The dangers in extreme income investing

Investors seeking income have taken to the extremes: reaching to the riskiest corners for yield while also piling up cash. Michael Fredericks says they are missing out on a happy medium.

If you’re investing for income today, or at any time in the past few years, you know it’s an endeavor fraught with uncertainty, perhaps even disappointment. And this may very well have you on an emotional risk-on/risk-off seesaw—trying to achieve a decent amount of income without indecent risk.

BlackRock has observed that a convergence of market and behavioral dynamics has caused many investors to operate at the extremes as they seek income: They are taking undue risk in a reach for yield and at the same time hoarding cash.

Neither the full-throttle risk nor the “no-risk” approach is optimal.

Consider that for an equal amount of income, investors needed to take more than double the risk they did 10 years ago. This is shown in the chart below.

I’d also argue that there is risk in the seemingly no-risk “run to cash” scenario. There’s opportunity lost by not investing those dollars in higher-potential opportunities as well as the tangible loss of growth and purchasing power after the effects of inflation and taxes.

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Fortunately, income seekers do have options between these two extremes. I think a managed, multi-asset approach to income investing that invests specifically for attractive yield at lower levels of volatility makes good sense today. As the portfolio manager of such a strategy, I’d offer the following observations and considerations for fellow income seekers:

Favor shorter duration

Duration, or interest rate sensitivity, of bond investments has steadily risen recently as investors have piled money into fixed income. Longer-duration assets may be particularly at risk as the Federal Reserve prepares to hike interest rates. Floating-rate securities or short-term fixed income might offer a better cushion in episodes of rising rates.

Use volatility

Equity market volatility, as measured by the VIX, touched its lowest level in 42 years in August. And it hasn’t taken off as much as we might have expected despite the looming election and other uncertainties. Times of low volatility can be opportune for buying an equity hedge while it’s inexpensive, to target some protection on the downside. At times when volatility spikes, pricing dislocations can occur in otherwise attractive assets. Market corrections, particularly when indiscriminate, can be times to look for buying opportunities.

Pick your places in high yield

Some pockets of high yield look better than others from a risk/reward standpoint. For example, the yields on CCC-rated high yield bonds are quite low on a 10-year basis given the historically higher default rates in this low-quality portion of the market. In our opinion, there’s not enough yield to compensate for the risk. On the other hand, in a slow but steadily growing economy, shorter-maturity, higher-quality high yield (BB and B rated) looks like a potentially interesting place—not for price appreciation, but for consistent cash flow. We would apply the same selective thinking to bank loans and other areas of credit fixed income.

Focus on dividend growers

Central bank policy has implications not just for interest rates and bond prices, but for pockets of equities. These are typically income-producing equities, such as utilities and consumer staples, which tend to act like bond market proxies. Stock dividends are still an attractive source of income, but we would not target the highest yielders now. We prefer stocks with a history of cash-flow generation and dividend growth. There is no guarantee that stocks will continue to pay dividends.

With a number of important events exacerbating uncertainty through year-end, we think it makes sense to keep risk at the low end of the continuum now. This might mean lower exposure to equities and some forms of credit. However, the Holy Grail for income investors today is selectivity and an active, eyes-wide-open approach to managing opportunities and risk.

Michael Fredericks, Managing Director, is head of Income Investing for the BlackRock Multi-Asset Strategies group and lead portfolio manager of the Multi-Asset Income, Managed Income, Global Multi-Asset Income and Dynamic High Income Funds. He wrote this post for The Blog.

Investing involves risks, including possible loss of principal.

Stock and bond values fluctuate in price so the value of your investment can go down depending on market conditions. Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher rated securities. Asset allocation strategies do not assure profit and do not protect against loss.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of November 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results.

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