- As the economy approaches late cycle and the Fed continues to tighten, investors may want to carefully evaluate risk if they choose to seek income-producing investments.
- Fidelity Multi-Asset Income Fund manager Adam Kramer has been finding potential opportunities among Treasury bonds, floating rate bonds, preferred stock, MLPs, and dividend-paying stocks.
- Kramer says emerging market bonds have sold off in 2018 and are becoming more attractive, but he has been waiting for better values in the high-yield and the convertible bonds.
Investors who are interested in income-producing assets have seen some significant shifts in recent months. Interest rates have been rising since the middle of 2016, with the rate on the 10-year Treasury moving from 1.38% in July of 2016 to 3.15% at the end of October 2018.
Rising rates have meant some big changes for bond and income-oriented investors. After years of strong returns, some bond investments have experienced modest losses. Meanwhile convertibles and dividend stocks performed well through the third quarter of 2018 but have struggled since then, as investors have worried about the likelihood of slower growth in corporate earnings and the economy in the year to come.
The recent changes in the markets present new opportunities for investors who seek out income-producing assets, according to Adam Kramer, lead manager of Fidelity Multi-Asset Income Fund (FMSDX), Fidelity Advisor Multi-Asset Income (FWATX), and co-manager of Fidelity Strategic Dividend and Income (FSDIX), and Fidelity Strategic Income (FADMX) funds—a series of funds that invest in a range of income-producing assets. "Increases in interest rates and declines in several income asset classes offer the chance to invest at more attractive levels," he says.
What today's rates mean for investors
Kramer uses a bottom-up approach to security selection, informed by an understanding of the ways macroeconomic factors could affect the markets for income-producing assets. He sees the US entering the late part of the business cycle, with the Fed raising interest rates, inventories building, profit margins and liquidity declining, and economic growth slowing.
"In this part of the cycle it's important to have preservation of capital at top of mind," he says. "One way I look to preserve capital is to seek out securities that offer both a high level of income and a wide enough spread to provide a generous cushion in case the security declines in value."
In other words, Kramer is searching for value and income, but always through the lenses of credit, interest rate, and equity risk. "This is a key component of the Fidelity Multi-Asset Income Fund, as the proper matching of the fund's income to duration and equity risks aim for a strong capital preservation feature and lower volatility through a full investment cycle," Kramer noted.
For example, Kramer has been finding value in select floating-rate debt securities. These assets, which are loans made by banks to below-investment-grade companies, have interest rates that adjust based on changes in a benchmark rate, typically the LIBOR. Their ability to pay more income as interest rates rise can help protect loan values when the Fed tightens. The securities currently offer coupons between 5% and 6%, offering the potential for healthy total return in the event that prices decline due to weakening in the economy.
"Bottom-up security selection is especially important in the loan market," says Kramer. "You have to be careful to purchase loans with strong covenants to protect shareholders in the event the issuer defaults."
Preferred stocks have also offered value recently, according to Kramer. He notes that the preferred market was substantially overvalued as recently as this past summer, when it traded at 103 cents per dollar of par value, on average, and nearly one-third of the market had a negative yield-to-call. High valuations are especially risky for preferreds, because the banks that issue them have the option to call the securities (buy them back) at par. Income-hungry investors were willing to stomach high prices in part because of the securities' attractive yields, and because, for a variety of technical reasons, banks hadn't been calling their overpriced preferreds. That changed in recent months: Several banks called their preferred stocks, causing prices to drop. Recently, only 3% of the market traded with a negative yield to call and the average price of the market had dropped to the mid-90s (yields of 6% to 7%), which Kramer says makes it an attractive time to start looking for value and income in the preferred space.
Kramer favors preferred securities that trade below par but have the potential be called at par, which means the issuer redeems the security for the par price, which would boost their total return. He notes that preferreds usually perform poorly late in the economic cycle—they were among the worst-performing income assets in 2008—but thinks they effectively have already had their correction. What's more, he says, issuers of preferred stock are stronger than they were in the last recession.
"In 2008 the preferred universe was mostly made up of securities from some of the weakest US banks," he says. "Now it's almost entirely composed of the strongest, highest-quality US banks."
The stock market's recent troubles have made dividend-paying equities more attractive than they have been in some time, according to Kramer. He looks for attractively valued shares of companies that have growing dividend payments with low payout ratios, meaning they pay out relatively little of their cash flow in the form of dividends. Low payout ratios give companies room to increase their dividends in the future and make them less likely to cut their dividends if they run into trouble, though of course stocks still have historically been more volatile than bonds in general.
"I'm finding value in health care, technology, industrials, transports, banks—in fact, in every sector except utilities," Kramer says. His hunt for attractively valued dividend stocks extends overseas, where he has identified opportunities in Japan, Europe, and China.
Convertible securities also look more appealing following a recent decline, he says. (Learn more about convertible bonds) This market's blend of issuers, which include mainly high-growth tech and health care companies, gives it a high correlation with the Nasdaq.
"After the massive correction in the Nasdaq, I'm finding opportunities in convertibles that have sold off between 15% and 20% and pay coupons of 2% to 3%," says Kramer. "I've been finding more opportunities lately than I had in the previous 2 years."
Likewise, MLPs now offer yields about 650 basis points higher than the dividend yield of the S&P 500, up from a spread of 550 basis points in August. That yield provides a big cushion to protect against price declines, Kramer says, especially considering that the companies have already been through the wilderness.
"When oil prices plummeted in recent years, these companies cut their dividends and restructured so they wouldn't have to cut dividends again," he says. "If the market's perception of these stocks improves, investors could benefit from both their coupon and higher prices."
Kramer is more cautious on high-yield and emerging markets bonds, both of which offer strong yields but carry significant risks. High-yield bonds' tendency to suffer during recessions becomes more of a concern as the economy enters the late stage of its cycle. Although high coupon payments—recently approaching 7%—offer some protection, the bonds could struggle if the economy weakens further and defaults rise. Kramer says emerging markets bonds have become more appealing following large recent declines, but formidable headwinds remain in the form of Fed tightening and weaker economies, particularly in China.
"Right now, emerging markets debt is mainly a play on what happens with the Fed and China," he says. "If those issues resolve favorably, these bonds could rally. Otherwise, much of the bad news might already be priced in.
Finally, Kramer thinks Treasury securities have become compelling following several interest-rate hikes. One reason: He thinks inflation may not pick up as much as many investors expect. He notes that although wages have risen, many other important components of inflation have fallen, including prices for housing, oil, and used cars.
Looking for income in 2019
Perhaps the easiest way to manage the current interest-rate environment is to consider investing in a diversified multi-asset-class bond fund, or income-oriented fund, managed account, or ETF. These options provide diversification and a professional manager who can react to shifts in bond pricing and the interest-rate environment.
For instance, Kramer manages Fidelity Advisor Multi-Asset Income (FWATX). That fund invests across the full spectrum of income-oriented asset classes from Treasury bonds to dividend-paying stocks and all of the high income oriented asset classes in between (REITS, MLPs, preferred stock, convertible bonds, high-yield, floating rate loans, and investment-grade corporates.) He also manages Fidelity Strategic Dividend & Income, which focuses on non-bond and high-yield bonds, and Fidelity Strategic Income, which invests across different types of income bonds.
Multi-sector funds that produce income
If you want to create your own mix of income-producing investments, or tweak your existing portfolio, here are some screens with illustrative results.
Dividend growth investments
Dividend stocks have been among the best performing income-producing assets in 2018. Fidelity's screening tools can help to identify dividend-paying investments, including funds, ETFs, or individual stocks.
Preferred securities, which are sometimes referred to as "hybrids," combine the features and characteristics of both stocks and bonds. Like common stocks, preferred securities provide you with an ownership or debtor stake in a publicly traded company. The term "preferred" refers to the fact that these securities provide shareholders with priority status when it comes to dividend or interest payments, which typically pay out at rates higher than those of common share dividends or bonds. While preferred securities generally offer attractive yields, opportunities for capital appreciation are generally lower than those from shares of common stock.
A convertible bond is a security that is sold with a set interest payment, like any other bond, but with the option to convert to a set number of stock shares. That gives the security some of bonds' downside protection, and some of the upside of stocks. However, investors should remember that convertibles also carry equity risk and can exhibit much more volatility than investment-grade bonds during periods of stock market weakness.
Master limited partnerships
Master limited partnerships, or MLPs, are publicly traded partnerships that are typically tied to the energy industry. While the price of commodities can influence the earnings of MLPs, these securities have delivered consistent income over time and have traditionally provided a relatively high distribution yield. For many investors, the risks of MLPs may suggest that the easiest way to gain exposure is through a diversified income-oriented fund, but there are several investment options for those who want a more direct investment.
Real estate investment trusts
Real estate investment trusts tend to have relatively high yields, as REITS are required to pay out 90% of their taxable income to shareholders. However, these investments can be sensitive to rising interest rates, and the dividend is normally taxed as ordinary income.
The bottom line
For most investors who have an appropriately diversified portfolio, a change in the direction of rates may just prove the value of their long-term strategy. In other words, for many long-term investors, perhaps even most, an increase in rates should not affect their long-term investment strategies or asset allocation plans. But for some more tactical investors, or those who may have more rate risk than they are comfortable with, the shift in rates is worth watching. Fortunately, there are plenty of options.
Next steps to consider
Match ideas with potential investments using our Stock Screener.
Analyze your portfolio and create a clear plan of action.
Learn how to navigate bond market fluctuations.
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