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A mixture of political dysfunction, economic uncertainty, heated trade rhetoric and Federal Reserve tightening led to a selloff in almost all asset classes in December. Prices factored in lots of bad news—and despite a strong 2019 recovery, some asset prices continue to reflect uncertainty.
Was the bad news enough to justify the big moves in prices? It’s true that economic growth is slowing in China and the European Union, and we may see a slowdown in the US too. But the news isn’t all bad: Inflation isn’t rising and the labor market remains strong. And given the softness in inflation and weakness overseas, the Fed doesn’t have much room to raise rates further. The result may be a better environment for income assets than many investors anticipate.
Consider preferred stocks, a big casualty of the December selloff. Income-hungry investors swarmed into preferreds in 2016 and 2017, pushing prices higher and yields lower. Demand was so intense that 33% of the market paid negative yields last summer, and in July, the overall preferred market traded at 105 cents on the dollar.
A correction began in August as investors became increasingly worried about the health of the US economy. By December, preferred stocks were trading at just 92 cents on the dollar and only 2% of the market carried a negative yield. That’s when I saw an opportunity to invest, hoping to capture a lot of value.
Investors were getting a 6.5% coupon. Moreover, preferreds offered potential trades back to par value that would boost the return into double digits. In December, we took advantage of preferred stocks of financial services companies such as Citigroup, Goldman Sachs, JP Morgan and Bank of America in the Fidelity Multi-Asset Income (FMSDX) and Fidelity Strategic Dividend and Income (FSDIX) funds.
In 2019, the preferred market has rallied and doesn’t look quite as attractive. Preferreds overall now carry a coupon of 5.8% and are trading at par. But other income asset classes still look appealing in the wake of the December selloff and the 2019 recovery. Here are some areas where I see opportunities.
Convertible bonds. I believe convertible bonds have the potential to be one of the best-performing income-oriented asset classes this year, largely for technical reasons. The US convertible bond market, today worth roughly $180 billion, has been shrinking over the years as companies took advantage of historically low interest rates to raise money through high-yield or investment-grade bonds rather than convertibles. This year, the convertible market is going to shrink much faster, as roughly 12% of the market—some $22 billion worth of convertible bonds—is going to mature. What’s more, another 15% or so of the convertible market is trading in the range that would allow the bonds to be converted to stock.
This is a wake-up call to investors. Anywhere from 12% to 27% of the convertible market is going to disappear this year, creating a tremendous technical tailwind that could drive prices higher. Roughly one-third of the market is issued by technology companies, about half semiconductor companies and half software companies. Chipmakers suffered in 2018 due to a range of factors, including inventory corrections related to economic weakness in China. Fundamentals for a lot of these companies could reach bottom and start to recover this year, which would provide another tailwind. As of January 31, 2019, we’ve added to Fidelity Multi-Asset Income’s (FMSDX) exposure to convertible bonds.
Leveraged loans. There’s a lot of negativity around leveraged loans, but I’m optimistic about them. The floating rates of these loans can offer protection from rising interest rates, and many investors sold after the Fed looked likely to slow its pace of rate increases. The loan market has other attractive features, however. Recently, it has offered the same yield as the high-yield market, about 7%. But leveraged loans are senior in the capital structure and have lower durations. As a result, these assets have less duration risk—meaning less risk of price losses if rates rise—than high-yield bonds, and more downside protection since the investment is secured by collateral.
I have been been adding to the leveraged loan allocation in Fidelity Multi-Asset Income (FMSDX) during the 3-4 months through the end of January, and have overweight positions in loans in both Fidelity Strategic Income (FADMX) and Fidelity Strategic Real Return (FSRRX).
High yield bonds. The high-yield market had become very rich by last October, offering yields just 309 basis points higher than the 10-year Treasury. The December selloff pushed spreads to 530 basis points, near the 20-year average.
Meanwhile, the duration of this asset class has come down to less than 4 years, reducing the potential impact of rising interest rates. One way I like to measure value in income assets is to take the spread between an asset’s yield and the yield on Treasuries, and then to divide it by the asset’s duration. By that measure, the high-yield market in December looked very appealing; it had reached a point that I’ve only seen it hit 5 times in the last 15 years.
The high-yield market has rebounded since then, but I believe, there’s still value to be found. High yields already have a yield of 7%, and it’s easy to envision prices increasing enough to push the total return up into the high single digits. And I believe the default rate is going to remain very low; we aren't likely to see many of the company-specific problems that we’ve seen in previous cycles. Fidelity Multi-Asset Income Fund (FMSDX) and Fidelity Strategic Dividend & Income (FSDIX) both have added to high-yield bond allocations as of January 31, 2019.
Master limited partnerships (MLPs). Many MLPs had to cut their dividends in 2016 and 2017 because of high debts and tax changes that forced corporate restructuring. All of that bad news was priced in by late 2018, when MLPs paid yields between 7 and 8 percentage points higher than the dividend yield on the S&P 500. With the dividend cuts in the rearview mirror, that spread left investors a comfortable a cushion, at the same time that the energy market started to stabilize.
These days, investors can generally collect an 8% coupon, and I expect to see dividend yields grow by somewhere around 4%. If that happens, it could give investors about a 12% return without even considering the possibility that valuations could increase. This is another case of too much bad news being priced into the market. Both the Fidelity Multi-Asset Income Fund (FMSDX) and Fidelity Strategic Dividend & Income Fund (FSDIX) hold MLPs as of January 31, 2019. The funds have offered an attractive spread, and have been getting paid to wait for the valuations to catch up to the fundamentals.
Emerging-market (EM) debt. Emerging-market bonds sold off sharply late last year as investors worried that the Fed’s tightening would strengthen the dollar, which would typically hurt these bonds. Investors also reacted to risks occurring in specific countries, such as Argentina and Turkey. As a result, these emerging market bonds have an average yield of 6.5% and an average duration of 7 years.
EM bonds may produce total return of just their coupon payments plus or minus 1 or 2 percentage points. That said, there is the real possibility of more upside—especially if we start to see an economic recovery in China and other emerging-market economies. And this year, I don't see the same catalysts in place that challenged emerging-market debt in 2018: The Fed isn’t likely to be a headwind—which is a huge positive—and a lot of the idiosyncratic risks have declined. Nevertheless, all that bad news continues to be priced into the spreads. That is precisely the kind of thing you want to look for as an income investor. Fidelity Multi-Asset Income Fund (FMSDX) and Fidelity Strategic Dividend & Income Fund (FSDIX) have added emerging-market debt investments through January 31, 2019.
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