Investing for Income
Desperately Seeking Income
In a recent BlackRock survey, yield was identified as one of the top issues facing investors and their financial professionals today.
Investors today are confronted with a perfect storm of variables that is weighing on income generation and dampening overall portfolio returns. The economy is muddling along at a slow pace, faced with structural headwinds and a weak employment picture, fragile credit markets and uncertainty over government policy. And while interest rates and inflation are expected to remain low, taxes are poised to move substantially higher — a particularly unkind combination for investors with an income objective.
For those desperately seeking income, senior investors at BlackRock recommend an approach that focuses on diversifying a portfolio's sources of yield in order to both limit risk and strike a balance between income and growth.
Credit-Sensitive Fixed Income
This current environment is a difficult one for bonds sensitive to movements in interest rates, such as Treasuries, but is a sweet spot for bonds relying on the fundamental credit strength of the underlying issuer, such as corporate debt, mortgage-backed securities and bank loans, to name a few.
According to Peter Fisher, Global Head of Fixed Income at BlackRock, "Quality spread products are worth buying. We find that cash on corporate balance sheets is currently supporting credit quality, although investors must remain watchful of how corporations deploy this capital. The potential for cash to be used for share repurchase programs or dividend increases may erode the relative protection it presently provides bondholders." Still, as investors' quest for yield stokes demand for these assets, the limited supply of (non-Treasury) higher-yielding bonds sets the stage for a strong technical backdrop that should benefit the performance of credit-sensitive fixed income sectors as investors move out the risk spectrum. The case for credit-sensitive assets is further supported by their higher yields, which are attractive relative to Treasuries.
Tax-Exempt Municipal Bonds
More Americans are turning to tax-exempt municipal bonds in preparation for potential tax hikes in the years ahead. Municipal bonds historically trade at pre-tax yields well below those of Treasuries, but offer a higher after-tax yield. For an investor in the 35% tax bracket, for example, a taxable investment would need to pay more than 6% to outpace the return of a tax-exempt bond yielding 4% (on an after-tax basis). As tax rates increase, the benefit of tax exemption would be amplified, allowing investors to keep more of what they earn. Over time, a tax-induced spike in demand for tax-exempt munis, coupled with a dearth of supply, could modestly benefit price performance in the municipal marketplace as well.
Large-Cap, High-Quality Equities
Equities can help to grow the foundation of a portfolio's income stream. "While the economic recovery slogs along, the strength of US corporations has been impressive, providing a strong underpinning for US stocks, particularly those of large-cap, high-quality companies," says Bob Doll, BlackRock Chief Equity Strategist for Fundamental Equities.
The case for equities is compelling when one considers their attractive valuations and yield component. High-quality, large-cap companies are trading at a discount to the market as well as relative to their long-term average, making their stocks an especially appealing value. These same companies have seen a dramatic, broad recovery in revenues, earnings and free cash flow. This may be deployed in shareholder-friendly ways, such as through the payment of dividends, providing a handsome income benefit to investors.
* Archived articles are current as of the original date of publication.