Opportunities for Income Investors

Whether or not we enter a recession, these ideas may generate enticing yields.

Key Takeaways

  • High yields across a variety of asset classes could offer attractive opportunities for income-oriented investors.
  • Focus on factors such as asset prices and credit quality and stay diversified.
  • Income investments that look appealing in 2024 include medium maturity US Treasury bonds, preferred stocks, short-maturity high-yield bonds, floating-rate bank loans, and energy.
  • In exchange for higher income, some assets may experience more volatility than traditional income investments.
  • Professional investment managers have the research resources and investment expertise necessary to help identify opportunities and manage the risks associated with higher-yielding security types.

For much of 2023, investors, consumers, and central bankers alike have been watching for a recession. Instead, the economy has kept growing and the job market has also remained healthy. So the big question remains: Will a recession arrive with the new year or can the Federal Reserve achieve a "soft landing" by keeping interest rates just high enough to slow inflation without crashing the economy?

But fretting over when the next recession may arrive is not a recipe for successful investing says Adam Kramer who manages Fidelity® Advisor Multi-Asset Income Fund (FAYZX). He says it's much more important to put together a diverse portfolio of income-producing assets that can help give you both downside protection if things go badly and also upside potential if they don't. Kramer points out that regardless of what phase of the business cycle the economy may be in, there are nearly always opportunities to buy mispriced assets that seek to help deliver income for investors and also have the potential to increase in price over time. Kramer says he looks for high-quality assets whose prices have been temporarily pushed down by investors overreacting to uncertainty about factors unrelated to the ability of the assets to deliver yield. As he puts it, "Think about how much the coupon payment is, how much duration risk there is, but also whether an investment has the potential to give you extra capital appreciation if bad news doesn't occur." Given the widespread uncertainty about where interest rates and the economy may be headed, this may be an especially useful approach for income-seeking investors to take in 2024.

Finding opportunities in US Treasury bonds

Kramer believes that opportunities in 2024 could exist in Treasury bonds with medium- to long-term maturities. Since the Federal Reserve began raising interest rates in 2022, rising yields have been accompanied by falling prices for Treasury bonds that were already in the market.

Bonds issued by the US Treasury offer low default risk and liquidity and Kramer believes Treasurys may offer a rare and attractive opportunity for those investors who have the ability to take advantage of it.

But while some see bad news, Kramer sees opportunity in these Treasurys. "These longer-maturity Treasurys are offering a very rare opportunity to 'do more with less,'" he says. "There's a lot of bad news about 'higher for longer,' but these bonds' relatively high coupon payments may offset the risk that higher interest rates could pose to bond prices. That means they should offer downside protection and could potentially generate significant single-digit total returns if the economy takes a downturn and rates move lower." For example, as of December 6, 2023, 7-year Treasurys are offering a 4.6% current yield. If the Federal Reserve cuts interest rates by 100 basis points, an investor would earn a 4.6% coupon plus capital appreciation of 6%. That would mean the potential upside total return would be 10.6% when the Fed makes its first rate cut. If rates were to instead rise by 100 basis points, an investor would lose that 6% in principal, but the 4.6% coupon would limit the decline in the value of the investment to only 1.4%, assuming the investor holds onto it for the entire 12 months. Says Kramer: "If you want the yield, liquidity, and low default risk of Treasurys plus the potential for rising prices when rates fall in the future, this may be a good time to get those things at attractive prices."

Opportunities beyond Treasurys

While Treasurys may present a unique opportunity as 2024 begins, Kramer also says a wide variety of income assets may deliver stock-like returns with less potential volatility than stocks in the year ahead. That's especially a consideration if the economy does in fact slow down. Stocks have historically outperformed both bonds and cash but during recessions, both bonds and cash have performed better than stocks.

Opportunities to do more with less are not secrets, but not all investment managers focus their attention on finding them. "Every manager's looking at stocks and investment-grade bonds," says Kramer. "Not as many are doing the work on other securities, but if we do the research, we can find opportunities."

One opportunity may exist in fixed-to-floating preferred stocks. Despite their name, preferred stocks are actually hybrid securities that in some ways resemble bonds but also represent equity shares in the companies that issue them.

Kramer likes preferred stocks of investment-grade US utility companies, master limited partnerships (MLPs), and big US banks, particularly those whose interest rates are either rising now or are scheduled to do so in 2024. "I think that those may be great ways to earn high, single-digit yields now while you wait for their prices to rise. Right now, you can buy them for less than their face value and their issuers can choose to buy them back from you for face value. If they don't choose to do that, the interest rates that they pay may increase and could earn a higher return that way. If you're looking for income, you'd probably rather collect an 8% or 9% current yield on these fixed-to-floating preferreds than a 3% dividend yield from the stocks of these same companies."

Opportunities in short-maturity, high-yield corporate bonds

Another group of income-producing assets likely to offer attractive returns in 2024 are bonds issued by companies whose credit ratings are just below investment grade.

Kramer says that the short-maturity, high-yield bonds issued by these companies can provide an attractive alternative to owning those companies' stocks, especially in a recession. In past recessions, bond prices have historically risen while stock prices have fallen. Right now, the interest payments—known as coupons—on many high-yield bonds are also higher than they have been in recent years. Those coupon payments, as well as their prices in the marketplace, contribute to the total return of these bonds.

Kramer says the default risk of companies rated just below investment grade has historically been low and he explains, "I feel like you're getting a bigger bang for your buck in high-yield bonds than in stocks of the same companies. If earnings decline, high-yield bond prices are likely to be less volatile than stock prices. High-yield is also attractive because more than 50% of the market is currently rated just below investment grade and presents relatively little credit risk. That's unusual. So even if the economy gets worse, you could still earn close to 10% on high-yield with typically much less volatility than stocks." In a diversified portfolio, those high yields could potentially offset declines in asset prices that often accompany economic slowdowns.

Keep in mind, though, that the bond universe is a far more vast and variegated place than the stock market and not all bonds perform equally well during recessions. Credit quality also varies widely among high-yield bonds, so careful research is important.

Opportunities in loans

Kramer has also found opportunities in floating-rate loans that banks make to companies and then sell to investors.

Floating-rate loans not only offer potential inflation protection, they are also a hedge against rising interest rates. That's because, unlike most bonds, the interest rates on floating-rate loans adjust upward along with rises in key consumer interest rates. That means loans are less likely than most fixed income investments to lose value when inflation and interest rates rise. While past performance is no guarantee of future results, loans historically have performed better than longer-duration fixed income bonds in rising-rate environments. From August 2022 to August 2023, for example, leveraged loans returned 11.22% on a total return basis, compared to investment-grade bonds' —0.23%.

Credit quality is an important consideration for investors in loans and Kramer is focusing on loans to what he believes are high-quality companies. "If you're getting a 9% current yield on a loan to a company such as Uber or Four Seasons Hotels or Bass Pro Shops, it matters less what's going to happen with the short-term market prices of these securities," says Kramer.

Securities issued by master limited partnerships (MLPs) that own and operate oil and natural gas pipelines are another place where one can currently find 8% to 9% yields. "In the past, master limited partnerships were shunned because everybody was down on energy pipelines and production, but we do need oil and gas," says Kramer. "These companies have been reducing their capital spending and acquisitions and their free cashflow yield is expanding as a result. This is a situation where the payout ratios have been dropping into the 50s, which is quite attractive for something that can have around a 9% dividend yield."

Dividend-paying stocks of oil and product tanker companies are yet another income opportunity in the energy industry. "Oil tanker companies pay out a large percentage of their income in the form of dividends, which is why they fit into a multi-asset income strategy," he says. "Having enough oil has become a national security priority and because of geopolitics, tankers have to travel longer routes to move oil around the world. I think the setup for tankers is going to be very constructive over the next 2 or 3 years."

Another dividend income opportunity may come from companies that mine gold. Gold has long been popular with investors who are concerned about the power of inflation to reduce the value of cash and other investments, but owning it also comes with risks. Gold-mining companies may give investors a less risky way to benefit from rising gold demand as they typically distribute a significant portion of their earnings to shareholders in the form of dividends. Like other stocks, dividend-paying value stocks of gold-mining companies have been affected by higher interest rates, but unlike common stocks, Kramer believes that both rates and a potential economic slowdown have already been priced in. Plus, gold miners now offer sustainable dividend payments of 4% to 5% as well as attractive prices.

More dividend-paying opportunities may also exist in consumer staples and large-cap pharmaceutical company stocks. "Many of these companies got very expensive compared to bonds but their valuations have come down as interest rates have risen. Drug stock prices have also been hurt by investors' assumptions about the impact of the GLP-1 weight loss drugs." Kramer says he's starting to look carefully at these dividend payers. "It's now quite possible too much bad news is priced in there. Yields are higher than Treasurys, so they may be another example of "doing more with less."

 
 

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