Income investments in a declining rate environment

Dave S. Gilreath © Sheaff Brock Investment Advisors

Elevated interest rates generally aren’t good for stocks, but they have an upside for other assets.

Sustained by the Federal Reserve’s efforts in the last couple years to tamp down inflation, elevated interest rates have pushed up the returns of various income investments.

Many stock-focused investors may not be aware that this category is currently delivering historically high returns, with manageable risk levels.

The Golden Age

This period is being called the golden age of income. Yet the end of this gilded status is in sight.

The goal of these vehicles isn’t growth, as it is for stocks, but for the cash they pay, either as guaranteed interest (paid by fixed-income) or as dividends on shares of other income investments.

Investors can either reinvest this cash or use it to meet spending needs. As the moniker implies, income is the main goal. If these investments rise in value, so much the better.

Non-bond income investments are known as alternative assets, a catchall term describing any investment that isn’t traditional — i.e., a stock or a bond.

Many of these alternatives pay a lot better than bonds. And bond income is taxed at the painful ordinary income rate, while dividends paid by various alternatives is often taxed much lower.

Democratization

In recent years, the variety of these investments accessible by all investors has grown considerably. Once available only to wealthy individuals and institutions, elite investments are increasingly being packaged into exchange-traded fund (ETF) products.

Most physicians qualify as accredited investors — those with high discretionary incomes who can afford to lose principal, so they’re eligible for various products unavailable to the average person.

The growing variety of income ETFs increases portfolio flexibility for all investors, including the wealthy. And flexibility is critical now that interest rates are expected to decline in the coming months. Many of these ETFs require no minimum investment, nor any holding period to avoid withdrawal fees. So they’re easy in, easy out.

As of early September, the global financial community was on the edge of its seat regarding an impending rate decision by the Federal Open Market Committee (FOMC), a 12-panel including all seven Federal Reserve governors and others.

The market was pricing in the likelihood that the FOMC would cut the interest rate it controls (the federal funds rate) in mid-September. As always, this would have a domino effect, pushing down rates on most loans and income paid by investments.

Regardless of whether the Fed cuts in September, the likelihood that a cut cycle will begin before year’s end creates the need to adjust existing holdings or, for those just getting into income investments, to tailor strategies accordingly.

Income investments include:

• Treasuries and investment-grade corporate bonds. In many ways, these are your father’s income investments. Today, they’re only appropriate for conservative investors who want assurance of a set yield, albeit low compared with various alternatives with reasonable risk. And unbeknownst to many individual investors, bonds carry risks that can whittle away at returns.

For decades, many advisors recommended a 60-to-40 percent stocks-to-bonds portfolio for investors nearing retirement, and reversing those percentages after retiring; some advisors still do. Yet, this recommendation has been widely discounted as suboptimal, especially for portfolios of high-net-worth investors.

In retirement, the well-heeled can maintain large allocations to stocks with equanimity because market downturns aren’t an issue for them. For these investors, bonds are by no means essential, given the vastly superior average returns of the stock market. Nevertheless, highly conservative investors may want to buy long-term bonds now to lock in current, historically high rates.

• High-yield corporate bonds, aka junk bonds. Once an investment generally frowned upon, high-yield bonds have achieved legitimacy as an alternative investment, despite their lower credit quality. As the name implies, they’ve historically paid much higher yields than investment grade bonds, with relatively few defaults. However, now that yields from investment grade corporates and Treasuries have risen significantly, there’s less daylight between their returns and those of high-yield bonds. As of September 1^st, the 10-year Treasury was paying about 4.2% annually, and 10-year investment grade corporate bonds, about 4.95%. Many high-yield bonds are paying only another 1.5 % — not enough to justify the higher risk.
• Preferred stocks. This is a sort of bond-stock hybrid, sold as shares like stocks but paying set yields like bonds. As this is a highly specialized market that lacks transparency for non-professionals, individual investors are usually better off buying shares of preferred stock ETFs, now paying annual dividend yields of 6.5% to 8%. Prices of many of these ETFs have risen in recent months, as some advisors projected.

If the Fed begins a series of cuts this fall, dividends from preferred ETFs may decline, but this may take a while, depending on the pace and depth of cuts. In the meantime, investors can use these vehicles to stay flexible, collecting dividends while keeping an eye on share prices. Unlike mutual funds, ETF shares can be sold during the trading day.

• Private credit. These are investments in debts of businesses and individuals who may have trouble accessing credit from banks or the public market or who want to avoid the hassle of going through traditional lenders. Investors in this debt can collect high rates of return on pooled investments that reduce risk by holding large swaths of holdings.

Investment in private credit has increased substantially since 2010, when it totaled less than $2 trillion. By January of this year, that figure had ballooned to more than $4.5 trillion.

Many of these vehicles, available only to accredited investors through advisors, are paying substantial annual returns — in the high single digits, and some, low double-digits.

• Investments for accredited investors composed of multiple asset classes, including combinations real estate and private debt.
• New, highly complex investments designed to offer the advantages of both bonds are stocks. An example is auto-callable yield notes — short- to mid-term market-yoked investments that seek a higher yield than bonds with comparable credit would provide. Individuals should be aware that “callable” means the issuer can call, or withdraw, the investment peremptorily under certain circumstances and pay investors a value according to set terms. So, investors aren’t always in the driver’s seat.
• Various widely accessible ETFs that generate income from options on stock indexes such as the S&P 500. These vehicles limit investors’ upside in index performance, but they also limit the downside.

Now and after rates decline, a sensible approach to seeking higher returns while managing risk is to buy shares of debt-based funds whose holdings have mixed credit quality (often denoted on research style boxes as moderate credit). These investments hold some debt with investment grade ratings — generally, those with A ratings or higher — and some with lower ratings, BBB+ and below. In evaluating a fund’s holdings, it’s a good idea to avoid funds with large tranches of holdings rated C or below.

Dual Strategy

Income investment allocation strategies for the next several months of course depend on one’s risk tolerance. Bond-inclined investors concerned about falling yields might consider a dual strategy: locking in current high yields on long-term Treasuries and corporate bonds while holding shares of income ETFs to take advantage of high dividends as long as they last. To remain nimble, investors should know these funds’ ex-dividend dates, the dates by shares must be owned to receive the next dividend payment.

Though all income investments should be assessed in terms of anticipated changes in the interest-rate environment, some may be suitable to hold perennially, especially for retirees seeking additional income streams.

For most investors, income vehicles are fine for a limited portion of their portfolios. Yet, whether retired or still working, most wealthy investors — and even many who aren’t so wealthy — will ultimately do much better by concentrating their portfolios in stocks to reap their superior long-term average returns.

Dave Sheaff Gilreath, CFP,^® is a Partner Advisor at Sheaff Brock Investment Advisors, powered by Allworth Financial LP, an investment advisory firm registered with the SEC. Investments mentioned in this article may be held by Allworth Financial, affiliates or related persons.