The Search for Yield

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Exploring income-producing investments

 

The slow pace of economic growth in the United States and around the world has led to low interest rates — and in some cases, negative rates — leaving investors searching for yield. With global economic growth expected to remain subdued for the foreseeable future, interest rates seem destined to stay lower for longer, possibly forcing investors to explore substitute income-oriented investments, such as dividend-paying equities. Sector, industry, dividend yield, growth levels, payout ratios and balance sheet strength are among the factors suggesting that not all dividend-paying companies are treated equally.

 

“The thirst for yield is pervasive throughout the investment community — with private and institutional investors alike searching for income-generating investments,” says Terry Sandven, Chief Equity Strategist at U.S. Bank Wealth Management. “The good news is that there are attractive alternatives available for investors — depending on their income needs, time horizons and risk tolerances.”

Navigating a Low-Yield Climate

One notable change in the markets is the unusual bond environment, with historically low bond yields. Investors may want to consider a variety of investments to enhance their income, including looking for higher yields in longer maturity high-quality bonds, or even accepting higher credit risk to increase incomes. Rob Haworth, Senior Investment Strategist at U.S. Bank Wealth Management, believes there is potential opportunity to create a greater level of income by incorporating higher-yield bonds into a diversified portfolio.

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“We are operating in a unique price environment for investment grade bonds,” Haworth says. “The yield you can potentially receive in exchange for taking on extra duration or credit risk, on a relative basis, is worth considering.” Not only can investors counteract the risk of holding stocks with investment grade bonds, but — when adjusted for inflation — these bonds can also yield marginally positive income, and they may be reinvested at higher rates at a later date.


Cautious investors may also consider taking advantage of the higher dividend yields. For these investors, it may be appropriate based on individual investment objectives to add a few stocks to balance out a bond-heavy portfolio or to consider revising asset allocations to help ensure they reflect newer trends in sectors such as technology and healthcare.

 

Additionally, niche investments can provide the possibility for growth opportunity. For instance, for qualified purchasers, private debt investments can have higher income potential. Real estate investment trusts, which trade like stocks and are backed by commercial property, may also be an interesting addition to an investor’s income mix. “This is one area that can offer investors higher incomes while tempering inflationary pressures,” Haworth says. “Once investors clarify which investment options can realistically sustain growth potential in a chosen time frame, the choices available will become more evident.”

 

 

 

 

 

Dividend-Paying Equities


“Dividend-producing stocks can present a compelling alternative for investors looking for income and long-term growth,” says Sandven, “with most S&P 500 companies currently paying dividends.” For example, Sandven notes, in the first quarter of 2016, dividends for S&P 500 companies totaled a new high of $113.9 billion,1 representing unprecedented opportunities at a time when interest rates are expected to stay low for the foreseeable future.

 

In a rare reversal of roles, the S&P 500’s dividend yield of 2.1 percent was significantly higher than the 10-year Treasury yield of 1.7 percent, as of Sept. 30, 2016. Reflecting this change, roughly 60 percent of S&P 500 companies are paying

dividends above the current 10-year Treasury yield. This has enabled investors to assemble portfolios of dividend-paying equities that, if

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selected carefully, can be consistent with their financial objectives.


However, it is important to note that not all dividend-paying companies are equal. “Our preference is to avoid high dividend-yielding companies in favor of companies that offer dividends yielding at or modestly above the S&P 500, with dividend growth rates exceeding that of the broad index,” Sandven says. In other words, he cautions, “Don’t simply go after the highest yields.”


As appealing as companies with high dividend yields might seem, the total returns may not be as strong when interest rates go up — and rates will eventually rise. Companies with high returns on investment capital, substantial growth relative to the overall economy, strong balance sheets and relatively low payout ratios tend to perform favorably in the long run, according to Sandven.

Review Your Yield Curve

 

Understandably, many investors re-entering the market are asking: Is the risk worth it? Dan Heckman, Senior Fixed Income Strategist at U.S. Bank, helps high-net-worth individuals answer that question by identifying both long- and shorter-range tactical approaches to investment allocations. 

 

Some investors want to retire after selling a business and are looking to generate income off a career’s worth of earnings while protecting themselves from the volatility of capital markets. However, those lingering in cash or money market accounts may be missing out on returns available from a modest increase in risk exposure.


Heckman has found better value for some clients by focusing on certain types of bonds, including tax-exempt securities, and pushing them further out on the yield curve. “This enables us to generate some additional income in a very tax-efficient manner,” he says. “Some of our clients have discovered they can generate more retirement income simply by opting for maturities of longer duration. That way, the portfolio can provide a more consistent and steady stream of income while at the same time creating the possibility of capital appreciation as the bonds roll down the yield curve, creating capital gains.”

 

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Manage Your Risks


“We’re all paying attention to new strategies for generating yield,” Haworth says. “An investment advisor can help develop the appropriate portfolio strategies and timing to provide the opportunity for favorable outcomes.”

 

Many investors are seeking a more analytical approach to risk management than in years past.  Individuals pursuing short-term cash flow, in particular, should be mindful of future rate increases and other variables not yet priced into the market. For the foreseeable future, investors may have to spend more time to help ensure they’re protecting their assets from exposure, and that might mean considering some of the aforementioned strategies and growth-oriented products for their portfolio.

 

The same basic rules still apply. Everyone has a comfort zone — whether it’s sticking to corporate bonds of trusted companies, municipal bonds backed by local tax obligations or dividend-paying stocks. No matter the size of that comfort zone, working with someone who can help navigate complex formulas for making investment selections might add value.

 

1 FactSet Research Systems

 

including the possibility of default, limited liquidity and the Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. Investments in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issues of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is free from federal taxes, but may be subject to the federal alternative minimum tax (AMT), state and local taxes. Private debt investments may be either direct or indirect and are subject to significant risks, and other factors. Investments in fixed income securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. including the possibility of default,

limited liquidity and the infrequent availability of independent credit ratings for private companies. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties (such as rental defaults).

 

[SIDEBAR] Strategizing Your Dividend Portfolio

 

The process for selecting dividend-paying companies should start with establishing guiding objectives. To make informed decisions, investors should consider several factors. A company’s sector, growth levels, payout ratios and balance sheet all determine the strength and endurance of a given equity.

 

The following criteria may serve as a useful cross-reference:

 

1. Company History: Companies with comparatively modest payout ratios, consistent free cash flow and a history of paying dividends. 



2. Dividend Growth: Companies growing revenue more consistently than their peers, operating in faster-growing segments of the market and delivering cash returns on invested capital above their cost of capital.

 

“This affords investors with
both income and appreciation potential, fueled by the underlying rate of growth of industries and companies while being less susceptible to dividend reductions due to high payout ratios and bondlike moves following Federal Reserve (Fed) rate decisions,” says Terry Sandven, Chief Equity Strategist at U.S. Bank Wealth Management. 


 

3. Thematic Appeal: Companies in growing sectors — such as cloud computing, e-commerce, mobile connectivity and services for aging populations — are better positioned for income and appreciation potential. 


 

4. Macroeconomic Outlook: 
High dividend-paying equities
tend to perform well during times of uncertainty and less strongly in periods of expansion when interest rates are rising. 


A conservative investor with limited exposure in dividend-paying equities might find comfort in a diversified basket of stocks across most sectors.

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