Today’s low-to-negative interest rate world has sent investors searching far flung corners of the market for yield, driving flows into a range of once obscure, high-yielding asset classes. Attractive income does exist in a host of areas, but not all income-producing assets are created equally in our view, and risks abound.
One such risk: Rising rates on the horizon. We expect the Federal Reserve (Fed) to initiate its first rate hike in a year this December. The pace of Fed rate increases is likely to be gradual, meaning rates should stay low from a historical perspective for the foreseeable future.
Still, some popular high-yielding asset classes (such as traditional dividend-paying stocks and REITs) could potentially suffer as rates begin to slowly trend higher.
What does this mean for investors? Thoughtful diversification is key when it comes to the hunt for yield as 2016 draws to a close. Our colleague Matt Tucker’s recent post echoed the same sentiment. We particularly like these three ways to seek income now.
U.S. investment grade credit
Higher-quality credit can help mitigate risks from higher-income areas, while still offering an attractive yield pickup relative to Treasuries, we believe. However, heavy supply and higher duration than the high yield sector are risks, as is rising corporate leverage. High yield does represent a rare, income-producing bright spot and stabilizing energy prices are supporting the asset class. But high valuations and a strong rally in 2016 could see some profit taking in the high yield sector, so we generally prefer investment grade bonds.
International exposure via emerging market (EM) debt
This sector offers higher yield for a slight pickup in risk. Economic fundamentals have turned a corner and a more stable U.S. dollar suggests an opportunity for local-currency bond investing. But we have become more selective given rising valuations. We prefer the front end of local markets with room for EM central banks to cut rates further, such as in Brazil and emerging Asia. An aggressive Fed tightening cycle or global risk-off scenario could pose a threat to the asset class, though we see the risk as low.
We think it is a good time for dividend-focused investors to divide stocks into dividend payers and dividend growers and balance out dividend portfolios. Dividend-paying stocks have performed strongly in a low-rate environment, but we believe they could suffer as rates rise.
In contrast, dividend growers have tended to outperform in a rising rate environment and typically have more stable payout ratios. These stocks generally offer competitive yield and upside potential through capital appreciation, and they have historically delivered attractive performance in rising rate environments relative to the highest yielding stocks. A prolonged low-growth, low-rate world could certainly see more defensive, divided-rich stocks thrive, but dividend growers do currently offer more attractive valuations.
It’s important to remember that all higher-yielding assets come with higher risks, but some of these risks appear more worth taking now. See the chart below for more on the opportunities and potential pitfalls we see for income investors today.