After a broad global rally in stocks and bonds, income-oriented investments offer fewer opportunities than they did a year ago.
So investors will need to lower their expectations. But there are still places to look for yield on a range of stocks and bonds. And income will be welcome if markets turn more volatile.
This is Barron’s eighth annual assessment of the income-producing parts of the financial markets. We assess 12 sectors and rank them in order of preference for 2020.
Our record last year was mixed. Energy pipelines were our top pick, and they finished near the bottom of the pack. Electric utility stocks fared much better than we had projected.
Yet the still-depressed group of energy pipelines remains a favorite for 2020. Here, investors can get yields ranging from 5% to 9%.
High-yielding stocks globally, meanwhile, can be a good alternative to bonds.
Real estate investment trusts still offer some opportunity after a robust run in 2019, with dividend yields averaging close to 3.5% and more than double that in the depressed mall sector. Less appealing are Treasuries, preferred stock, and tax-free municipal bonds.
Here are the 12 sectors:
Investors are cool to most everything related to fossil fuels, including energy pipeline operators. That makes these investments outliers in a yield-parched world. They provide some of the stock market’s highest dividends—5% to 9%—as well as appreciation potential if they come back into vogue.
Industry leader Enterprise Products Partners (EPD), at $28, yields 6.2%, while Kinder Morgan (KMI), at $21, yields 4.7%. Energy Transfer (ET), at $12, is the least liked major pipeline operator and yields nearly 9%. The J.P. Morgan Alerian Index MLP exchange-traded note (AMJ), which tracks the Alerian MLP index, now yields 8%.
As more companies convert to corporations, pipeline operators are no longer synonymous with master limited partnerships. Many investors prefer corporations because they don’t generate the hated K-1 tax forms that MLPs do and appeal to a broader investment audience.
“The U.S. needs energy infrastructure, and global energy demand should continue to grow; the sector is undervalued,” says Rob Thummel, a portfolio manager at Tortoise Capital Advisors, which invests in the sector.
He’s partial to Williams Cos. (WMB), Enterprise Products (EPD), and Magellan Midstream Partners (MMP). Also worth a look: Closed-end funds such as Kayne Anderson MLP/Midstream Investment (KYN) and Tortoise Energy Infrastructure (TYG), which yield 10% or more.
Overseas dividend stocks
With higher dividend yields than U.S. stocks, foreign shares are a good source of income. Ample yields reflect the outperformance of U.S. equities in the past decade and the emphasis overseas on dividends, rather than on stock buybacks. If the dollar weakens and international markets finally best the S&P 500 index (.SPX), the sector could be a big winner.
In the depressed energy sector, two of the better plays are Europe’s largest oil companies: Royal Dutch Shell (RDS/B), at $61, and BP (BP), at $39. Both yield over 6% and have secure dividends, absent a collapse in oil prices.
Out-of-favor telecoms are also attractive. China Mobile (CHL), at $41, yields 4%, and European industry leader Vodafone Group (VOD), at $19, yields 5%. Deutsche Telekom (DTEGY), at $16, yields 4% and holds a valuable controlling stake in T-Mobile US (TMUS) that is equal to half of its market value. Canada’s largest telecom, BCE (BCE), trades at $45 and yields 5%.
In Asia, Toyota Motor (TM), at $141, yields 2%, has a cash-rich balance sheet, and trades for about 10 times forward earnings. Hong Kong–based conglomerate CK Hutchison Holdings (CKHUY), at about $10, offers almost 4%. European drugmakers outpaced their U.S. peers last year, amid optimism about their product pipelines. Novartis (NVS), at $95, yields 3%, and GlaxoSmithKline (GSK), at $47, yields 4%.
Among exchange-traded funds, iShares Core EAFE MSCI (IEFA), at $65, yields 3.2%; iShares Core MSCI Emerging Markets (IEMG), at $54, yields 3.3%; and Vanguard FTSE Europe (VGK) at $58, yields 3.3%.
U.S. dividend stocks
There are still plenty of income pockets in a record stock market that allow investors to put together a portfolio with roughly double the 1.8% yield on the S&P 500.
Exxon Mobil (XOM), at $70, yields 5%, and Chevron (CVX), at $120, yield 4%. Pfizer (PFE), at $39, yields almost 4%, and cruise industry leader Carnival (CCL), at $50, yields 3.9%. United Parcel Service (UPS), at $117, yields 3.3%. Kraft Heinz (KHC), the biggest loser in the food group in 2019, has the top yield among its peers at 5% after cutting its payout by 36% last year.
David King, manager of the Columbia Flexible Capital Income fund (CFIAX), is partial to General Mills (GIS), which, at $53, yields 3.7%. The company has cut debt since its 2018 purchase of Blue Buffalo Pet Products, potentially paving the way for its first dividend increase since 2017 in its fiscal year that starts in May, he says. Oil refiners are a good source of income, with King favoring one of the largest, Valero Energy (VLO), which at $93, yields 3.8%.
There are plenty of dividend-focused mutual funds and ETFs, including top-performing Vanguard Dividend Growth fund (VDIGX), which reopened to investors last year. Large ETFs include Vanguard High Dividend Yield Index (VYM) which yields 3%, and the ProShares S&P 500 Dividend Aristocrats (NOBL), which features companies with long histories of annual payout increases, rather than those with the highest yields. It pays 1.9%.
Wall Street warmed to real estate investment trusts, which returned 29% (including dividends) based on the broad and popular Vanguard Real Estate ETF (VNQ). That nearly matched the S&P 500 in 2019.
J.P. Morgan’s REIT analysts recently forecast an 8% to 9% total return for REIT stocks in 2020, based on a combination of dividends—now averaging more than 3%—and 4.3% growth in funds from operations, or FFO, an important measure of cash flow.
The negative is that REIT valuations are near record highs at about 20 times estimated 2020 FFO. The J.P. Morgan analysts wrote that those valuations could “act as a cap on absolute upside from here.”
Industrial REITs were standouts. Warehouse leader Prologis (PLD) gained 50%, as investors sought direct plays on the e-commerce boom. Mall REITs suffered from the same trend and had the worst performance in the group. Simon Property Group (SPG), the largest mall REIT, lost 11%, while the smaller Taubman Centers (TCO) declined 32%. Reflecting elevated risk in the mall sector, Simon yields 5.7% and Taubman, 9%, against Prologis at just 2.4% and the Vanguard REIT ETF at 3.4%.
Investors now favor apartment REITs, such as AvalonBay Communities (AVB) and Equity Residential (EQR), which yield 3%. Top New York office REITs Vornado Realty Trust (VNO) and SL Green Realty (SLG) are contrarian plays because of concerns over new Manhattan office supply and the high cost of upgrading older buildings. Vornado and SL Green yield 4% and trade below some analysts’ estimates of their asset values.
U.S. telecom stocks
The sector offers a combination of elevated yields and depressed valuations.
Verizon Communications (VZ), at about $61, was up less than 10% in 2019 and has a secure 4% dividend. AT&T (T) was the sector standout, rising 37%, to $39, thanks to an ultralow valuation at the start of 2019 and pressure from activist investor Elliott Management, which took a stake during 2019. AT&T yields over 5%. Verizon trades for 12 times projected 2020 earnings of $5 a share, while AT&T trades at 11 times earnings. Both are cheap, relative to the market’s price/earnings ratio of 18.
A related play is Comcast (CMCSA), the largest U.S. cable company. Its growth outlook is better than the telecoms, thanks to its lucrative broadband services. Comcast’s stock, at $45, yields less than 2%, but trades for a reasonable 14 times projected 2020 earnings.
Often overlooked, convertibles are stock-bond hybrids designed to provide the upside of stocks and the downside protection of bonds. They did that in 2019, returning 22%, as measured by the SPDR Bloomberg Barclays Convertible Securities ETF (CWB). There are two main types of convertibles: traditional bonds with a fixed maturity date and so-called mandatory convertibles that are equity substitutes.
Traditional convertibles have more downside protection. Tesla (TSLA) demonstrated that feature, as the company’s 2% convertible held up well at midyear when the electric-car manufacturer’s stock cratered, and it has rallied along with the stock in recent months. Technology and biotech companies are major issuers of convertibles because they can get low borrowing costs of 2% or less.
Mandatory convertibles from electric utilities normally have three-year maturities and provide higher yields than common shares. But they have less upside than the stocks. DTE Energy (DTE), parent of Detroit Edison, has a 6.25% issue due in 2022, and American Electric Power (AEP) has a 6.125% issue due in 2022.
After a rocky 2018, the market had one of the its best years in a decade, returning 14% based on the Bloomberg Barclays U.S. Corporate High Yield Bond Index. With the average junk bond now yielding just 5.1%, down from 8% at the start of 2019, returns may be modest in 2020.
Marty Fridson, the chief investment officer at Lehmann Livian Fridson Advisors, says a total return around 3.5% is possible in 2020, based on an assumption of a slight rise in Treasury yields and little change in the spreads between junk bonds and Treasuries.
Investors favored better-quality junk issues in 2019, but the most speculative part of the market, bonds rated CCC, rallied in December, helped by gains in hard-hit energy debt.
The large Vanguard High-Yield Corporate fund (VWEHX) bested most of its peers in 2019, gaining almost 16%. The two largest ETFs are iShares iBoxx High Yield Corporate (HYG), yielding 4.3%, and SPDR Bloomberg Barclays High Yield (JNK), yielding 5%.
Junk-rated energy debt offers a high-yielding alternative to riskier common shares. Examples include Southwestern Energy (SWN) 7.5% bonds due in 2026, at a 8.75% yield; Range Resources (RRC) 4.875% bonds due in 2025, at 8%; and Diamond Offshore (DO) 4.875% bonds due in 2043, at nearly 10%.
Tax-exempt muni bonds
The municipal market is getting treacherous in the wake of a rally that dropped yields as much as a percentage point in 2019.
Muni-bond funds had returns of 6% to 11% in 2019, but they will be hard-pressed to repeat that in 2020, given current low rates.
Absolute yields on AAA-rated 10-year munis now stand at 1.4%, about 78% of the yield on the comparable-maturity Treasury, against an average of close to 85% in recent years. Many munis yield less than the current 2% U.S. inflation rate.
Alan Schankel, muni bond strategist at Janney Montgomery Scott, thinks that muni returns will run at 2% to 3% in 2020. One supporting factor could be continued strong flows into mutual funds after a record 2019, when an estimated $90 billion of new money poured into funds.
The largest fund is the Vanguard Intermediate-Term Tax-Exempt (VWIUX), with a 2.7% trailing 12-month yield, and the biggest exchange-traded fund is iShares National Muni Bond (MUB), yielding 2.4%
High-yield munis are popular as investors search for yield. This demand enabled Nuveen, which runs Nuveen High-Yield Municipal Bond (NHMAX), the largest open-end fund with a low-grade focus, to bring to market a closed-end fund with a similar strategy: Nuveen Municipal Credit Opportunities (NMCO), which yields 5%. Muni closed-end funds are no longer bargains after 20%-plus total returns in 2019.
Taxable muni bonds
Tax-law changes that took effect in 2018 restricting the ability of state and local governments to refinance tax-exempt debt have led to a boom in taxable muni bonds. Total issuance approached $70 billion in 2019 and may hit $100 billion this year, against an annual average of $30 billion for much of the decade. Big issuers include California and the Dallas/Fort Worth airport.
One advantage of taxable munis over corporate bonds is that they are generally tax-exempt in the issuer’s home state, although they are subject to federal income taxes. With top state rates now at 10% or above in places like California, that is a nice bonus.
Closed-end funds focused on the sector include BlackRock Taxable Municipal Bond Trust (BBN) and Nuveen Taxable Municipal Income (NBB). Both yield over 5%. Another play is the Invesco Taxable Municipal Bond ETF (BAB), which yields about 3.7%.
A group of high-quality issuers like Georgetown University and the University of Pennsylvania have issued 100-year munis in recent years that now yield in the 3.25% to 4% range. Beware of rate risk with such ultralong maturity dates.
Many professional investors have long sneered at electric utilities as richly valued and low growth. Yet the group, as measured by the Utilities Select Sector SPDRETF (XLU), has delivered an 11.6% annualized total return in the past decade and 10% during the past five years.
It is harder, however, to make a strong case now for utilities, after a 25% gain in the XLU during 2019 that lowered its dividend yield to 3.1%. Four leading utilities, Dominion Energy (D), Southern Co. (SO), Duke Energy (DUK), and American Electric Power (AEP), now trade for an average of 20 times projected 2020 earnings—a premium to the market.
The largest utility, renewables-rich NextEra Energy (NEE), is valued at 27 times forward earnings. The bull case is that utilities are defensive and can produce mid-single digit profit growth in the coming years.
Preferred stock looks less appealing after a strong run in 2019. The iShares Preferred & Income Securities ETF (PFF) returned 16%, including dividends, for the year. It now yields about 5%.
Banks are the largest issuers, and some preferred shares from JPMorgan Chase (JPM), Morgan Stanley (MS), and Bank of America (BAC) now yield less than 5%.
That is a nice premium above the 30-year Treasury, which yields just 2.3%. But there are risks. Preferreds are typically perpetual, while issuers are able to redeem them at their face value in five years if rates fall.
That means a lot of downside—some preferred stocks fell 20% in price during the late-2018 interest-rate rise—and limited upside. One plus is that most preferred dividends get preferential tax treatment, like those of common stocks.
“It is heads, you win a little, and tails, you lose a lot,” Dan Fuss, the veteran bond manager and chief of the Loomis Sayles Bond fund, told Barron’s in the fall.
A recent JPMorgan preferred with a 4.75% dividend rate now yields 4.64%, and a Morgan Stanley 4.875% issue yields 4.80%. With most of these securities trading at a premium to face value, investors should look at the lower “yield to call,” which is based on an assumed redemption at the call date five years after issuance, rather than the higher current yield.
Preferred-focused closed-end funds, such as Nuveen Preferred & Income Opportunities (JPC) and John Hancock Preferred Income (HPI), have returned more than 30% this year. They look fully priced.
The best thing about Treasuries is their defensive value. U.S. government bonds have often moved inversely with equities and thus offer put-like qualities—and some yield.
Treasury yields, however, are paltry, ranging from 1.5% on T-bills to 2.3% on the 30-year bond. No wonder that prominent investors like Warren Buffett and DoubleLine Capital CEO Jeffrey Gundlach aren’t enamored of them.
Treasury inflation-protected securities, or TIPs, are an alternative to U.S. Treasuries, since the inflation break-even is about 1.8% for the 10-year and 30-year—below the current 2% inflation rate.
“The ultimate enemy of fixed-income investors is inflation,” says Stephen Cianci, senior global portfolio manager at MacKay Shields. TIPs offer protection against rising inflation at a good price, he adds.
Exchange-traded funds, such as iShares TIPS Bond (TIP), can offer a smart way to invest in Treasuries. Others range from the safe iShares Short Treasury (SHV) to the riskier iShares 20+Year Treasury Bond (TLT).
Given the narrow yield gap between short and long Treasuries, it may pay to stay shorter.
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