Interest rates have risen steadily over the past six months but remain low by historical standards. Traditional high-quality bonds that many of us owned for decades are not doing the job for investors looking for income. The potential for rising interest rates brings more risk in the bond market than has been evident recently. Here are some income ideas that may help with these challenges.
When investors think about income, or yield, they would normally think of bonds first. Next, they might think about getting extra yield from their stock portfolios, maybe with a dividend strategy that might be heavy on real estate investment trusts (REITs) and utilities. Those types of strategies are appropriate for a portion of a portfolio to get some yield, but they can also carry interest rate sensitivity if rates rise. There are equity income ideas that tend to perform well even in a rising rate environment.
The first idea is energy stocks. The energy sector currently yields about 5% based on dividends paid in 2020, higher than all the other S&P 500 sectors. Optimism over potential price increases is warranted by three factors. First, as the economy reopens, travel activity will pick up— potentially in the second half of this year—energy will likely to be a beneficiary. Second, technical analysis work shows attractive upside potential based on recent price appreciation after an extended period of weakness. And third, the sector appears attractively valued, especially when considering the income potential.
Dividends can be cut, so any investment in equities is not without risk. Oil prices can be volatile, and alternative energy is gaining market share. So, this may be more of a medium-term trade than a long-term investment. That said, the chances are good that oil prices will hold steady in the $55--60 per barrel range this year, sufficient for the sector to maintain rich yields while potentially seeing some additional price appreciation—on top of the 17% year-to-date gain.
Banks represent another income idea. The financial sector has a dividend yield of 1.9%, but banks yield 2.6%, based on the S&P 500 Bank Index. Although plenty of bond strategies carry yields in that range or higher, banks do not bring the interest rate risk that bonds do. Historically, bank stocks have exhibited positive correlation to interest rates (the stocks have tended to outperform as yields have risen). Bank stocks also tend to like a steepening yield curve—long-term interest rates rise faster than short-term rates—which we may see over the balance of 2021 as the economic recovery gains steam. Bank dividend payouts may rise over the next year or two as the Federal Reserve eases up on payout restrictions. More progress on vaccine distribution should also enable a fully re-opened economy and drive stronger economic growth, which should bode well for the profitability and, therefore, dividend payout potential for the financial sector. Banks may make sense for income investors with an eye toward total return.
There are fixed income options that may be suitable for income-oriented investors. For investors looking to limit interest rate risk, bank loans may be an attractive option due to the improving economic environment and limited rate sensitivity. Bank loans offer potential yields in the 4% range with extremely low interest rate sensitivity. It is important to understand the trade-off between interest risk and credit risk. There is no such thing as a free lunch. Additional income compensation comes with assuming credit risk (the risk of a default or credit downgrade) and the risk that prices drop sharply in a risk-off environment if demand suddenly dries up.
Yields across much of the fixed income market are low, so it is appropriate for income-oriented portfolios to have some equity market exposure to generate additional income. Several segments of the equity market—particularly the energy sector and banks—offer higher yields than traditional high-quality bonds and offer attractive capital appreciation potential as interest rates rise. For suitable fixed income investors looking for yield, bank loans warrant a look, particularly when short-term rates increase.
The views expressed are provided for information only and are not to be used or considered as an offer or solicitation to buy or sell securities or investment products. To determine which investment(s) may be appropriate for you consult your financial advisor.
- The economic forecast set forth in this presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.
- Data provided by LPL Financial and FactSet.
- References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.
- All investing involves risk including loss of principal.