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Nothing new on interest rates: Federal Reserve officials continue to hold them at unprecedented lows.
The Fed has held the influential federal funds rate near zero since December 2008. Low interest rates have helped elevate stock prices, but they’ve depressed traditional safe income sources.
To capture meaningful income – income that generates a real return after inflation and taxes – investors must venture out on the risk curve. The latest Fed non-event ensures more of the same.
REITs, MLPs, dividend growth stocks, lower-grade bonds and preferred stocks remain the primary income sources for investors. These can be fine income vehicles, but none offer a contractual guarantee of income and return on invested capital. This is an issue for conservative income investors. Regardless how safe a dividend or a distribution is, the market price of that investment will move up and down – and lately more down.
Investor sentiment has turned negative, particularly on high-yield equity income. The question is, why?
Risk perception tops the list. High yield is associated with high risk. Conflating the two isn’t irrational.
Small-cap high-yield oil and gas producers – Breitburn Energy Partners (NASDAQ: BBEP) and Linn Energy (NASDAQ: LINE), for example – have been clobbered this year. These investments sport high yields because a dividend or distribution looms. Share and unit prices are depressed. When income streams are reduced, so are share and unit prices. The yield on the initial investment is no longer so high.
The constant threat of rising interest rates also weighs on share and unit prices. The concern is that rising rates will raise borrowing costs, squeeze margins and reduce cash flows. In turn, dividends and distributions will be threatened.
The logic is sound, but not necessarily applicable.
Yes, rising interest rates would raise borrowing costs. Pass-through entities – business development companies (BDCs), REITs and MLPs – must tap equity and debt markets in order to grow. Rising interest rates would raise the costs associated with tapping financial markets.
But rising rates are a double-edged sword. They’re also indicative of stronger economic growth. So while capital costs might rise, so will the price BDCs, REITs and MLPs can get for their output. Contrary to popular belief, these investments tend to hold their own in a rising-rate environment.
Commercial REITs have generated an average annual return of 11.4% over the six monetary tightening cycles that have occurred since 1979. When U.S. Treasury yields were rising, REITs generated an average annual return of 14.9%. MLPs rose in seven of the 10 periods, with an average annual gain of 4.7%. BDCs do well because they hold a large portfolio of variable-rate loans. When rates rise, these loans generate more income.
Value Opportunities
The share and unit prices of many high-yield investments are depressed, but I see value opportunities. I especially like the opportunities to pick up yield in the high-yield recommendations in the High Yield Wealth portfolio. We have a number of solid BDCs, REITs and MLPs offering double-digit yields that show no inclination to cut payouts.
Government Properties Income Trust (NYSE: GOV) is one of many on offer. Government Properties yields 10.8%. Its dividend is easily covered by funds from operations (FFO).
If risk aversion dissuades you from reaching for higher yield, then double back on quality dividend growth. For example, Microsoft (NASDAQ: MSFT) recently raised its dividend 16%. I first recommended Microsoft two years ago to High Yield Wealth readers. Microsoft shares yield 3.3% today, but the cost-basis yield to High Yield Wealth readers is 4.4% because of dividend growth. It also helps that Microsoft shares are up 33%.
I expect High Yield Wealth recommendations to continue to provide dependable income, regardless of what the Fed does with interest rates. On that front, I don’t see the Fed doing anything with interest rates in 2015 and beyond.
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