Income investors feasted in 2014. This year, the menu is decidedly less attractive, but not unpalatable. Our search for attractive income investments turned up issues that pay 3% all the way up to nearly 10%, and many that could rise in value in coming quarters, while much of the income universe falls.
If market seers agreed on one thing a year ago, it was that 2014 would bring falling bond prices and rising yields, as the Federal Reserve pulled back on its bond-buying program. The program ended in October, but bonds, especially longer-dated ones, gained throughout the year. The 30-year Treasury returned 30%. Its yield shrank to 2.8%, from 4%.
Against that backdrop, most income investments shined. A year ago, we favored high-yield blue chips, municipal bonds, real estate investment trusts, telecom stocks, convertible bonds and electric utilities, in that order (“Where to Find Great Yields,” Jan. 13, 2014). All but telecoms thrived (see table on this page). REITs and utilities soared. Master limited partnerships and junk bonds, two groups we found less appealing, underperformed.
Later this year, the Federal Reserve is widely expected to begin raising its target federal-funds rate from its current ultralow range of zero-0.25%, set in late 2008. Rising rates are generally bad for bonds, though the looming hike doesn’t ensure negative returns across the board. The Fed, eyeing a strong dollar and weak growth overseas, is sure to step lightly. Its rate-targeting holds the most sway over short-term issues, where most savers would be happy to see yields rise. Longer issues could see continued support from foreign buyers. And inflation is low—1.3% in the past year. Valuations are broadly stretched, however, and investors should use caution in the search for yield.
Here are some recommendations.
Bonds
Most U.S. bond categories are priced for low returns in 2015, and some could turn negative. The benchmark 10-year Treasury yield has fallen to 2.2% from 3% a year ago; over the past half-century, it has averaged more than 6%. Municipal bonds and high-grade corporates outperformed with Treasuries in 2014. Among issues with 10-year maturities and double-A credit ratings, investors can find munis that pay 2% and corporates that pay 3%. High-yield bond returns were barely positive in 2014, with yields offsetting price declines. The energy sector led the weakness. The SPDR Barclays High Yield Bond(ticker: JNK) exchange-traded fund, with an average credit quality of B and average duration (a measure of a bond’s sensitivity to changes in interest rates) of just over four years, recently yielded 6%.
Junk bonds hold two advantages when interest rates rise. Their higher starting yields offer more cushion against price declines, and because rising rates tend to coincide with an improving economy, junk can benefit from the improving financial condition of companies. The category could outperform in 2015. Bank of America Merrill Lynch predicts 2% to 3% total returns for junk as rates climb in 2015, versus zero for high-grade corporates. That’s a thin reward for the added risk, so don’t load up. Professional management here can earn its keep. Vanguard High-Yield Corporate(VWEHX) takes a conservative approach, focusing on bonds that are just a notch or two below investment-grade. That can help this actively managed fund outperform during weak patches; in 2014, for example, it returned 4.6%, beating 99% of peers. Expenses, at 0.23% a year, are a fraction of the group average.
For munis, the supply-and-demand outlook appears balanced for 2015, and credit conditions are likely to remain strong. Alaska, North Dakota, and Texas have the most negative exposure to low oil prices, because they lead states in the amount by which oil production exceeds consumption. Bonds in these states could slightly underperform if oil’s price remains low, but don’t expect them to tumble. Munis in general still offer an after-tax yield advantage over Treasuries for investors with high tax brackets, combined with higher credit quality than corporate bonds, but payouts aren’t generous. Fidelity Municipal Income (FHIGX) sticks mostly with single- and double-A bonds, has an average duration of just under seven years, and yields 1.9%. (That’s equivalent to over 3% for investors in the highest tax bracket.) It beat more than 90% of its peers in 2013, when munis broadly lost money. Expenses of 0.46% a year are half the group average; even so, they gobble precious yield.
High-grade corporate bonds look unattractive—especially, in some cases, compared with the shares of the same issuers. Nine-year Microsoft (MSFT) bonds yield 2.7% to maturity. The shares also pay 2.7%, and unlike the bond coupons, the dividends are likely to grow. Nine-year Johnson & Johnson (JNJ) bonds pay 2.6%. One option for investors is to pick up extra yield from a discounted portfolio of bonds through closed-end funds (see below).
Emerging-market bonds still yield much more than developed-market bonds, but key issuers, such as Russia, Brazil, and Turkey, are just above junk credit ratings, so downgrades in 2015 could hurt. For investors who don’t mind the risk, T. Rowe Price Emerging Markets Bond (PREMX) holds a mix of government and corporate issues with an average credit quality of double-B, and a yield of 6.3%. Expenses are 0.94% a year.
While shares and other assets below generally compare favorably with bonds for income seekers, investors shouldn’t stray from prudent asset allocations in order to max out their paydays. Even Treasuries play an important role, because they tend to rise in value when risky assets plunge. That 10-year yield of just under 2.2% won’t make anyone rich, but it’s more than twice what investors get in Germany or Japan, and so could attract overseas support in 2015 to help offset the pull of rising rates. Over the next year, our top suggestion for the investor who needs 6% portfolio income is to combine a 3% average yield with the occasional sell order.
Dividend Stocks
Stock investors should look beyond traditional yield sources. Utilities just turned in their best year since 2000. Not coincidentally, the group’s valuation of nearly 18 times projected earnings over the next four quarters is the highest it has been since 2000. The sector yields 3.3% and dividends have lately grown by an average of 4% a year—more than bonds, yes, but investors can do better. Verizon Communications (VZ) and AT&T (T) languished in 2014, as they defended share in a saturated market against cost-cutting rivals. Our second choice is Verizon, which yields 4.8%, for its better wireless spectrum and dividend coverage. Our first choice is neither.
Elsewhere, Ford Motor (F) and General Motors (GM) are thriving and combine yields exceeding 3% with potential for share-price gains as investors gain confidence in the auto industry’s transformation. Pfizer (PFE) and General Electric (GE) are slow growers, but yields of over 3.5% add appeal. Boeing (BA) pays 2.8% and enjoys swelling free cash flow. JPMorgan Chase (JPM) yields 2.6% and can afford to pay more.
Technology is a fertile source for income. Microsoft yields 2.7% and has raised its dividend at a double-digit clip in recent years. Cisco Systems (CSCO) pays 2.7% and should benefit from a strong year for network switch sales. Intel (INTC) is extending its advantage in chip manufacturing as the cost of boosting speeds rises. Its shares yield 2.7%. These payments are a bit lower than what investors can get in tobacco, food, and electric utilities— Philip Morris International (PM) yields 4.7%, for example, andConsolidated Edison (ED) yields 4%—but that can work out well in 2015 if high-yield stocks fall in sympathy with bonds. And tech has more potential for long-term payment growth.
Taking that theme of modest but growing yields to an extreme, Citigroup (C) and Bank of America (BAC) pay trivial amounts now, but are expected to quickly restore their dividends, with yields reaching 2% to 3% of today’s share prices by 2016. General Motors, Boeing, and Bank of America made our list of top 2015 stock picks in last week’s cover story.
For a scattershot approach, consider Schwab U.S. Dividend Equity (SCHD), a passively managed exchange-traded fund. It selects large companies that score well on metrics like yield, dividend growth, and return on equity. Among aforementioned names, Microsoft, Intel, and Pfizer are top holdings. The fund yields 2.8%. Expenses are so low it will almost feel good to pay them: 0.07%.
Real Estate Investment Trusts
Equity REITs trounced the broad stock market in 2014, but don’t expect a repeat this year. The group trades at 25 times projected 2015 adjusted funds from operations, or AFFO, compared with a long-term average of 16 times, according to Credit Suisse. AFFO is a measure of cash flow available to investors. The average REIT yield is 2.9%, or just 0.7 percentage point above the 10-year Treasury yield, compared with an average spread of 1.2 percentage points. At current prices, REITs are likely to produce mid-single-digit returns in 2015, and could lose money if rates rise faster than expected.
Favor hotel REITs. Hotels are generally riskier than other properties for two reasons. Their tenants (travelers) sign up for ultra-short stays, often a night or two, giving little visibility into future cash flows. And hotels are much more sensitive to swings in the economy than, say, hospitals. For both reasons, hotel REITs tend to carry slightly higher dividend yields than the broad sector. If the economy continues to improve, hotel chains are likely to enjoy higher cash flows. And short-term tenants are just the thing to have when interest rates rise, because owners can pass along higher interest costs in the form of price hikes.
RLJ Lodging Trust (RLJ) does business coast-to-coast with big chains, such as Marriott International (MAR) and Hyatt Hotels (H). Despite a 38% gain last year, it trades at 14.2 times projected 2015 AFFO and yields 3.6%.
Another option is to seek out REITs that don’t fit neatly into popular categories. Plenty of investors seek exposure to malls, offices, or apartment buildings. Few look for a blend of megaplex theaters, ski parks, and charter schools—tenants for EPR Properties (EPR). Its shares advanced 25% last year. They sell for 13.7 times projected 2015 AFFO and yield 5.9%.
Master Limited Partnerships
In 2014, U.S. crude oil plunged from $98 a barrel to $54, as production grew faster than demand and Saudi Arabia declined to try to prop up prices. Natural-gas prices held up for most of the year, but ended down more than 25% on what’s shaping up to be a mild winter.
That spoiled the income rally for master limited partnerships, which trade like stocks and pass the bulk of their income—often from oil and gas assets—to unit holders as distributions. The Alerian MLP Index returned 4.8%, and recently yielded 6.1%.
The yield compares well with other income investments; the spread to the 10-year Treasury yield is 3.9 percentage points, versus an average of 3.4 points over the past decade. The problem is that if crude and gas prices remain weak, MLPs that profit from production will likely cut their distributions. These make up about 5% of so of the Alerian index, but their prices have plunged to the point that their yields are in double digits, boosting the index’s yield. For example, Breitburn Energy Partners (BBEP) yields over 20%, suggesting that investors anticipate a deep pay cut. Safer names that collect fees for transporting oil and gas have less exciting yields. Enterprise Partners Products (EPD) pays 4%.
Daring investors can find risks worth taking. Memorial Production Partners (MEMP) fell 34% last year and now yields 15%. At least two firms, Bank of America Merrill Lynch and Wunderlich Securities, count it among their top picks for 2015, citing hedges that can offset weak oil and gas prices over the next two years and excess liquidity that can fund unit repurchases. Looking ahead to 2016, seven analysts have ventured distribution forecasts, the most bearish of which is $1.40 per unit, for a yield of 9.6% of the recent unit price. That gives Memorial units the potential to rise in price while supplying lavish income in 2015.
Cautious investors should aim for lower yields. Plains All American Pipeline (PAA) combines low-risk storage and pipeline businesses with a smaller marketing operation that has exposure to oil prices. Three-quarters of projected 2015 cash flow comes from fees. The partnership has increased distributions in 40 of the past 42 quarters, including through a short-lived plunge in crude prices in 2008. Units have fallen 12% in price over the past three months and yield 5.1%. Wall Street predicts 9% distribution growth in 2015. Plains All American can grow slowly with rising production in coming years or rebound faster if crude rises. A strong balance sheet could allow it to scoop up cheap assets from weaker players.
Preferred Stocks
Preferred stocks shined in 2014. They don’t offer the upside potential of common shares or the higher credit standing of bonds. Their appeal comes from relatively plump yields. But they come in so many variations that shopping for good ones is about as easy as gene sequencing. Some pay fixed rates; others, floating rates. Fixed did particularly well in 2014, but floating could be better-positioned for a 2015 rate hike. Some are cumulative, meaning dividends in arrears build up. Some mature, while others are perpetual. There are also call dates to watch out for.
For investors who expect rates to climb in coming years, Wells Fargo Series Q preferred shares (WFC.PQ) recently sold for $25.65 apiece with a current yield of 5.5%. In September 2023 they can be called at $25 or converted to floating rate shares that pay the three-month Libor rate, recently 0.24%, plus 3.09 percentage points. It’s a non-cumulative issue rated triple-B by S&P. For more yield, the Bank of America series W (BAC.PW) is noncumulative and rated double-B, with no floater conversion. It sells at a slight premium with a current yield of 6.5%, and is callable at par in September 2019, for a yield to call of 6.1%.
Closed-End Funds
Closed-ends are investment vehicles, not individual assets, but they deserve mention because they can trade at discounts to the value of their underlying assets, which can enhance their yields. Many also boost their yields through leverage, which isn’t ideal for 2015. Some have managed distribution rates that can exceed their portfolio income. That isn’t a deal-breaker for investors who need the income. If the fund typically trades at a discount to the value of its assets, a little return of capital can add value.
MFS Intermediate Income Trust (MIN) aims for an 8.5% distribution rate, but only about one-third of distributions have lately come from portfolio income. It trades at a 10% discount, doesn’t use leverage, and holds a mix of government and investment-grade corporate bonds, half from the U.S. and the rest from other developed countries. The average duration is just over three years. The fund is one option for investors who need high current income without high risk, even if part of it is their own money coming back to them.
Western Asset Mortgage Defined Opportunity (IGI) holds mostly U.S. corporate bonds with investment grade credit ratings, although it dabbles in junk and foreign bonds. It doesn’t use leverage and has an average duration of just under seven years. The distribution rate of 5.7% is supported by portfolio income. The discount is only 1%, but it has averaged close to 5% over the past six months. Any increase in the discount from here could be a good opportunity, because investors will receive net asset value in December 2024.
Business Development Companies
Business development companies are structured like closed-end funds and specialize in providing financing, often with variable rates, to companies that, for example, aren’t large enough to tap bond markets. The group underperformed in 2014. It has about 7% exposure to energy investments, so loan losses could rise. Then again, yields around 10% for many BDCs provide a cushion, so long as the payments are well covered by cash flows. Keefe, Bruyette & Woods, an investment bank specializing in financial-service companies, predicts a 5% gain for BDC shares in 2015, bringing total returns to 10%-20%.
Two to consider are Ares Capital (ARCC), which yields 8.8%, and Apollo Investment(AINV), 9.6%. Apollo has more energy exposure, about 13% of its portfolio. But shares recently traded at a 15% discount to their third-quarter book value, suggesting potential oil and gas writedowns are more than priced in.
Short of bank robbery or Nigerian government bonds, those are some of the highest payouts that investors can secure. But buy them sparingly.
E-mail: editors@barrons.com
