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AAM Viewpoints – Searching for Yield in a Low Interest Rate Environment


The U.S. 10-year Treasury is a barometer for interest rates and factors such as geopolitical concerns, slowing global growth and trade are only a few of the many variables that can impact yields. The important decision for most investors is not whether to invest, but rather which investments might help you meet your goals while staying within your risk tolerance parameters. With the 10-year U.S. Treasury yielding less than 1.75% and the 30-year U.S. Treasury yielding less than 2.2%, we are getting questions on where to put money to work to generate higher levels of income.


We’ve been using alternative income-producing assets for years in our Privately Managed Accounts (PMA). With the 10-year Treasury at three-year lows and an estimated $15 trillion negative yielding sovereign debt around the globe, “lower for longer” remains the theme for income investors. We finished October 2018 with the 10-year Treasury yield at 3.14% and the majority of bond managers expecting rates to continue to rise during 2019. This, however, was not the case and as of September 2019, the 10-year Treasury yield declined 48% from October levels and now sits near three-year lows. This movement in rates and the continued expectations, in some camps, that rates will rise eventually, has many investors sitting on the fence and missing potential opportunities in the market. The S&P 500 total return this year is 18.74% (as of 9/30/2019), the Barclays Aggregate Index has returned 8.52% YTD (year to date) and the Barclays Municipal Index has returned 6.75% this year.


Eurozone Sovereign Yields


As illustrated below, yields in the Eurozone have plunged as European countries continue to face recessionary and deflationary pressures. Germany’s economy shrank in the second quarter as global uncertainty and the trade war took a tool on its manufacturers. GDP (Gross Domestic Product) for the three months ended June contracted 0.1% compared to the previous quarter. By comparison, U.S. Treasury yields look attractive even at these subdued levels. There has been an abundance of news this year that has helped fuel the “flight to safety,” but when you look at rates around the globe you see that U.S. Treasury yields are compelling to foreign investors. The table below reflects the 95 basis point YTD drop in the U.S. 10-year Treasury which leaves the U.S. benchmark rate below 1.7%, but still trails the drop seen across other major sovereign markets.


sovereign yields


Source: AAM – Bloomberg


Alternative Income Ideas for Investors


We are now approaching a 40-year bull market for bonds. Since the early 1980s we’ve only had three years in which the Bloomberg Barclays U.S. Aggregate Index has posted a negative return. 2019 will likely be another positive year for the Aggregate as every component asset class in the index is up on a year-to-date basis. With a 67% probability the Fed will cut rates again this month and the potential for an additional cut this year, the question becomes: “How do you build income-producing portfolios with yields at historic lows?” The current low interest rate environment provides little compensation for duration risk and the compression of credit spreads makes reaching for yield via credit risk exposure a lukewarm proposition at best. Against a backdrop of “lower for longer,” it may be time to consider bond alternatives. 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 class diversification in portfolios. We’ve been tactically investing in these assets in our PMA strategies because of the above average levels of income they have been offering. (See historical dividend yields in the chart below).


historical yield comparisonSource: AAM – Bloomberg | Past performance is not indicative of future results.


Master Limited Partnerships (MLPs)


The first MLP was organized in 1981 and 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 pass on income to investors and as such 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 derive all but 10% of its revenues from commodities, natural resource or real estate activities. The Alerian MLP Index (AMZ) currently has an average dividend yield of 8.53% for those that can stomach the potential volatility. The index has returned 10.91% YTD.


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 in 2019 as evidenced by the MSCI U.S. REIT Index (RMZ) return of 26.87% as of 9/30/2019 with a dividend yield of 3.86%. 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 but because REITs can be exposed to a single sector or multiple sectors (Health Care, Commercial, Residential, Retail, etc.). You need to understand what you own when investing in the asset class.


Business Development Companies (BDCs)


A BDC is a publicly traded company that invests in private companies. They were created by Congress in 1980 under amendments to the Investment Company Act of 1940. Business Development Companies provide financing for small to mid-sized firms and service a segment of the capital markets that has been traditionally 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. As a result, BDCs provide a unique opportunity to invest in small to middle market private companies and receive attractive dividend yields (as of 9/30/2019 the average yield for the Wells Fargo BDC Index (WFBDC) was 9.87%) while benefiting from the diversification in the BDC’s investment portfolio. YTD the index is up 22.73%.


Quality Dividend-Paying Stocks


Dividend-paying stocks may have lost some of their luster as income investments with the recent record highs in many indices, but we believe they are still worthwhile candidates for income. The average dividend yield for securities in the S&P 500 is 1.93%, the Dow Jones Industrial Average is 2.30%, and the Russell 3000 average is 1.88%. Diversifying a portfolio with these assets may also help reduce overall portfolio volatility.


Conclusion


We are strong advocates of diversification. While we are fans of bond alternatives in the current environment, we would supplement – not replace – existing fixed income investments. While we might dial down the rheostat, we would not turn it off altogether. Investors should manage their exposure to all asset classes but avoiding traditional bond investments all together is not our recommendation. In our opinion, owning individual bonds remains an important portfolio component for income investors and in many cases is the only true “flight to quality” asset class if ballast to equity market volatility is the expectation. Bonds remain the only asset class with a defined maturity and defined stream of cash flows


We believe asset class diversification and staying invested during volatile periods is the best approach to maximizing total return potential. Even when we witness moves in interest rates and credit spreads, coupon return still makes up the majority of total return and staying invested is likely the best course of action.


 


CRN: 2019-1004-7727R


Common Stock: An investment in common stocks should be made with an understanding of the various risks of owning common stock, including the possible deterioration of either the financial condition of the issuers or the stock market.


Dividend Payment Risk: Dividends are not guaranteed and a company’s future abilities to pay dividends may be limited. Moreover, it should be clear that a company currently paying dividends may cease paying dividends at any time.


Business Development Company Concentration: BDCs generally depend on the ability to access capital markets, raise cash, acquire suitable investment and monitor and administer those investments in order to maintain their status as a BDC. A failure to do so may adversely affect the value of the BDC shares. BDCs often invest in securities that are not publicly traded with adversely impacts their ability to value those assets and reduces the investments’ liquidity. BDCs are closed-end funds which tend to trade at a discount from their net asset value and are subject to risks related to factors such as the manager’s ability to achieve a fund’s objective, market conditions affecting the fund’s investments and use of leverage.


REITs: An investment in Real Estate Investment Trusts (REITs) securities is subject to additional risks, including negative developments in the real estate market, such as vacancy rates and competition, volatile interest rates and economic recession.


Master Limited Partnerships (MLPs): MLPs are generally taxed as partnership whose interest are generally traded on a securities exchange. 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 MLP.


This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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