miners might sell off, but a lot of that risk is already priced in.
While the market may or may not be correct in pricing in the risk of a rise in real yields, gold miner stocks offer a natural volatility dampener in the event that real yields rise. However, if real yields do not fall sharply, investors may reasonably expect to collect growing dividends and eventual capital appreciation.
Finding ideas
Investors interested in multi-asset income strategies should research professionally managed mutual funds or separately managed accounts. You can run screens using the Mutual Fund Evaluator on Fidelity.com. Below are the results of some illustrative mutual fund screens (these are not recommendations of Adam Kramer or Fidelity).
