OCEAN CITY — The low-yield environment we’ve been in for the past five years has forced investors to rethink their approach to investment income. We think bond yields will likely remain range-bound in the near term, as global disinflationary forces weigh on interest rates.
We advocate a diversified approach to generating income to cope with low rates and rising risks. While equities are not a direct substitute for bonds, as they typically come with more volatility and risk, they can be used to supplement portfolios with an income focus.
The composition of a portfolio should be primarily determined by an investor’s goals, and be aligned with their time horizon and risk tolerance. When that time horizon is short and risk tolerance low, income-seeking investors need to be content with the low yields in investment-grade fixed income. If they need greater cash flows in the near term, they will have to stretch into higher yielding equity segments. However, these higher yields come with higher risk — in particular the risk of interest rates moving up. The good news is that some of these sectors have pulled back since the beginning of the year, offering select opportunities for investors willing to weather upcoming volatility.
Utilities stocks, as an example, have fallen 7% since January, and valuations have declined as a result. The sector currently yields roughly 3.7%, and is trading at a trailing price-to-earnings ratio of roughly 16, above its historical average but near the lows of the past couple of years. According to the BofA Merrill Lynch (BofAML) Global Research Utilities team, regulated growth names (water utilities, for example) appear best positioned within the sector for a rising rate environment.
Telecom stocks have performed in line with the broader index this year, but valuations have come down given relatively strong earnings growth. The sector yields slightly over 5% currently, and offers some of the cheapest valuations among high-yielding equities.
Real Estate Investment Trusts (REITs) are another segment of the market to pull back since the beginning of the year. With a dividend yield of 3.4% (as measured by the S&P 500 REITs subsector), REITs can offer exposure to the improving U.S. housing market. In particular, multifamily REITs should profit from the growth in demand from millennials, who continue to exhibit a desire to move to urban areas and a preference for apartment housing. At the other end of the spectrum, senior housing and healthcare REITs should continue to benefit from increasing longevity and the aging of the baby boomer generation.
Energy Master Limited Partnerships (MLPs) have been a favored asset class for investors looking for high yields and exposure to the U.S. shale boom; however, they have sold off more than 20% in 2015, as the rapid decline in oil prices has painted the Energy sector with a broad brush. While not appropriate for all investors, MLPs are currently yielding more than 7% (as measured by the Alerian MLP Index), and can offer certain tax advantages.
Dividend growth stocks offer the advantage of expected increases in dividends, and have outperformed the broader market over time. Therefore, for investors with longer time horizons, future dividend growth can offset higher current yields
(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)