In a world of low and in some cases negative interest rates, investors continue to struggle to find yield. As such, they still find themselves in an all too familiar place: Accept less income, or take on more risk in the search for yield.
But with global growth still sluggish and bond and stock prices looking expensive, balancing income and risk is more important (and challenging) than ever. The question for investors isn’t “Where can I go for yield?” It is: “In this environment, where can I find meaningful yield without taking on significant or unknown risk?”
There is a bit of a balancing act between yield and risk. Let’s take a look how it can be done in three areas of opportunities for investors seeking income today.
Bonds, or fixed income, essentially play two roles in a portfolio: They offer yield, or income, as well as potential diversification benefits as a sort of ballast to counter equity risks. Bonds run the gamut of risk and income. Short-term Treasuries offer the lowest default risk and generally the lowest yield, while high yield bonds typically offer considerably higher yields, but with significantly more risk.
These two investments are quite different, but both can play a crucial role in a portfolio. However, the yields of Treasuries are paltry while credit instruments like high yield bonds exhibit equity-like risk, albeit with potentially higher yields. For investors looking to balance yield AND risk, risk-adjusted returns are important. That’s where municipal bonds come in.
Municipal bonds aren’t an exciting topic over a cocktail party, however they were one of the best performing bond categories in 2015. According to Bloomberg data on the S&P AMT-Free National Municipal Bond Index, munis returned 3.3 percent in 2015, beating taxable investment grade bonds. This year, munis remain one of the highest sources of yield on a risk-adjusted basis. The sector’s tax-exempt status is another plus, and munis are a portfolio diversifier, with negative correlations to equities and high yield, our analysis shows.
Other parts of the fixed income market have experienced volatility recently due to energy exposure or anticipation of Federal Reserve (Fed) moves, but the municipal bond market has been relatively stable. This may surprise some given the recent default announcement of Puerto Rican debt, which is a vivid reminder of why it’s important for investors to be completely aware of what they own and the risk they take in search of yield. (iShares ETFs are not impacted directly by the default, as none hold bonds issued by any U.S. territories, such as Puerto Rico or Guam.)
If you prefer equity-like risk to come from equities in your search for yield, dividend stocks are a logical place to look. But it is important to remember that not all dividend stocks are created equal. As I’ve written before, my preference is for the segment of the market known as “dividend growers,” which as the name implies, are companies with a history of increasing dividends. There are some conditions—and clear distinctions—that may set dividend growers apart from other dividend stocks in today’s market, particularly their attractive valuations, stable earnings and stronger balance sheets.
Somewhere in between
Finally, there is an often overlooked option for investors looking to balance risk and yield: preferred stocks. Preferreds are income-generating securities that have both stock and bond characteristics. When it comes to risk, they’re somewhere in the middle of the spectrum. Similar to a bond’s coupon payment, preferred stocks pay fixed or floating dividends. They can appreciate in value like a common stock, but they’re not as volatile.
Some question if preferred stocks will remain an attractive asset class in a rising rate environment. But since we expect the Fed to continue its dovish stance and rate rises to be gradual, we wouldn’t expect to see big downward spikes in preferred prices. Preferred stocks may also be attractive in this environment due to the fact that they’re issued mainly by financial companies, like banks, where net interest margins generally show improvement. Also, see what my colleague Russ Koesterich has to say on preferreds.
Investors looking to balance risk and income while searching for yield may want to consider the iShares S&P National AMT-Free Municipal Bond Fund (MUB), the iShares Core Dividend Growth ETF (DGRO) and the iShares U.S. Preferred Stock ETF (PFF).
Heidi Richardson is Head of Investment Strategy for U.S. iShares and a regular contributor to The Blog.