Yield has been a scarce commodity in the capital markets for a number of years, hindering investor efforts to generate investment income.
Global central banks have kept short term interest rates at 0%, or even negative in many developed countries. They also have repressed longer maturity bond yields by purchasing huge quantities of government bonds in the open market. Finally, the pandemic has contributed further to a massive glut of global savings, which has fueled significant demand for yield-oriented investments. This poses a challenging environment for income-oriented investors.
However, despite the low-yield environment, income-oriented investors need not be consigned to trivial returns. But it does require evaluating the potential risk and return profile for a more comprehensive set of income-producing investment alternatives.
Thinking beyond the two-dimension asset class mindset
Many investors still operate in a constrained two-dimensional financial world, where the two major dimensions are traditional bonds and stocks. Bonds have historically addressed investor needs for income, diversification, and safety, while stocks have filled the need for those seeking long-term capital appreciation.
High-quality bonds may still provide some modicum of safety and diversification, especially as a hedge against the possibility of a severe stock market correction. However, with bond yields remaining exceptionally low (about 1.7% for the broad U.S. high-quality bond market), traditional bonds may not be able to adequately fulfill an investor’s need for income.
There are areas of the capital markets that can augment the income being generated from traditional bond investments. However, these other areas are more multi-dimensional in their risk and return characteristics.
Certain types of investments can generate substantial incremental income, although the income may not be “fixed”. These “alternative” investments, which blur the traditional two-dimensional lines between bonds and stocks, have proven to be compelling areas for generating income and total return performance without significantly increasing a portfolio’s overall risk profile.
Multi-dimension income opportunity universe
The following areas can be “mined” for opportunities to include in an investor’s overall portfolio to add incremental income:
Large cap dividend-paying stocks
Historically, dividend paying “blue chip” stocks have been the cornerstone of an income investor’s portfolio. They have generated reasonable, modestly growing dividends. However, over time, and driven predominantly by tax laws, corporations have migrated dramatically from returning a portion of profits via dividends to returning capital to investors more indirectly via large stock buyback programs. Currently, the approximately 1.3% dividend yield of the S&P 500® index is at an historically low level, and growth in dividends has been subdued due to the philosophical shift from distributing capital to investors by paying dividends to buying back stock.
Another reality of relying on blue chip equities for incremental income is that a large portion of dividends paid in the overall market come from a narrow segment of the market, dominated by financial, consumer, traditional information/communication, and energy companies. More than 40% of the total sum of S&P 500 index dividends comes from just 25 companies.
Given the changed environment for large cap dividend-paying stocks, this is currently not a rich vein to mine for incremental income.
Preferred stocks are securities that, like bonds, have fixed payments, but the payments can be halted or eliminated altogether without putting the company into default. Preferred securities are senior in standing to common stock, and, as such, their dividends are more assured than common stock dividends. Preferred stocks have been paying yields averaging approximately 4%, which remains relatively attractive in the current environment. The preferred stock market is dominated by bank and financial institution issuers, which account for about 80% of the market. Investors must be mindful of this sector concentration. The structure of preferred securities also can be quite complex.
Given the large size and differentiation of security type, the preferred market can be a rich vein for adding incremental income to a portfolio. However, careful credit and security structure research is necessary in buying individual preferred stock issues.
Equity market sub-segments
- Real estate (REITs and MREITs). Real estate makes up only about 2.5% of the of the S&P 500 index but has historically been a very good place to add incremental income. REITs (real estate investment trusts), which dominate this sub-segment, are diversified across several segments, including apartments, office, warehouse, shopping, data center/cellular towers, and mortgages. Dividend yields for this group are also not homogenous. Although the average for the real estate sector is only about 2.3% currently, the range is much wider, from about 1.5% for growth-oriented cell tower REITs to about 10% for leveraged mortgage REITs.
Given the wide range of companies, structures and dividend yields, this could be an attractive area for income mining opportunities, especially in the mortgage related and mortgage REIT area of the market.
- Utilities. Utilities, also about 2.5% of the S&P 500 index, have historically been heavily used as an area to augment income. The current dividend yield for this subsector is approximately 3%. Unlike real estate, this is a very homogenous group given that it is heavily regulated.
Utilities tend to be more sensitive to changes in interest rates than other sectors, which can put them at greater risk during a sustained rise in bond yields. Also, the sector is facing challenges from sustainability and climate issues that may put dividend growth at risk. Consequently, utilities represent a thin vein of opportunity for incremental income.
- Business Development Corporations (BDC). BDCs are a very small part of the equity market and not part of most indices. They are basically companies that specialize in providing loans and mezzanine financing to companies that may be smaller, private and higher risk due to high levels of debt. Dividend yields are always quite high, currently about 8%, but can be somewhat more volatile.
This is an area where deep research and selectivity may uncover some very high yielding “nuggets.” But after very strong performance as a group over the past year, this area also is currently a thin vein of opportunity. However, given that this market segment can suffer bouts of illiquidity in market downturns, it is important to keep your “mining pan” ready.
- Master Limited Partnerships (MLP). MLPs are “pass through” companies, structured as limited partnerships that are required to pay out the bulk of their profits in distributions. As such, their dividend yields are very high (currently in the range of 7% to 9%) relative to other sectors of the stock market. The underlying business of the majority of MLPs is energy-related, specifically the energy pipelines business. Consequently, returns from the sector tend to track with the energy sector. Like utilities, the sector is also faced with the evolving challenges of sustainability and climate change. They also present some additional challenges for investors due to their complicated tax and reporting issues.
Like BDCs, MLPs require deep research and selectivity. MLPs are currently a modest vein of opportunity given elevated valuation after a strong rally in the sector over the past year. However, the sector can experience sharp corrections at times. As certain companies show evidence they are responding to questions regarding sustainability and tax complexity, MLPs could become an attractive area to add meaningful incremental income.
- Closed End Funds (CEF). Closed end funds are a unique mutual fund structure. Unlike open-end mutual funds, which are required to price and transact at net asset value each day, CEFs have a limited number of shares (hence the closed-end moniker) and are listed and traded on stock exchanges. The underlying assets, like open-end funds, are stocks and bonds. However, unlike open-end funds, CEFs can use leverage to magnify returns but are less liquid. Given that this sector is dominated by individual investors rather than institutional investors, it is oftentimes possible to buy these funds at meaningful discounts to their intrinsic net asset value. These discounts can sometimes be as high as 20%. Buying CEFs at wide discounts is the main driver behind generating incremental income.
Currently there are limited opportunities in CEFS. But like other niche sectors of the capital markets, it is important to keep your “mining pan” ready when liquidity vacuums in the market provide opportunities to buy discounted assets that can generate significant incremental income.
Adding an additional dimension mindset
Income-oriented investors, or even investors who are looking for additional diversification, have options outside of the traditional two-dimensional stock and bond mindset to augment income or improve risk-adjusted returns.
Another dimension, using a diversified set of “alternative” or “opportunistic” income producing assets, can be incorporated as a dedicated allocation to a portfolio. The risk level of the income options reviewed here, relative to the S&P 500 index, is about 50% to 75% (beta of .50 -.75)—somewhat riskier than bonds but less risky than stocks. As a result, you can add income and diversification to a portfolio through these types of assets while reducing the risk level, but not eliminating it, of a typical equity portfolio.
Thrivent Multidimensional Income Fund (TMLDX) draws from a wide range of income-oriented investments, with roughly 55% of the portfolio allocated to alternative type income-oriented investments, including preferred securities, convertible bonds, closed-end funds, and dividend-paying equities. The Fund also shoots for higher yields by allocating about one-third of its assets to high yielding corporate bonds. (See: A diverse path to income: Thrivent Multidimensional Income Fund)
Thrivent Opportunity Income Plus Fund (IIINX) also seeks higher yields by investing in alternative type income-oriented investments, such as leveraged loans and securitized debt. It also has significant holdings in high yield and investment grade corporate bonds and international government bonds. (See: Thrivent Opportunity Income Plus Fund)