Income investing outlook: See a little light

by Adam Kramer, Portfolio Manager, Fidelity Investments

A flexible multi-asset strategy finds opportunity in a time of bad news.

Key takeaways

  • In the face of inflation, war, and economic uncertainty, a flexible, multi-asset strategy may offer higher income and better capital preservation than traditional bonds.
  • Some assets these strategies invest in may be more volatile than traditional bonds.
  • Convertible bonds, floating-rate loans, preferred stocks, select high-yield bonds, dividend-paying stocks of precious metal producers and oil tankers, master limited partnerships, and real estate investment trusts that own casinos, hotels, and office buildings, are among the investments that may offer opportunities in the months ahead.
  • Professional investment managers have the research resources and investment expertise necessary to identify mispricing and manage the risks associated with these higher-yielding securities.

Between the most destructive war in Europe since the 1940s, the highest inflation since the 1970s, and perhaps the most persistent pandemic since the 1910s, 2022 has already had more than its share of dismaying news. Now, spring is bringing higher interest rates and concerns about whether the Federal Reserve can lower inflation without tipping the US into a recession, something which already looks likely in Europe. Meanwhile, COVID is surging again in China, despite the government’s zero-tolerance policy. In addition to the costs in human health and wellbeing, the new outbreak puts additional strain on global supply chains and further increases inflation pressures.

All this bad news weighs on financial markets. However, the resulting abundance of uncertainty and even outright pessimism is also creating opportunities for professional investors who can recognize when markets overreact to bad news and temporarily drive down asset prices. These investors also know that market sentiment changes constantly and that investments delivering the highest returns today may not be the ones that do so next quarter or next year. So they look for assets whose prices have been pushed down by an excess of anxiety.

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 environment, a professionally managed, tactical approach to income investing that can spot those opportunities may help investors.

In the second quarter of 2022, fear of rising interest rates and volatile markets are helping create opportunities in convertible bonds whose underlying stocks are trading below their conversion price. They not only pay interest; their low duration reduces some of the potential drawbacks of longer-duration bonds as rates rise.

A wide variety of companies have been issuing convertibles that provide a way to invest in industries and themes such as software, renewable energy, cryptocurrency, and the metaverse. Many of these companies’ stocks have fallen significantly and convertible bonds have gone from peak (some would say over-inflated) valuations to very low levels in less than 12 months. Securities of debt-free, innovative companies are trading at 60 to 90 cents on a dollar, which provides an attractive risk-reward profile. These convertibles are trading near their bond values and are less sensitive to downward moves in the underlying stocks.

Through careful credit analysis, expert managers can find convertible bonds that are likely to return to their par values as fundamentals improve over time. These bonds could return to par more quickly if their issuer improves its liquidity or if the bonds get called or bought back. They could also return to par immediately if the issuer were to be acquired by another company.

The plusses of convertible bonds include:

  • Less volatility. While convertible bond prices can fall as 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. Historically, there have been very few bankruptcies in convertibles because many issuers are top technology companies with no 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. The ability to convert those bonds to stock and collect dividends also helps to alleviate rate risk fears.

On the minus side, convertible bonds offer lower coupon rates 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 opportunities

Inflation is a concern for fixed income investors in particular because it is leading to higher interest rates, which in turn cause bond prices to fall. It's unclear how long the current rise in inflation will be with us, but rising consumer prices mean that interest rates are rising, too.

Rising rates are increasing the attractiveness of floating-rate assets including fixed-to-floating preferred stocks and loans. 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 rising rates which makes them less likely than most fixed income investments to lose value when rates rise.

The preferred market is pricing in some bad news and prices have become increasingly attractive. Preferred stocks are mostly issued by investment grade banks. Many of them offer higher coupons than do those banks' investment grade bonds as well as a floating rate option. Despite these attractive features, preferred stocks have been selling off and investors can now get premium yields, wider spreads, and floating rate features at better prices than they would have found just a few months ago.

While past performance is no guarantee of future results, floating-rate loans 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) dividends may be another interesting source of income in the coming months, though investing in them is best left to professional managers. MLPs have been the best performing asset class so far this year because energy prices have gone up, but also because investors are starting to realize that they're less expensive than high-yield bonds issued by energy companies. MLPs pay the highest yields of any income-oriented asset class (around 8.2% presently) 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, though they are not as inexpensive now as they have been recently.

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

Real estate investment trusts (REITs) have become much less expensive so far this year and opportunities exist, especially in hotels, casinos and office buildings. Hotel REITs can grow their earnings by raising prices and many are reinstating their dividends after cutting them during the pandemic. REITs in general pay dividends that are higher than the yields of both the S&P 500 and investment-grade bonds but they can be volatile and changes in real estate values as well as interest rates or economic conditions can affect them.

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

Dividend-paying stocks of precious metal mining companies are paying healthy dividends and and are also pricing in too much bad news regarding interest rate increases. Precious metal miners’ stocks usually move with real yields which take into account inflation. If inflation rises and real yields move lower, precious metal miners and gold itself typically move higher.

Stocks of oil tanker operators may also offer opportunity because they have been carrying relatively little oil in their ships, oil producers are holding back, and prices are high. When oil inventories inevitably increase, oil prices and energy stocks may drop, but oil tankers could generate peak, mid-cycle cashflows over the next couple of years.

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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