Interest rate hikes to tame inflation may be roiling global markets as investors grapple with recession concerns, but higher interest rates have also arguably made fixed income potentially interesting again for new allocations. With yields for some income investments hitting multi-year highs, today’s note provides an overview of the landscape for income investors and puts current yields in context.
For the first time in quite a while, the fixed income space has something appealing to offer income investors – decent yields. The yield on the Bloomberg USAgg Index, a benchmark for investment-grade fixed income, ended September with a yield of 4.75% (see chart below), a level not seen since early December 2008. Meanwhile, the yield on the Bloomberg US Corporate High Yield Bond Index was near 10% at the end of September, after barely averaging more than 4% in 2021. Double-digit yields for that index were last seen in March 2020, when markets were reeling from the uncertainty of the pandemic.
With a volatile macro backdrop and broad-based weakness, some equity income investments are also offering yields on par with what was previously seen during the pandemic-driven lows of 2020. For example, the second quarter of 2020 was the last time REITs had a yield above 4%. Similarly, the S-Network Composite Closed-End Fund Index not seen a yield north of 10% since April 2020. With energy being a bright spot in a tough market, yields for energy infrastructure indexes are not at relative highs, but they were sitting above their 10-year averages at the end of September, with the Alerian MLP Infrastructure Index yielding 7.84%.
Clearly, higher yields are coming at a cost, with rising interest rates putting downward pressure on both stocks and bonds this year. Stubbornly high inflation, which is necessitating aggressive rate hikes, largely offset higher yields, as real yields for many assets remain negative. When yields spiked in 2020 for high-yield bonds, REITs, and closed-end funds, the move was short-lived as the Fed took steps to bolster US financial markets, and yields quickly moderated. With the Fed focused on bringing down inflation and poised to continue raising rates, today’s yields may mark the start of an extended period of higher rates, instead of the flash in the pan spike seen in 2020. Although with pervasive concerns about a recession, the macro environment remains precarious.
What’s an income investor to do? It probably depends on what he or she believes about inflation and interest rates. If one expects more rate hikes and a prolonged period of higher interest rates, there would be no rush to jump into fixed income with two feet. One may start tilting their portfolio gradually towards fixed income or take a wait-and-see approach. In the meantime, energy infrastructure may be appealing to those concerned about inflation and prefer real asset exposure. While not at relative highs, yields for energy infrastructure remain attractive, and the space may be less sensitive to rising interest rates (read more). If particularly concerned about a recession, utilities may be the safety play in the near term. Utilities have held up well this year given their defensive nature, and yields were 30 basis points below their ten-year average at the end of September. Alternatively, investment-grade bonds with a shorter duration (less interest rate risk) may also be a compelling safe haven.
Bottom line:
As fixed income yields become more attractive, income investors will likely be considering portfolio adjustments depending on their outlook and expectations. While many assets are providing yields at multi-year highs, investors will likely want to take a measured approach against a backdrop of significant macro volatility and uncertainty.
CEFX is the underlying index for the Invesco CEF Income Composite ETF (PCEF) and ETRACS 1.5X Leveraged Closed-End Fund ETN (CEFD). AMZI is the underlying index for the Alerian MLP ETF (AMLP) and the ETRACS Alerian MLP Infrastructure Index ETN Series B (MLPB).
Current Yields vs. History
Midstream/MLP yields are currently above their ten-year averages. Even with weakness in September, YTD total return remains strong as energy continues to be a bright spot in a challenging tape.
Yields for the Dividend Dogs index suite are generally in-line or above their five-year averages. SDOGX has seen the best performance YTD, down only -13.07% compared to a -23.87% loss for the S&P 500, which is the starting universe for the index.
Multiple screens for dividend durability, including evaluating cash flows, EBITDA, and debt-to-equity ratios, help ensure reliable income from the durable dividend indexes.
Closed-end funds have been pressured by the rising interest rate environment, and the current yields for the three CEF indexes are well above their historical averages.
