Income outlook: Uncertainty and opportunity

by Adam Kramer, Portfolio Manager, Fidelity Investments

A flexible multi-asset investing approach may help you make the best of 2022.

Key takeaways

  • Investing in a wide variety of assets may help meet investors' needs for income in 2022 despite economic and interest-rate uncertainty.
  • Some assets these strategies invest in may be more volatile than traditional bonds.
  • In a time of inflation, these strategies may offer higher income and better capital preservation than traditional bonds.
  • Convertible bonds, floating-rate loans, floating-rate preferred stock, dividend-paying stocks of gold producers, master limited partnerships (MLPs), and real  estate investment trusts (REITs), are among the investments that may offer income opportunities in 2022.
  • Professional investment managers have the research resources and investment expertise necessary to identify mispricing and manage the risks associated with these higher-yielding securities.

Not long ago, expectations were that 2022 would arrive with the COVID pandemic on its way out and pent-up consumer demand fueling economic recovery as life returned to something like it used to be. Instead, inflation is rising, the recovery may be slowing, and uncertainty is growing about what’s next for everything from interest rates to winter weather to supply chains to COVID itself.

The potential for policy error is also complicating attempts to see what the future may hold. The Federal Reserve faces the difficult challenge of managing interest rates so as to slow inflation without triggering recession.

This uncertain environment presents challenges, but for professional investors who have the flexibility to choose from among a 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 ambiguous environment, a professionally managed, tactical approach to income investing that can seize those opportunities may help investors achieve their income goals in 2022.

A good time for convertibles

With low but potentially rising interest rates and high stock prices greeting 2022, convertible bonds look attractive because they not only pay interest, they also reduce some of the potential drawbacks of both stocks and longer-duration bonds. A wide variety of companies have been issuing convertibles that provide a way to invest in industries and themes such as renewable energy, cryptocurrency, and the metaverse. Many of these companies’ stocks, such as those of Tesla and NextEra Energy, have risen significantly and convertible bonds have provided an attractive way to get exposure to them.

Among their pluses:

  • Less volatility. While convertible bond prices can fall if interest rates rise and stock prices decline, they are less sensitive to such changes than both stocks and traditional corporate bonds.
  • Growth potential. Convertibles offer the potential for capital appreciation from their underlying stocks and can also participate in the dividend growth story of a company.
  • Downside protection. In bankruptcy, convertible bondholders get paid before stockholders, but after some other holders of debt.
  • Hedges against inflation and rising rates. Convertible bonds generally are less sensitive than high-yield or other bonds to the risk higher interest rates may pose. They can participate in a company’s dividend growth story and the ability to convert those bonds to stock also helps to alleviate rate risk fears.
  • Attractive pricing and downside protection. Convertibles may help allay concerns about buying stocks at very high prices because they can be converted to stock at prices that have been determined in advance. As the stock rises, the convertible bond’s participation rises until it eventually moves in tandem with the stock. However, as the stock drops, the convertible bond participates less with these movements. This is because a convertible bond is a corporate obligation of a company to be repaid at par and will eventually trade like a bond if the stock drops beyond a certain point. The end result is a much better risk-reward profile than the underlying stock.

On the minus side, convertible bonds offer a lower coupon rate due to the option to convert the bond into common stock. Issuing companies with little or no earnings—like startups—create an additional risk for convertible bond investors.

The convertible bond market is both small and specialized, and conditions in it can change quickly. This is because unlike other asset markets, the makeup of the convertible market is constantly changing as existing bonds get converted to stock and leave the market while new bonds with different features take their place.

Some other inflation hedges

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. They offer potential inflation protection and a hedge against the rising interest rates that inevitably accompany inflation. 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 historically have performed better than longer-duration fixed income bonds in a rising-rate environment. 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) dividends are another interesting source of income for the year ahead, 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. Many MLPs have been increasing their free cashflows by cutting their capital spending and paying down debt. MLPs may also benefit if proposed increases in corporate income tax rates come to pass. That's because as partnerships, rather than corporations, they have tax advantages that would become increasingly valuable in a higher tax environment.

MLPs come with legislative, concentration, market, interest rate and other risks and as well as special tax considerations.

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. 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, shopping mall, strip mall, and US sunbelt REITs.

Changes in real estate values or economic conditions can have a positive or negative effect on issuers in the real estate industry.

Dividend-paying value stocks from gold mining companies are another potential source of income. These stocks are paying healthy dividends and are also inexpensive by historical standards because investors have focused on growth stocks and have been willing to pay a premium for growth. 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, which makes the dividend-paying gold miners an interesting way to gain equity exposure in today's environment.

Remember, stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Gold industry stocks can be significantly volatile and may be affected by a variety of factors including gold prices, international monetary and political developments, and central bank actions. Fluctuations in gold prices often dramatically affect the profitability of companies in the gold sector.


Copyright © Fidelity Investments

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