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Investing styles cycle in and out of favor: One year growth is in favor, another year value is the cat’s meow.
High-yield investing has been out of favor for at least the past 18 months. High yield has been perceived as a sign of weakness. Once an investment sells off to lift the yield into double digits, an accelerator effect frequently occurs and selling intensifies.
Perception is the problem. High-yield investing has received a bad rap because of the carnage in energy. The oil and natural gas exploration master limited partnerships (MLPs), in particular, have been decimated. Cascading streams of distribution income have given way to desiccated trickles.
But high-yield investments aren’t homogenous, even within the energy sector. (You can read more about the differences here.) Some high-yield energy investments are worth the risk. It’s worth discriminating, because you can find solid double-digit yield.
Because I discriminate, I continue to recommend MLP pipeline giant Energy Pipeline Partners (NYSE: ETP) and its 15% yield. I’m no longer alone on this island. David Tepper, president of Appaloosa Capital, picked up five million ETP units last quarter.
Other high-yield sectors have also been pushed to the sidelines.
Anticipation of higher interest rates – ongoing since early last year – has weighed on investments perceived as interest-rate sensitive. I refer to real estate investment trusts (REITs) and business development companies (BDCs). Both sectors are awash with companies offering double-digit yields.
The perception is that when the Federal Reserve raises the federal funds rate – a key interest rate – capital costs will rise and margins will be squeezed. Higher expenses extracted from a static revenue source puts the dividend at risk, so we’re told.
Perception fails to jibe with reality, though. A research report from one well-regarded investment boutique found that REITs historically outperformed stocks and bonds during periods of rising interest rates.
This isn’t difficult to understand. REITs own properties that have tenants that generate cash flow. When the economy performs, demand for these properties rise. REITs are able to raise their rents and generate more revenue from their properties. This means that even if the cost to borrow rises, increased expense can be offset by higher rents.
Contrary to popular folklore, rising interest rates aren’t the death knell of REIT dividends. But guess what? Even if they were, interest rates remain muted. Short-term rates have moved higher. Yields on short-term U.S. Treasury securities – less than a year maturity – have risen roughly 10 basis points. On the longer end of the curve, rates are actually down.
As for BDCs, interest rates are working to their advantage. Short-term rates are up; long-term rates are down. Most BDCs lend with floating rates, which are based on short-term rates. When short-term rates rise, BDC loans can be reset at a higher rate.
Concurrently, BDCs borrow long term. Falling long-term rates lower borrowing costs. Again, we see a favorable paradigm forming: interest income rises, interest expense falls, the potential for more dividends rise. Today, perception continues to muck up the gears. Like REITs, BDCs have sold off on the perception that rising rates threaten the dividend. The opposite is true.
For the past year, the bias has been against high-yield investing. I expect the bias to change in 2016. In fact, it’s already starting to change. As more quality high-yield investments prove they can maintain their distributions and dividends, investors’ risk perceptions will change. More investors will embrace high yield.
Of course, not every double-digit yield is investment grade. Because I discriminate, I can offer quality double-digit-yield investments in the High Yield Wealth portfolio. But they’re going fast. Yields are starting to shrink because unit and share prices are starting to rise. High-yield investing is cycling back to favor. I believe it will continue to cycle back through 2016.