INSIGHTS

On March 21, 2017

Alternative Sources of Income

INVESTMENT REVIEW

Stocks further added to their post-U.S. election gains in February, supported by continued expectations of new business-friendly policies along with a decline in bond yields. The yield on the 10-year U.S. Treasury note ended the month slightly down at 2.36%, and sovereign yields in Europe mostly declined amid increased political uncertainty after spiking in January on inflation concerns.

Dividend-paying equities rallied along with the broad stock market, with the Russell 1000 Dividend Growth Index returning 3.3% as favorable year-end earnings reports bolstered the view that the global economy was accelerating, and in anticipation of promised tax cuts and regulatory rollbacks that could further strengthen the expansion. The Federal Reserve’s hints of a March interest-rate increase were further indication that the Fed’s governors expect strong economic growth in the coming months.

Real estate investment trusts (REITs) were also broadly positive during the month, with the FTSE NAREIT Equity REIT Index advancing 3.9%. REITs benefited from continued strong fundamentals for U.S. commercial real estate markets, as well as from the modest decline in Treasury yields. The stocks advanced on generally solid fourth-quarter 2016 earnings reports, despite somewhat muted 2017 management guidance as companies waited for clarity on issues such as overhauling the tax system, infrastructure spending and health care reform.

Master limited partnerships (MLPs), as measured by the Alerian MLP Index, posted a 0.4% gain, adding to the sector’s strong returns of the past year. Oil prices remained in a tight $50 to $55/barrel range, but natural gas prices experienced steep declines as the market accounted for a very mild end to the winter withdrawal season. Performance within the MLP group was driven mostly by company-specific factors such as earnings, mergers and acquisition activity, restructurings, equity offerings, and distribution changes, which led to a modest gain for the sector.

Preferred securities rose 1.8% in February as measured by the BofA Merrill Lynch Core Fixed Rate Preferred Index. Credit spreads narrowed during the month amid encouraging economic data. Yields on preferreds relative to their issuing companies’ senior debt also narrowed. In this environment, preferred securities fared better than longer-dated Treasuries, investment-grade corporate bonds and high-yield bonds. Light issuance aided preferreds’ performance during the month, helping to maintain a favorable supply-demand dynamic.

Taxable closed-end funds returned 3.2% based on the Morningstar U.S. Equal Weighted All Equity CEF Index. Nearly all sectors of the closed-end fund market had positive returns for both the funds and their underlying holdings. As in January, equity funds collectively outpaced fixed income funds and saw their average discount to net asset value continue to narrow. At the end of February, equity funds had an average discount of 5.7%, compared with their long-term average of 5.2%.

INVESTMENT OUTLOOK

Global economic growth is on an upswing that we believe will continue through the rest of this year. The U.S. economy is moving into the late stages of the business cycle, which normally implies a slowdown, but the easier fiscal policies proposed by the Trump administration could extend the expansion for another year or two. Dividend policies will take on more importance as interest rates rise, in our view, as dividend growers generally outperform higher-yielding, lower-growth stocks when rates move up. In this environment, we believe companies with stronger business models and solid cash-flow generation are better able to grow earnings and dividends through market share gains or acquisitions, supporting dividends and dividend growth.

REITs have historically performed well in periods of accelerating growth—even when interest rates and inflation are also rising. We anticipate that demand for commercial properties will generally continue to outstrip new supply in the U.S., driving rents and REIT cash flows in the coming months. In addition, we see the potential for positive earnings surprises as the year unfolds considering the conservative guidance companies have provided.

We believe the global oil market will shift into undersupply later this year and that North America will gain market share as a global energy supply source. North American producers have lower up-front investment costs that give them a considerable advantage over most other production alternatives. Over time, we believe MLP fundamentals may strengthen as commodity prices rise, volumes grow and the supply/demand for pipelines improves. To the extent that the Organization of the Petroleum Exporting Countries (OPEC) maintains its quota discipline, the oil rebalancing process could be pulled forward, meaning that fundamentals for MLPs may improve faster.

Fixed income continues to be vulnerable to rising yields, although we believe preferred securities remain well-positioned relative to other areas of fixed income thanks to their high income rates and wide yield spreads relative to Treasuries and corporate bonds, which could help cushion the impact of rising rates over time. Additionally, the primary issuers of preferreds—banks and insurance companies—stand to benefit from a steepening yield curve, lighter regulation and potential corporate tax cuts, which can bolster their earnings power, strengthen credit fundamentals and lead to narrower yield spreads.

In the closed-end-fund market, we believe the best long-term returns will likely be found in equity closed-end-fund categories with discounts selling wider than their historical averages. We expect additional discount narrowing within equity sectors in 2017, as these funds ended the month with an overall discount modestly wider than their long-term average. The potential for incremental discount narrowing in the taxable fixed income and municipal closed-end fund segments is more muted, in our view, as they both ended the month close to their historical discount averages.

CRN: 2017-0302-5838R

Opinions in this piece are those of Cohen & Steers and are not necessarily that of AAM.

Risks of Investing in Equity Securities: The value of common stocks and other equity securities will fluctuate in response to developments concerning the company, political and regulatory circumstances, the stock market and the economy. In the short term, stock prices can fluctuate dramatically in response to these developments. Different parts of the market and different types of equity securities can react differently to these developments. These developments can affect a single company; all companies within the same industry, economic sector or geographic region; or the stock market as a whole. Dividend-paying stocks may be particularly sensitive to changes in market interest rates, and prices may decline as rates rise. Special risks of investing in foreign securities include (i) currency fluctuations, (ii) lower liquidity, (iii) political and economic uncertainties, and (iv) differences in accounting standards. Some international securities may represent small- and medium-sized companies, which may be more susceptible to price volatility and less liquid than larger companies.

Risks of Investing in Real Estate Securities. The risks of investing in real estate securities are similar to those associated with direct investments in real estate, including falling property values due to increasing vacancies or declining rents resulting from economic, legal, political or technological developments, lack of liquidity, limited diversification and sensitivity to certain economic factors such as interest rate changes and market recessions.

Risks of Investing in MLP Securities. An investment in MLPs involves risks that differ from a similar investment in equity securities, such as common stock, of a corporation. Holders of equity securities issued by MLPs have the rights typically afforded to limited partners in a limited partnership. As compared to common shareholders of a corporation, holders of such equity securities have more limited control and limited rights to vote on matters affecting the partnership. There are certain tax risks associated with an investment in equity MLP units. Additionally, conflicts of interest may exist among common unit holders, subordinated unit holders and the general partner or managing member of an MLP; for example, a conflict may arise as a result of incentive distribution payments.

MLPs are subject to significant regulation and may be adversely affected by changes in the regulatory environment, including the risk that an MLP could lose its tax status as a partnership. MLPs may trade less frequently than larger companies due to their smaller capitalizations, which may result in erratic price movement or difficulty in buying or selling. MLPs may have additional expenses, as some MLPs pay incentive distribution fees to their general partners. The value of MLPs depends largely on the MLPs being treated as partnerships for U.S. federal income tax purposes. If MLPs were subject to U.S. federal income taxation, distributions generally would be taxed as dividend income. As a result, after-tax returns could be reduced, which could cause a decline in the value of MLPs. If MLPs are unable to maintain partnership status because of tax law changes, the MLPs would be taxed as corporations and there could be a decrease in the value of the MLP securities.

MLPs: MLPs are limited partnership or limited liability companies that are generally taxed as partnership whose interests are generally traded on securities exchanges. Most MLPs generally operate in the energy natural resources or real estate sector and are subject to the risks generally applicable to companies in those sectors. Those risks include, but are not limited to, commodity pricing risk, supply and demand risk, depletion risk and exploration risk. MLPs are also subject to the risk that authorities could challenge the tax treatment of MLPs for federal income tax purposes which could have a negative impact on the after-tax income available for distribution by the MLPs.

REITs: An investment in a Real-Estate Investment Trust (REIT) securities is subject to additional risks, as companies involved in the real estate industry are subject to changes in the real estate market, vacancy rates and competition, volatile interest rates and economic recession.

Dividends: Dividends are not guaranteed and will fluctuate. Dividend yield is one component of performance and should not be the only consideration for investment.

Fixed Income: Bonds typically fall in value when interest rates rise and rise in value when interest rates fall. Bonds with longer periods before maturity are often sensitive to interest rate changes. The financial condition of an issuer or its credit ratings may drop, resulting in the issuer’s inability to make interest and/or principal payments in the future. A bond issuer might prepay or “call” a bond before its stated maturity at a depressed price.

Risks of Investing in Closed-End Funds. Risks include higher interest rates, economic recession, deterioration of the bond and equity market, possible downgrades, early call provisions, changes to the tax status of the bonds and defaults of interest and/or principal. Shares of closed-end funds are also subject to various risks, including management's ability to meet the fund's investment objective, and to manage the fund's portfolio when securities are redeemed or sold, during periods of market turmoil and as investor perceptions regarding the funds or their underlying investments change. In addition, closed-end funds frequently trade at a discount to their net asset value in the secondary market.

Risks of Investing in Preferred Securities. Investing in any market exposes investors to risks. In general, the risks of investing in preferred securities are similar to those of investing in bonds, including credit risk and interest-rate risk. As nearly all preferred securities have issuer call options, call risk and reinvestment risk are also important considerations. In addition, investors face equity-like risks, such as deferral or omission of distributions, subordination to bonds and other more senior debt, and higher corporate governance risks with limited voting rights.

Risks associated with preferred securities differ from risks inherent with other investments. In particular, in the event of bankruptcy, a company’s preferred securities are senior to common stock but subordinated to all other types of corporate debt. Throughout this commentary we will make comparisons of preferred securities to corporate bonds, municipal bonds and 10-Year Treasury bonds. It is important to note that corporate bonds sit higher in the capital structure than preferred securities, and therefore in the event of bankruptcy will be senior to the preferred securities. Municipal bonds are issued and backed by state and local governments and their agencies, and the interest from municipal securities is often free from both state and local income taxes. 10-Year Treasury bonds are issued by the U.S. government and are generally considered the safest of all bonds since they are backed by the full faith and credit of the U.S. government as to timely payment of principal and interest.

Preferred funds may invest in below investment-grade securities and unrated securities judged to be below investment-grade by the Advisor. Below investment-grade securities or equivalent unrated securities generally involve greater volatility of price and risk of loss of income and principal, and may be more susceptible to real or perceived adverse economic and competitive industry conditions than higher grade securities. The benchmarks do not contain below investment-grade securities.