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Financial Industry Insights from Advisors Asset Management
On April 01, 2022
Alternative Sources of Income, Review & Outlook
Investment Review Following strong gains for stocks and generally modest gains for credit-sensitive fixed income securities in 2021, these types of assets struggled in the first two months of 2022. Stocks and credit securities were hit early by concerns around rising interest rates, and later in the period by the Russian invasion of Ukraine. The geopolitical tension added pressure and sent volatility sharply higher. The invasion, and subsequent economic sanctions leveled against Russia by the West, sent oil prices and other commodities such as wheat and aluminum sharply higher. The move in commodities increased concerns that global growth will slow and inflation will rise more than previously expected.
The Russell 1000 Dividend Growth Index declined 4.5% for the year-to-date period through February, with income-oriented stocks participating in the downturn but holding up significantly better than the broader stock market in an uncertain environment. Most sectors had declines, but value-type stocks generally outperformed growth stocks in a reversal of 2021 performance. Technology companies were a negative standout after strong returns in 2021. Energy stocks were a positive exception, continuing to benefit from high and rising prices for oil and natural gas. Financial and consumer staples stocks had relative outperformance.
Master limited partnerships (MLPs) had a total return of 16.4% as measured by the Alerian MLP Index, amid sharply higher commodity prices. Pressure ramped up on already tight global crude oil markets with the onset of the Russia-Ukraine conflict, with crude prices rising above $100 per barrel by the end of February. Most sectors in the index had double-digit gains, led by liquified natural gas (LNG) exports. The sector, which has been benefiting from the significant pricing differential between U.S. and global LNG markets, surged, as already tenuous global LNG supply was threatened. Gathering & processing companies, which tend to be highly sensitive to moves in commodity prices, also outperformed.
Real estate investment trusts (REITs) had a total return of -11.2%, as measured by the FTSE Nareit All Equity REIT Index. While REITs were hindered by macro factors, their earnings remained healthy, with the majority of companies beating fourth-quarter expectations. In terms of sector performance, hotels was the only group with a gain in the period, favored for having short leases in an inflationary environment. Offices, which underperformed in 2021, had only a small decline amid optimism about returning to work trends. Regional malls underperformed following strong outperformance in 2021.
Preferred securities returned –6.1%, as measured by the ICE BofA Core Fixed Rate Preferred Index. Investors generally favored higher-quality, shorter-duration paper in the period, causing preferreds to underperform U.S. Treasuries and all but the longest-dated corporate bonds. High-yield debt also outperformed, as bonds in the category overall have a shorter duration. The high-yield market may have also been helped by exposure to energy companies, which were cushioned by significant increases in oil and natural gas prices in the period.
Closed-end funds declined 7.2%, based on the S-Network All Taxable ex-Foreign Plus Capped Muni CEF Index. Pressure across capital markets sent net asset values (NAVs) and market prices lower for most equity and fixed-income closed-end funds. Taxable fixed-income funds led decliners, posting losses on a NAV basis and larger declines in market price. After trading at a premium for much of 2021, taxable fixed income funds saw their discount to NAV widen to 3.2% in the period from a 0.8% premium at the start of the period. That compares with their long-term average discount of 3.3%. National municipal funds saw their average discount widen to 4.7% from 0.3% at the start of January, compared with a long-term average discount of 3.9%. The average discount for equity funds widened to 2.5% from 1.6% compared with their long-term average of 5.3%. Among equity fund sectors, diversified commodity, single commodity and MLP funds were the only ones that rose amid a broad decline in stocks.
Investment Outlook Dividend-paying equities: Equity markets are likely to face continued challenges in 2022. The Russian invasion of Ukraine has raised the chances that economic growth will slow while inflation rises, a combination that warrants caution and a defensive posture. Given the geopolitical tension and uncertainty, the energy and materials sectors should be considered defensive. We think that consumer discretionary and financial sectors may be under pressure for the near term. The information technology sector, which has seen a steep correction in relative valuations, may be in a better position, particularly since corporate spending on technology is more resilient than consumer spending.
Master Limited Partnerships: While the energy sector broadly (and midstream in particular) has rebounded, investor interest in midstream equity securities still appears to be in the early innings. The sector, which we view as an attractive play on strengthening commodities, offers several advantages, in our view. In an environment of rising inflation, many midstream companies have some combination of pricing power, high margins and predominantly fixed costs. At the same time, many midstream companies have cleaned up their balance sheets, borrowing at lower rates and pushing out debt maturities. Following a period of retrenchment, midstream companies have begun increasing their cash returns to shareholders via dividends, special distributions and/or stock buyback announcements. In our view, return of cash to shareholders should be a driving force for midstream total returns in the coming years.
Real Estate Investment Trusts: In an economy with healthy demand, the persistence of supply chain issues and, more recently, spiking oil prices have contributed to greater inflation, increasing the likelihood that the Fed will raise interest rates. We believe REITs are well positioned to tolerate an increase in rates due to their ability to offset higher financing costs with rent increases. Construction starts in many sectors have been delayed by labor shortages and higher costs for building materials, reducing supply pressures. This dynamic is allowing landlords to raise rents, leading to above-average cash flow growth. Meanwhile, REITs continue to offer attractive levels of income relative to traditional asset classes.
Preferred securities: We believe preferreds continue to offer value, particularly relative to higher-duration, high-quality fixed income investments. Preferreds’ subordination spreads (credit spread compensation relative to senior debt) have widened and provide additional compensation for the increased risks related to geopolitical factors and inflation, in our view. We believe preferreds have the potential to outperform corporate bonds, with higher income, a narrowing of subordination spreads, and potentially lower duration risk relative to rising Treasury yields driving relative price performance.
Closed-end funds: While the Fed remains on track to raise interest rates, expectations of aggressive tightening have cooled given the risk of slower growth due to the Russia-Ukraine conflict. That said, volatility is likely to remain elevated, and investors will keep a close eye on inflation and economic growth, as both more persistent inflation and slow economic growth will filter down to closed-end funds. We expect that as the Fed tightens, discounts will expand and move to or through their long-term averages in many funds and sectors—retreating from the historically full valuation levels reached in 2021. We will continue to seek opportunities created by any market volatility in reaction to developments related to the war and evolving macro conditions.
CRN: 2022-0401-9906 R
Opinions in this piece are those of Cohen & Steers and are not necessarily that of Advisors Asset Management (AAM).
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.
Data quoted represents past performance, which is no guarantee of future results.
The views and opinions in the preceding commentary are as of the date of publication and are subject to change. There is no guarantee that any market forecast set forth in this presentation will be realized. The preceding commentary does not reflect the performance of any fund or account managed or serviced by Cohen & Steers and there is no guarantee that investors will experience the type of performance reflected in this commentary. This material should not be relied upon as investment advice, does not constitute a recommendation to buy or sell a security or other investment and is not intended to predict or depict performance of any investment. This material represents an assessment of the market environment at a specific point in time, should not be relied upon as investment advice, is not intended to predict or depict performance of any investment and does not constitute a recommendation or an offer for a particular security. We consider the information in this presentation to be accurate, but we do not represent that it is complete or should be relied upon as the sole source of suitability for investment.
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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. 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. Foreign securities involve special risks, including currency fluctuations, lower liquidity, political and economic uncertainties, and differences in accounting standards. Some international securities may represent small- and medium-sized companies, which may be more susceptible to price volatility and less liquidity than larger companies.
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.
Risks of Investing in Closed-End Funds. Shares of many closed-end funds frequently trade at a discount from their net asset value. The funds are subject to stock market risk, which is the risk that stock prices overall will decline over short or long periods, adversely affecting the value of an investment in a fund.
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 Cohen & Steers. 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.
Contingent capital securities (sometimes referred to as "CoCos") are debt or preferred securities with loss absorption characteristics built into the terms of the security, for example a mandatory conversion into common stock of the issuer under certain circumstances, such as the issuer's capital ratio falling below a certain level. Since the common stock of the issuer may not pay a dividend, investors in these instruments could experience a reduced income rate, potentially to zero, and conversion would deepen the subordination of the investor, hence worsening the investor's standing in a bankruptcy. Some CoCos provide for a reduction in the value or principal amount of the security under such circumstances. In addition, most CoCos are considered to be high yield or "junk" securities and are therefore subject to the risks of investing in below investment-grade securities.
Index Definitions
An investor cannot invest directly in an index and index performance does not reflect the deduction of any fees, expenses or taxes.
The Russell 1000 Dividend Growth Index is screened for liquidity and dividend status, and represents the performance of companies that have successfully increased their dividend payments over a period of ten years.
The FTSE Nareit All Equity REIT Index contains all tax-qualified REITs with more than 50% of total assets in qualifying real estate assets other than mortgages secured by real property that also meet minimum size and liquidity criteria.
The Alerian MLP Index is a float-adjusted, market-capitalization-weighted index that consists of the 50 most prominent large- and mid-cap energy master limited partnerships.
The ICE BofAML Core Fixed Rate Preferred Securities Index tracks the performance of fixed rate U.S. dollar denominated preferred securities issued in the U.S. domestic market.
The S-Network All Taxable ex-Foreign Plus Capped Muni CEF Index is a market capitalization-weighted index comprising all taxable closed-end funds and diversified municipal bond funds, except for single-country funds and region-specific equity funds.
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