Where to look for income ideas in 2019

Volatility created potential opportunities in income-producing investments.

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Key takeaways

  • 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 stock

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.

Convertible bonds

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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Investments in publicly traded master limited partnerships (MLPs) involve risks and considerations that may differ from investments in common stock. Tax complexity risk: MLPs are generally considered pass-through entities for tax purposes, and have special tax considerations. Pass-through entities may generate unrelated business taxable income (UBTI), which may have undesirable tax consequences for retirement accounts and other tax-exempt investors. If you hold MLP units, you are generally treated as a partner for tax purposes and will be issued a Schedule K-1 (Form 1065) rather than a Form 1099 for use in filing your tax return. A K-1 lists the partner's share of income, deductions, credits, and other tax items. If the MLP has operations in multiple states, you may need to file a separate tax return in each state. An MLP that is treated as a corporation in the United States, rather than as a pass-through entity, for federal income tax purposes will be obligated to pay federal income tax on its income at the corporate tax rate. In this case, the amount of cash available for distribution by the MLP would be reduced and part or all of the distributions made could be taxed entirely as dividend income; Form 1099 would be furnished rather than a Schedule K-1. Please see the MLP’s website, SEC filings, or most recent shareholder report for further details about the tax treatment of your investments. Legislative risk: The tax treatment of publicly traded MLPs could be subject to potential legislative, judicial, or administrative changes, possibly on a retroactive basis. Any such changes in tax treatment could negatively affect the value of an investment in an MLP. Concentration risk: Many MLPs are concentrated in the energy infrastructure sector. This narrow focus of MLPs may present considerably more risk than a diversified investment across numerous sectors of the economy. Market risk: MLPs may exhibit high volatility, particularly during periods of economic stress or due to other events affecting the particular sector or industry in which an MLP operates. Interest rate risk: The market prices of MLPs are sensitive to changes in interest rates. As interest rates rise, the prices of MLP units may decline (and vice versa). Rising interest rates could also increase the MLP’s cost of capital, which may limit potential growth through acquisition or expansion and reduce distribution growth rates. Distribution policy risk: All or a portion of an MLP’s distribution may consist of a return of capital from an MLP unit holder's original investment. You should not assume that the source of a distribution is net profit from the MLP’s operations. Liquidity risk: Despite the fact that MLPs are publicly traded, investments in MLPs may be relatively illiquid due to their unique investment strategy, asset concentration, or other factors. Lack of liquidity can negatively affect your ability to sell MLP units. Additionally, should a secondary market exist, investors who need to sell MLP units may be subject to significant loss. Commodity price risk: The price of MLP units may be negatively affected by fluctuations in commodity prices. A significant decrease in the production or supply or sustained reduced demand for natural gas, oil, or other energy commodities can limit revenue and cash flows of MLPs and therefore the ability of MLPs to make distributions to unit holders. Regulatory risk: The assets of MLPs tend to be heavily regulated by federal and state governments. Changes in regulation can adversely affect an MLP’s profitability and therefore the value of MLP units. Conflicts of interest: The general partners of an MLP typically have limited fiduciary duties to the MLP and may have conflicts of interest, which could result in the general partners favoring their own interests over the MLP’s interests.

Exchange-traded products (ETPs) are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed income investments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. ETPs that target a small universe of securities, such as a specific region or market sector, are generally subject to greater market volatility, as well as to the specific risks associated with that sector, region, or other focus. ETPs that use derivatives, leverage, or complex investment strategies are subject to additional risks. The return of an index ETP is usually different from that of the index it tracks because of fees, expenses, and tracking error. An ETP may trade at a premium or discount to its net asset value (NAV) (or indicative value in the case of exchange-traded notes). The degree of liquidity can vary significantly from one ETP to another and losses may be magnified if no liquid market exists for the ETP's shares when attempting to sell them. Each ETP has a unique risk profile, detailed in its prospectus, offering circular, or similar material, which should be considered carefully when making investment decisions.

Interest income generated by Treasury bonds and certain securities issued by U.S. territories, possessions, agencies, and instrumentalities is generally exempt from state income tax, but is generally subject to federal income and alternative minimum taxes and may be subject to state alternative minimum taxes.

Preferred securities are subject to interest rate risk. (As interest rates rise, preferred securities prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.)
Preferred securities also have credit and default risks for both issuers and counterparties, liquidity risk, and, if callable, call risk. Dividend or interest payments on preferred securities may be variable, suspended or deferred by the issuer at any time, and missed or deferred payments might not be paid at a future date. If payments are suspended, or deferred by the issuer, the deferred income may still be taxable. See your tax adviser for more details. Most preferred securities have call features, which allow the issuer to redeem the securities at its discretion on specified dates as well as upon the occurrence of certain events. Other early redemption provisions may exist, which could affect yield. Certain preferred securities are convertible into common stock of the issuer; therefore, their market prices can be sensitive to changes in the value of the issuer's common stock. Some preferred securities are perpetual, meaning they have no stated maturity date. In the case of preferred securities with a stated maturity date, the issuer may, under certain circumstances, extend this date at its discretion. Extension of maturity date would delay repayment of principal on the securities. Please read the prospectus, which may be located on the SEC’s EDGAR system, to understand the terms, conditions, and specific features of the security prior to investing.

In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities). Fixed income securities also carry inflation risk, liquidity risk, call risk and credit and default risks for both issuers and counterparties. Lower-quality fixed income securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. Foreign investments involve greater risks than U.S. investments, and can decline significantly in response to adverse issuer, political, regulatory, market, and economic risks. Any fixed-income security sold or redeemed prior to maturity may be subject to loss.

There are additional considerations for bonds issued by foreign governments and corporations. Foreign debt can be more volatile than US dollar–denominated debt due to the impact of currency fluctuations and the risks of adverse issuer, political, regulatory, market, or economic developments. These risks may be more pronounced in emerging markets, which may be subject to greater social, economic, regulatory, and political uncertainties. Investments in debt denominated in a foreign currency involve exchange-rate risk, which is the risk that a decline in the value of the local foreign currency relative to the US dollar will have an adverse effect on the value of your investment once principal and interest payments are converted to US dollars.
A REIT is a security that trades like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages. A REIT is required to invest at least 75% of its total assets in real estate and to distribute at least 90% of its taxable income to investors. Illiquidity is an inherent risk associated with investing in real estate and REITs.
There is no guarantee that the issuer of a REIT will maintain the secondary market for its shares, and redemptions may be at a price that is more or less than the original price paid.
Changes in real estate values or economic conditions can have a positive or negative effect on issuers in the real estate industry, which may affect the fund or funds.
Unlike bonds, preferred stock is perpetual and has a higher duration than long-term bonds. Also, they are lower in the capital structure than bonds.

High-yield/non-investment-grade bonds involve greater price volatility and risk of default than investment-grade bonds.

Floating-rate loans generally are subject to restrictions on resale. They sometimes trade infrequently in the secondary market, so may be more difficult to value, buy, or sell. A floating-rate loan might not be fully collateralized, which may cause it to decline significantly in value.

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