Mark Paccione, CFA
Senior Manager | CAPTRUST Consulting Research Group
With 10-year U.S. Treasury bonds yielding around 2% and money markets paying little to nothing, investors are searching for vehicles with higher current income.1 While traditional “core” Fixed Income remains a vital part of any income portfolio, other bond market sectors and some non-Fixed Income securities can increase a portfolio’s yield without incurring excessive risk. This article explores several of these investments along with strategies for constructing a portfolio geared for income, yet still diversified across an array of asset classes.
Beyond core Fixed Income (which for this article’s purposes includes Treasury/government agency bonds), we explore Fixed Income sectors such as investment grade corporates, high yield Fixed Income, emerging market bonds, non-agency mortgages and bank loans that offer higher yields than U.S. Government bonds, albeit with varying degrees of increased risk.
• Investment grade corporates represent debt issued by companies generally in good financial standing with a minimum bond credit rating of BBB or better. Of the non-core Fixed Income sectors identified, investment grade corporates are one of the more conservative options.
• High yield Fixed Income investments are corporate bonds with higher yields than investment grade corporates as the issuers tend to be in poorer financial health and carry lower bond credit ratings.
• Emerging market bonds invest in countries and corporations within the developing world. These bonds carry traditional Fixed Income risks such as the financial condition of the issuer and ability of the issuer to repay, along with additional currency risks and potential political and economic risks inherent in developing market economies.
• Non-agency mortgages refer to mortgage backed securities that are not guaranteed or issued by government agencies, such as Freddie Mac and Fannie Mae, and thus carry no implicit government guarantee.
• Bank loans represent loans made by financial institutions to companies typically below investment grade. Bank loans are floating rate instruments so they have the potential to benefit in a rising rate environment relative to their fixed rate brethren.
Several real assets such Master Limited Partnerships (MLPs) and Real Estate Investment Trusts (REITs) present attractive opportunities from an income generating perspective.
• MLPs are publicly traded entities that own domestic energy infrastructure, such as oil and natural gas pipelines. MLPs are designed as pass-through entities; fees and revenues generated by the underlying assets are passed through to the limited partners/investors. Because of the steady income stream that comes from assets in traditionally heavily regulated industries with set pricing schedules, MLPs have grown in popularity among investors seeking yield.
• REITs are also pass-through entities that generate income from underlying assets. However unlike MLPs, REITs invest in assets, such as apartment buildings, shopping malls and other property types.
Investors should understand the unique risks associated with MLPs and REITs before investing in either. While the general interest rate level will affect MLPs and REITs, each has additional risks not found in Fixed Income. For example, MLPs are at risk of regulatory changes that negatively impact pricing, while REITs are susceptible to macro trends affecting real estate.
Finally, certain equity securities also present income opportunities. Preferred equity, senior to common stock as a claimant on company assets, can pay an attractive dividend. Certain common stock sectors present income opportunities as well via dividends. Traditionally, utilities, financials and certain industrial companies tend to pay higher dividends relative to other sectors, such as technology. When investing for dividends, investors should keep in mind that price declines can offset income gains and that purchasing “dividend payers” has become extremely popular among the investment community, especially in recent months. While the strategy still has merit, investors should pay attention to the quality of the dividends and avoid investing heavily in any one company or sector.
The chase for yield is understandable. When investing for income, an investor must remember two critical concepts: risk and portfolio construction. Selecting the highest yield or the highest dividend-paying security can be a perilous decision within a portfolio context; generating high income alone is not a sufficient portfolio solution. Investors must never forget the maxim: the greater the expected return, the greater the risk. In order to reduce risk, investors seeking income should construct allocations that incorporate a wide array of asset classes, making sure the portfolio is not reliant on any single security, issuer, sector or asset class. While many investment vehicles are exposed to similar risks, each will react differently depending on prevailing market conditions and interrelationships within the capital markets. We encourage you to reach out to your CAPTRUST Financial Advisor if you are interested in exploring concepts discussed in this article.