INSIGHTS

On December 11, 2017

AAM Viewpoints – Alternative Income Ideas for Investors

We are over 30 years into a bull market for bonds and since the early 1980s we’ve only had three years in which the Bloomberg Barclays U.S. Aggregate Index had negative returns. Year-to-date (YTD) the index has posted a 3.07% return (as of 11/30/2017) and will likely be positive again this year as each component of the index is up. So, with a 98% probability the Fed will raise rates later this month and potentially 2-3 times next year, how do you build income-producing portfolios if interest rates begin to rise? We continue to believe Master Limited Partnerships (MLPs), Real Estate Investment Trusts (REITs), Business Development Companies (BDCs), and dividend-paying equities could be candidates to help increase overall income and provide asset diversification in portfolios.

Master Limited Partnerships (MLPs)

In 1987, Congress limited the use of MLPs to real estate and energy companies. These limitations were put into place as a result of the perceived loss of corporate taxes since MLPs do not pay federal taxes. To qualify for the pass-through status, at least 90% of the MLP’s income must be qualifying income. To qualify as an MLP, a company must have all but 10% of its revenues be from commodities, natural resource or real estate activities. The Alerian MLP Index (AMZ) currently has an average dividend yield of 8.16%. Broadly speaking, earnings and cash flows appear to be improving yet the market seems to be grouping these with other energy companies so they have underperformed this year. This appears to be a compelling opportunity in our view.

Real Estate Investment Trusts (REITs)

REITs have existed for more than 50 years and began when Congress granted the legal authority to form REITs in 1960 as an amendment to the Cigar Excise Tax Extension of 1960. These dividend-paying securities are performing well again in 2017 as evidenced by the MSCI U.S. REIT Index (RMZ) return of 5.02% as of 12/4/17 with a dividend yield of 4.29%. Since REITs pay out 90% of their earnings in the form of dividends to qualify for special tax treatment, they have the potential to provide a high level of income. Fundamentals have been improving and as REITs are exposed to multiple sectors (Health Care, Commercial, Residential, Retail, etc.) so you need to understand what you own.

Business Development Companies (BDCs)

A BDC is a form of publicly traded private equity created by Congress in 1980 under amendments to the Investment Company Act of 1940. Business Development Companies service a special need that has gone underserviced by banks. We see this trend of lending to smaller companies that are challenged when accessing normal capital markets as a trend that should stay around for some time for the BDCs. As a result, BDCs provide a unique opportunity to invest in small- to middle-market private companies with the potential to receive attractive dividend yields (as of 12/5/2017 the average yield for the Wells Fargo BDC Index (WFBDC) was 9.89%) while benefiting from the diversification in the company’s investment portfolio. The dividends have grown 9.25% over the past 12 months and we view this as a positive for the group.

Quality Dividend-Paying Stocks

Dividend-paying stocks may have lost some of their luster as income investments with the recent record highs in many indexes, but we think they are still worthwhile candidates for income. The average dividend yield for securities in the S&P 500 is 1.90%, the Dow Jones Industrial Average is 2.14%, and the Russell 3000 average is 1.82%. Diversifying a portfolio with these assets may also help reduce overall portfolio volatility.

Bond Investments

We believe investors should manage their exposure to all asset classes and shouldn’t avoid traditional bond investments. Owning individual bonds remains an important portfolio component for income investors, in our opinion, and we suggest looking at securities with high coupons to help manage portfolio volatility. The higher coupons have the potential to provide more interest income and can help offset bond price movements during volatile interest rate environments while providing the investor with a steady income stream over the life of the bond. When looking at bond investments, keep in mind the municipal market (tax-exempt and taxable) also appears to offer value, but we believe investors should keep their duration short and consider laddering strategies. While few bonds are immune to higher inflation and higher interest rates, you can take steps to offset the negative price returns that come with higher rates. Although we continue to underweight Treasury and Agency issues, we believe there are still opportunities in traditional bond alternative income-producing securities. A combination of these different types of assets has the potential to increase income and improve portfolio diversification, in our view.