Key takeaways from Adam Kramer
Investors had plenty to worry about late last year. They fretted about the Federal Reserve taking a hardline approach to tightening monetary policy, and about increasingly tense international trade negotiations. They worried that China's economy was teetering on the edge of recession, and about a strong US dollar and a weakening US economy.
Then in January the Fed changed its tone on monetary policy, suggesting it would relax the pace of interest rate hikes. Investors sat up and took notice. In March, the Fed went a step further, nixing plans for any rate hikes in 2019.
The Fed's pragmatism was good news in investors' eyes. It showed that the Fed is basing its policies on economic data from both the US and global economies. And it's acknowledging that too much tightening can spark a recession—especially late in the economic cycle.
Meanwhile, the Chinese economy appeared to stabilize, with repercussions around the world. Increased confidence in China means more business for economies trading with that country, including the EU and the US. Meanwhile, global trade tensions softened considerably. The result: Investors felt more comfortable shifting toward risk assets, like stocks and high-yield bonds.
Investors' more-optimistic perspective pushed up valuations on many income assets. Yet careful income investors can still find areas of opportunity.
REITs have been a top performers this year
REITs have been among the best-performing asset classes this year, gaining more than 14% through early May. REITs have fared well in part because they offer a stable coupon—currently around 4%—that can grow by up to 3% or 4% a year as rents rise. In 2019, earnings have grown faster in the real estate sector than in the rest of the market, helping REITs' valuations expand. Now the REIT market is fairly rich, with the average REIT trading at a premium to its tangible net asset value.
Still, some pockets of the REIT market have been overlooked. For instance, shopping centers and strip malls, self-storage properties, and lodging REITs all trade at discounts to their tangible net asset values. Shopping centers and strip malls have suffered from sustained pressure on retailers, and lodging REITs have been hurt by worries about excess capacity and competition from firms like Airbnb.
As of March 29, my team had a neutral REIT weighting in the Fidelity Strategic Dividend and Income (FSDIX) fund, with roughly 15% of the fund's portfolio allocated to the sector. In the Fidelity Multi-Asset Income (FMSDX), I recently held just one REIT issuer: mall operator Simon Property Group. Simon Property Group hasn’t risen with the rest of the REIT market, in part because of worries about slowing mall traffic and the waning fortunes of big retailers such as Sears and Macy's that often anchor these types of shopping centers.
I believe that fear is largely unwarranted for the Simon Property Group, and think the market has priced in too much bad news. The company owns excellent properties, and the trend as these anchor tenants have moved out has been to reconfigure malls into more of a lifestyle destination, reinvigorating these properties as new types of tenants move in.
Opportunities in convertible bonds
I also think the convertible bond market has looked attractive. In March, I described the technical tailwinds supporting the convertible bond market. Those factors remain in place, with strong demand and lots of new issues coming to the market with attractive terms.
Many of the companies issuing convertible bonds are new entrants to the market. More companies are using these securities to finance mergers and acquisitions—and that could be the start of a trend. For example, the industrial company Fortive recently came to the convertible market for the first time with plans to issue $1.25 billion in convertible notes to finance an acquisition. These sorts of issues present opportunities to buy in at attractive terms.
I have been seeing value among semiconductor companies, which make up a large portion of the convertible market. These bonds are very sensitive to moves in the equity market and were hit particularly hard last year. But I think fundamentals in the semiconductor industry are improving, including the inventory issues that have plagued chipmakers. In the Fidelity Convertible Securities Fund (FCVSX) and the Fidelity Multi-Asset Income Fund (FMSDX), I have been finding opportunities among convertible bonds from chipmakers such as NXP Semiconductors (NXPI), ON Semiconductor (ON), Micron Technologies (MU), Western Digital Corp. (WDC), Microchip Technology Corp. (MCHP), Advanced Micro Devices (AMD), Lam Research (LRCX).
Convertible bonds can also offer a lower-risk, income-oriented way to invest in emerging markets. Emerging markets companies have issued more than $1.5 billion in new, dollar-denominated convertible bonds in recent months. One example: MercadoLibre (MELI) is an Argentinian e-commerce firm that's considered the Amazon.com of Latin America. In Fidelity Multi-Asset Income (FMSDX) Fund, I added the company's US-dollar convertible bonds; they provided diluted equity exposure with the protection of seniority in the capital structure. The company's stock is very volatile, and buying its convertible bonds provided some access to its return potential with less risk. Moreover, the foreign companies issuing convertibles generally don’t pay income on their stocks, and buying the convertible provides access to that income component.
Risk in Treasuries and preferreds
I have been shying away from a few types of income assets. Investment-grade bonds—specifically Treasuries—offer the least appeal. Low interest rate payments offer little cushion in the event of principal declines. I recently reduced the Fidelity Multi-Asset Income Fund's (FMSDX) Treasury allocation from about 50% to around 10% as of April. It was still the fund’s largest position, but also its largest underweight position relative to its supplemental benchmark, a 50/50 mix of the S&P 500 and the Bloomberg Barclays US Aggregate Bond Index. I've kept the fund's duration at 3 years—roughly in line with the benchmark—but with a different composition that includes a mix of Treasuries and high-yielding asset classes such as emerging market debt, high-yield bonds, floating-rate debt, and a few fixed-to-floating preferred issues.
I haven't seen many opportunities among preferred stocks, either, which still look too richly valued. In the Fidelity Multi-Asset Income (FMSDX) Fund, I have only held a few select preferred stocks that still offer a good risk reward. Moreover, in the Fidelity Strategic Dividend & Income Fund (FSDIX) my team and I have established a large underweight to the asset class.
Late last year, there was so much bad news priced into preferred stocks that they were trading down to 92 cents on the dollar in December. Now, the banks that make up around 70% of the preferred market are in better shape and these stocks are trading at all-time high valuations of around 102 cents on the dollar. While preferred stocks still offer attractive income—the market currently yields 5%—there's simply not a lot of cushion for error, as the call risk is understated. For example, today nearly 15% of the preferred market trades at a negative yield to call—investors can lose money if companies choose to redeem those securities at par.
Preferred stocks still can play an important role in an income-oriented fund, however. Over the years, all of the major US income-oriented asset classes have had runs as the top total-return performer, and in any given year there has been a wide difference in returns between different asset classes, sometimes as high as 5,000 basis points (50 percentage points). In fact, 14 of the last 20 full calendar years have seen "high-yielding" asset class as the top performer rather than the S&P 500 or Bloomberg Barclays US Aggregate Index. Indeed, as the performance data above demonstrates, once MLPs and REITS are considered, the magnitude of the performance differentials is further magnified. This means that single–asset-class investors or those utilizing the traditional 50/50 balanced stock and investment-grade bond portfolio, may not be capturing these additional alpha opportunities on a yearly or consistent basis.
Of course, all these investments come with their own risks. This is one reason why I think it may make sense to consider a flexible multi-asset class approach to income-producing assets.
Fidelity has a number of tools to help investors screen through mutual funds and ETFs for research ideas. You can run screens yourself using the Mutual Fund Screener, or in the ETF or stock research areas of Fidelity.com. Below are the results of some illustrative screens (these are not recommendations of Adam Kramer or Fidelity).
The Fidelity screeners are research tools provided to help self-directed investors evaluate these types of securities. The criteria and inputs entered are at the sole discretion of the user, and all screens or strategies with preselected criteria (including expert ones) are solely for the convenience of the user. Expert screeners are provided by independent companies not affiliated with Fidelity. Information supplied or obtained from these screeners is for informational purposes only and should not be considered investment advice or guidance, an offer of or a solicitation of an offer to buy or sell securities, or a recommendation or endorsement by Fidelity of any security or investment strategy. Fidelity does not endorse or adopt any particular investment strategy or approach to screening or evaluating stocks, preferred securities, exchange-traded products, or closed-end funds. Fidelity makes no guarantees that information supplied is accurate, complete, or timely, and does not provide any warranties regarding results obtained from its use. Determine which securities are right for you based on your investment objectives, risk tolerance, financial situation, and other individual factors, and reevaluate them on a periodic basis.
Next steps to consider
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