Given today’s historically low interest rates, we are continuously being asked about the best options for generating portfolio income. This piece reviews important income-generating asset classes and includes ideas from various Janney disciplines, including the Investment Strategy Group, Wealth Management, and Capital Markets.
Different Types of Asset Options
The Investment Strategy Group has always advocated for holding a healthy amount of blue chip stocks and bonds as the core portion of a portfolio. Due to their consistent cash-generation capabilities, blue chip firms have a strong capacity to meet their
bond coupon payment obligation and fund-growing dividends.
We view owning high-quality stocks as important because they are critical for maintaining purchasing power. While they can be subject to short-term bouts of volatility, over longer timeframes they have proven to be the critical element for growing assets
that maintain purchasing power and generate wealth.
While conservative investors may lean toward the more defensive sectors of the market, we see high-quality dividend opportunities across all sectors of the economy.
The defensive sectors of the market include Utilities, Consumer Staples, and Health Care. These sectors are considered defensive because their earnings typically hold up better during tough economic times. Consequently, they are perceived as lower risk and typically perform relatively better during times of market turbulence when the economic outlook is uncertain. Stable earnings have resulted in high, growing dividends for many firms within these sectors.
The Technology sector has many secular drivers that were accelerated by the pandemic. This is translating into well-supported, growing dividends for many Tech firms that should be considered for core holdings of income portfolios.
While the Consumer Discretionary, Financials, Industrials, and Materials sectors are considered cyclical sectors with earnings closely tied to the economy’s performance, there are many high-quality firms within these sectors that have healthy and growing dividends. Many of these firms should be considered for core portfolio holdings.
Uncertainty surrounding the economic outlook and future profitability are key risks for stocks, while firm-specific risks are always present for individual stocks. Owning a well-diversified portfolio of stocks is always recommended.
Investment-grade bonds are issued by government entities or firms that have a strong ability to meet their financial obligations. These bonds are backed by stable, reliable cash flows and have a low risk of default relative to less creditworthy bonds
(non-investment grade, high yield, or junk bonds).
U.S. Treasuries are considered the safest investment-grade bonds and consequently have low yields because of their low-risk nature. As a result of the pandemic, Treasuries are now trading at historically low yields—demand for safe-haven Treasuries
spiked early in the pandemic, causing their price to rise and yield to drop (bond prices move opposite of interest rates).
Treasury bonds can lose value as interest rates move higher. This is a risk today as the vaccines are rolled out and economic activity and interest rates ultimately normalize.
Investment-Grade Corporate Bonds
Investment-grade corporate bonds usually track Treasury yields and underlying interest rates closely.
However, they offer higher yields than Treasuries because of their higher risk of default. They are now trading at historically low yields since they track Treasuries and since the perceived default risk is low as the outlook for economic growth improves.
The potential for higher interest rates as the economy improves is a risk facing corporate bonds, similar to Treasuries. Higher defaults is another potential risk, if economic growth were to falter.
Non-Investment Grade Bonds
Non-Investment Grade or high yield bonds (also called junk bonds) are bonds that pay higher interest rates because their cash generation needed for interest payments is less reliable than investment-grade bonds. High-yield bonds are more likely to default,
so they must pay a higher yield to compensate for higher risk. The fortunes of the issuer of high yield bonds are closely tied to the economy’s performance, with the probability of default rising in times of economic stress. Consequently, the
performance of high yield bonds is correlated with the economic cycle.
During the early stages of the pandemic, high yield bonds significantly underperformed investment-grade bonds, anticipating high defaults. Since the hard lockdown ended last spring, economic improvement has led to strong performance in high yield bonds as the market anticipates lower defaults.
Our Chief Fixed Income Strategist expects interest rates to rise moderately in 2021 and 2022, in sympathy with an improving economy. This implies that short-term bonds should outperform long-term bonds (long-term bond prices are more sensitive to changes in interest rates).
However, it’s hard to generate income with rates low to begin with. He, therefore, suggests potentially taking more default risk by owning lower-quality bonds—lower investment-grade corporates and higher-rated (BB- and better) high yield corporates for those with the risk budget to handle them. This offers a balance between low interest rate risk and moderate income generation.
Preferred Stocks (preferreds)
While preferred stock comes with no voting rights, it entitles the holder to a fixed dividend, usually in perpetuity. This dividend payment takes priority over that of the common-stock dividend, but is subordinate to the bondholders. Consequently, preferred
dividends offer a more secure income stream relative to the common stock dividend, but less secure than bond interest payments.
Like bonds, preferred shares also have a par value which is affected by interest rates. Since most preferreds are perpetual securities (meaning they have no maturity date) they are very sensitive to changes in interest rates. This presents a headwind in a rising interest rate environment.
Preferred securities typically have a call feature that allows them to be redeemed by the issuer at face value five years after the offering date. This feature limits the upside in their price.
Our Chief Fixed Income Strategist likes Preferreds because they are one of the few areas of the fixed income arena where investors can access 4%+ yields without dipping deeply into non-investment-grade securities. He cautions that while yields are attractive in preferreds, it’s important to be mindful of extreme duration risk by avoiding securities with low “fixed for life” coupons as well as to ensure diversification, since some indexes have a concentration in banks.
Convertible Bonds (converts)
Convertible bonds are hybrid securities that allow the owner to receive cash or a specified number of common stock shares in the issuing company at the bond’s maturity (essentially a bond with an embedded call option on the common stock). They pay
a coupon like a bond while the stock conversion feature becomes more valuable as the stock price rises. The bond-like feature can provide downside protection in volatile markets, while the stock conversion feature allows for participation in stock
Converts have default risks like other corporate bonds and the stock conversion feature (the embedded call option on the common stock) loses value when the stock price falls. We have a favorable outlook for this asset class, given our favorable outlook for the economy and stock market.
A real estate investment trust (REIT) is a company that owns, and in most cases operates, income-producing real estate. REITs own many types of commercial real estate, ranging from office and apartment buildings to warehouses, hospitals, shopping centers,
hotels and commercial forests. REITs must pay out at least 90% of their taxable income to shareholders which typically results in a relatively high dividend yield.
The major risks for REITs include default risk and higher interest rates. Their performance has been correlated with bond yields and higher interest rates pose a potential headwind.
Our Janney Capital Market’s REIT analyst is looking for modestly positive returns for REITs in 2021 which should set the stage for a better 2022. He states that while the group should benefit from a U.S. 10-Year Treasury rate still hovering around 1.0%, the recent rate bias has been upward, and that has rarely been good news historically for REIT stock performance.
He remains bullish on Industrial REITs on strong fundamentals driven by e-commerce demand. He expects Towers and Data Centers to continue outperforming in 2021 given very strong demand drivers such as 5G, streaming, the cloud, and continued support for working from home (WFH). He sees risk in owning Apartment REITs due to COVID-related demand issues in the large urban coastal markets and continued new supply. He remains concerned with traditional retail (malls and shopping centers), hotels, and office given a challenging combination of both secular and cyclical issues.
Business Development Companies (BDCs)
A BDC makes loans to businesses that are not publicly traded. BDCs typically pay out high dividend yields, as their profits are not subject to corporate taxes (investors receive a 1099).
According to our Janney Capital Market’s BDC Analyst, BDCs are considered risky investments, as credit losses could cause them to under-earn their dividend, essentially returning capital to investors, which reduces book value. He notes that a lower-risk alternative to equity are BDC “baby bonds” which typically yield around 5% for a 5-year maturity. Our favorable outlook for the economy should provide a tailwind for BDC’s to earn their equity dividend in 2021.
Municipal Bonds (munis)
Munis are debt securities issued by state and local governments. These can be thought of as loans that investors make to local governments, and are used to fund public works such as parks, libraries, bridges & roads, and other infrastructure. Munis can be tax-exempt or taxable.
- Tax-Exempt Municipals: Interest paid on municipal bonds is often tax-free, making them an attractive investment option for individuals in high tax brackets.
- Taxable Municipals: This asset class has grown rapidly since 2017’s tax changes which stipulate that state and local governments that want to refinance older high-rate tax-exempt debt before maturity must do so in the taxable muni market. Yields generally exceed those on likerated corporate debt and are in the range of 1.5% to 5%, depending on maturity and credit quality.
Our Chief Fixed Income Strategist sees opportunity in two- to seven-year maturity taxable municipal bonds in the A ratings (high-quality) range. He believes taxable munis remain a “forgotten” sector for many institutional investors held hostage
to benchmarks. As a result, valuations across taxable munis are attractive relative to similarly rated corporate bonds, especially in the short to intermediate portion of the yield curve.
Master Limited Partnerships (MLPs)
An MLP or publicly traded partnership is a publicly traded entity taxed as a partnership. It combines the tax benefits of a partnership with the liquidity of publicly traded securities. To obtain the tax benefits of a pass through, MLPs must generate
at least 90% or more of their income from qualifying sources such as from production, processing, storage, and transportation of depletable natural resources and minerals.
Many MLPs are tied to oil and gas production and their value can fluctuate significantly based upon oil and gas prices. K1 tax forms are issued to MLP owners, which complicates tax filing.
Our Director of Wealth Management Research sees opportunities for income in Private Real Estate and Private Credit, within the income-producing alternative space.
It should be noted that investors accessing these types of strategies are generally required to meet SEC-mandated net worth requirements prior to investment.
Private Real Estate—Core Commercial
Core commercial real estate is an income-focused alternative investment strategy that involves buying and holding fully developed real estate properties. Strategy returns are generated from the tenant lease payments, which are distributed to investors
through ongoing income distributions, as well as through modest capital appreciation should the properties rise in value over time.
Compared to publicly listed REITs, returns are driven purely by the performance of the underlying real estate assets versus listed REITs, which trade as stocks and can often be more correlated with equity markets than with real estate property prices. Over the long term, investors can expect fund yields in the 4-6% range net of fees, although this will vary depending on the specific fund and market environment.
Private Credit—Direct Lending
Direct lending (as opposed to traditional bank lending) is another investment strategy common with income-seeking investors in which fund managers will make direct, whole loans to private companies. Returns are derived from the underlying loan interest
payments, which generally pay a floating rate on top of a credit spread determined by the borrower’s level of credit risk.
While there is a wide range of borrowers in the private market, a large percentage of companies are of lower credit quality, so investors considering purchasing a direct lending fund should be prepared to assume a fair amount of credit risk. Over the long term, investors can expect fund yields in the 6-8% range net of fees, although this will vary depending on the specific fund and market environment.
Mutual Funds, ETFs, Closed-End Funds and UITs
Our Head of Investment Company Products sees income opportunities within several different fund products.
- Mutual Funds: Mutual funds come in many different forms and typically offer active portfolio management in a diversified portfolio. The income they offer typically ranges around 1.0% to 3.0%.
- Exchange-Traded Funds (ETFs): ETFs are similar in many ways to mutual funds, except that ETFs are bought and sold throughout the day on stock exchanges while mutual funds are bought and sold based on their price at day’s end. ETFs also come in many forms today and usually passively track indices. Passively tracking indexes typically results in relatively low fund expenses which can help overall investment performance. The income they offer typically ranges around 1.0% to 3.0%.
- Closed-End Funds (CEFs): A closed-end fund is a portfolio of pooled assets that raises a fixed amount of capital through an initial public offering (IPO) and then lists a fixed number of shares for trade on a stock exchange.
Like a mutual fund, a closed-end fund has a professional manager overseeing the portfolio and actively buying and selling securities.
– Closed-end funds may offer the potential for higher regular income than other types of investment products because of their ability to use leverage (they borrow at short-term interest rates and buy securities with longer-term maturities which can enhance fund income). However, the leverage used to create the additional income causes CEFs to exhibit more volatility than other investment solutions. The yields these investments offer are about 6% to 8% for taxable funds and 4% to 5% for tax-free funds.
Unit Investment Trusts (UITs)
A UIT is an investment company that offers a fixed portfolio, generally of stocks and bonds, as redeemable units to investors for a specific period of time. They are designed to provide capital appreciation and/or dividend income. Income-producing UITs have yields around 2.5% to 4% and typically pay consistent monthly income.
Summary of Income-Producing Asset Options
|Asset Class||Potential Yield||Notes|
|Dividend Paying Stocks||1-4%|
Viewed as core holdings to maintain purchasing power. Risks include
volatility tied to economic uncertainty while firm-specific risks are
present for all stocks.
Higher interest rates tied to economic improvement pose a risk to
underlying bond values.
|Non-Investment Grade Bonds||3-5%|
Economic weakness and the potential for higher defaults pose the
major risk for underlying bond values.
Higher interest rates tied to economic improvement is a primary risk.
Default risk and concentration in banks are also risks.
|Convertible Securities||2-3%||These securities have risks similar to stocks and bonds.|
|Real Estate Investment Trusts (REITs)||3-6%|
Yield varies with quality of firm. The major risks for REITs include default
risk and higher interest rates.
|Business Development Companies (BDCs)||6-12%|
Yields vary widely depending on quality of BDC. Major risk is credit
losses causing under-earning of dividend, which reduces book value.
Primary risks are higher interest rates and default. Yields vary depending
upon taxability and credit quality.
|Master Limited Partnerships (MLPs)||5-12%|
Yield varies with MLP quality. Many MLP’s perceived value and default
risk fluctuate with oil and gas prices. K1 tax form required.
Income Alternatives including Private Real Estate and Credit
Credit default risk of security holdings is the primary concern for these
alternative investment options.
General economic, stock market, interest rate, and default risks, along
with portfolio manager skill, are primary risks.
|Exchange-Traded Funds (ETFs)||1-3%|
General economic, stock market, interest rate, and default risks, along
with potential sector or asset class concentration, are primary risks.
|Closed-End Funds (CEFs)||4-8%|
Yield varies with quality of holdings, amount of leverage used, and
taxability of fund. Primary risk is leverage and associated volatility.
|Unit Investment Trusts (UITs)||2.5-4%||Quality of assets within trust and potential for default is primary risk.|
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