OCEAN CITY — In a yield-starved world, finding reliable sources of income is proving increasingly challenging. In the past, high-quality bonds have been the preferred place to look. However, in today’s zero interest rate environment, clipping coupons from fixed income securities is proving insufficient for most investors. We have been forced to expand our horizons in seeking yield, and we find that several areas within the global markets offer opportunities – but with added risks.
In our last Monthly Letter, “Low for Longer,” we highlighted ways to diversify income strategies, some through equities. With many international markets looking increasingly attractive, we now expand the hunt for yield overseas.
In recent years, the hunt for yield has pushed income-seeking investors into previously uncharted territories. This “portfolio effect” of assets moving into riskier investments in search of yield will likely only accelerate given the growing amount of bonds with zero or negative yields. Within U.S. equity markets, the sectors that traditionally have provided higher dividend yields are Utilities, Telecom, Tobacco and Real Estate Investment Trusts (REITs). They have benefited from this trend over the past year, far
outpacing the broader market. Investors have flocked to these sectors, ignoring the fact that many of the stocks may be overvalued. However, given the lack of alternatives, they may continue to be supported by further inflows.
More recently, Master Limited Partnerships (MLPs) have provided another income alternative. Many have attractive yields and can offer added tax advantages, while providing investors with exposure to the boom in U.S. energy. However, MLPs have been hit by the decline in oil prices over the past six months. BofAML Global Research believes overall production growth should continue in 2015 even with oil prices at current levels, and many MLPs have secured revenues by locking in projects over the next two years. Investors should be selective, and evaluate investments on a case-by-case basis as a long-term downturn in commodity prices can create the risk of distribution cuts in this space.
As the field of attractive income opportunities in the U.S. has narrowed, we think investors should shift their gaze overseas. In Europe, equity dividend yields are much higher on average than in the U.S., and valuation measures (like price to book value) are generally lower.
The region’s economic outlook hinges on whether the actions of the ECB can overcome significant political and demographic challenges. As growth remains feeble, it is important to select high-quality, larger cap companies that have stronger balance
sheets and global exposure. Our strategists at BofAML Global Research believe the speed of portfolio rebalancing into higher-quality European equities with yield will pick up given the dearth of fixed income opportunities there.
For some investors, additional approaches can supplement income, such as covered call writing and other option overlay strategies that can also reduce the volatility of equity portfolios. While the increased market turbulence we have experienced in the past several months is generally unfavorable for investors, higher volatility increases option premiums, generating more income from such strategies. However, these approaches can limit upside potential and may not be suitable for everyone.
(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)