The Federal Reserve's plan to keep interest rates near zero for at least the next two years is forcing financial advisers to consider new — and more risky — ways to generate income for their clients.
The Fed's announcement last month means that such low-risk savings vehicles as Treasuries, certificates of deposit and money market accounts can't even be counted on to keep pace with inflation.
Indeed, while the consumer price index rose 3% last year, the 10-year Treasury currently yields less than 2%, five-year CDs return around 1%, and money market funds' minuscule yields practically require the Hubble Telescope to identify.
“It's a terrible dilemma for seniors and folks that are used to some sort of stream of reliable income,” said Rob Siegmann, chief operating officer and senior adviser at Financial Management Group Inc.
“There's no riskless income that's reasonable at this point,” said Jay Wong, co-portfolio manager of the Payden Value Leaders Fund (PYVAX).
For many advisers, the way out of the low-return box involves turning to high-dividend-paying stocks, master limited partnerships, emerging-markets debt and high-yield bonds.
Here is a breakdown of what advisers need to know about each:
High-dividend-paying stocks
Current yield: 3.5%- 5%
High-quality dividend-paying stocks have been the favorite of advisers and in-vestors for more than a year now. Equity income mutual funds took in $30.88 billion last year, the second-most of any fund category, according to Lipper Inc.
It isn't hard to see why.
The S&P 500's yield is greater than that of the 10-year Treasury for just the second time since 1947. That, combined with interest rates that eventually will rise (pummeling bond prices in the process) and a slow growth economy, makes stocks that pay dividends very appealing.
“It's a good place to be considering all the risks in the global economy,” said Michael Joyce, president of JoycePayne Partners PC.
He focuses on companies with a history of raising dividends and having enough cash on hand to continue paying them, regardless of market “hiccups.”
The popularity of high-dividend-paying stocks, however, is leading some pros to pay closer attention to valuations.
“We're not saying they're overvalued now, but it's a discussion we're having regularly,” said Michael Fredericks, head of U.S. retail-asset allocation for BlackRock Inc. and lead portfolio manager of the BlackRock Multi-Asset Income Fund (BAICX).
Mr. Joyce is being cautious, too. Instead of actively adding to his high-dividend-paying equity positions when new clients or cash comes in, he is setting up limit orders to take advantage of any market dips.
Master limited partnerships
Current yield: 4.8%-5.9%
Oil and natural gas pipeline companies constitute the core of master-limited-partnership investments. Energy producers pay these firms to transport, and sometimes store, their commodities, essentially making the MLPs high-cash-flow-generating toll collectors.
“It's a pretty simple business, and demand for transporting goods and services have been strong,” Mr. Wong said.
Because of their legal status of MLPs, their income is taxed only at the partner level. Also, federal law mandates that MLPs pay out a significant portion of their income, which is why yields are relatively high.
That said, the complicated tax status of MLPs is one of the pitfalls for investors who own individual master-limited-partnership interests, said Jason Ware, a senior research analyst at Albion Financial Group.
“Many investors prefer simply to not deal with these complicated K-1 and 1099 tax forms,” he said.
Investing in MLPs through a mutual fund or an exchange-traded fund eliminates the extra paperwork, but it also eliminates the tax benefit, which eats into gains.
Yield chasing is more of a concern in MLPs than it is in other high-dividend-paying stocks, Mr. Wong said.
If rates rise and dividend-paying stocks go out of favor, MLPs could the first to be left behind, he said.
It is also possible, though not very likely, that tax reform could change the way MLPs are structured.
Emerging-markets debt
Current yield: 5%-6%
Fast-growing emerging markets have been a favorite of investors. But unlike emerging-markets equity, the sovereign and corporate debt of emerging-markets countries and companies has drawn attention only recently.
In fact, about half the $46 billion that has flowed into emerging-markets-bond funds has come only in the past two years. And the category is still far smaller than the $180 billion in emerging-markets-equity funds, according to Morningstar Inc.
It is no coincidence that the bond fund inflows came as interest rates fell and the emerging-markets-bond yields started looking more attractive, especially in light of their stronger balance sheets vis-à-vis developed countries.
“Most people think of emerging-markets debt as a high-yield asset class, but it's actually investment-grade,” said Luz Padilla, portfolio manager of the DoubleLine Emerging Markets Fixed-Income Fund (DBLEX).
Mutual fund investors have a choice when investing in emerging-markets debt: dollar-denominated or local-currency-denominated.
Dollar-denominated emerging-markets debt has been available for more than a decade, but the local-currency market didn't emerge until 2005. A number of local-currency-focused emerging-markets-debt funds have been launched recently.
Denominating an emerging- markets bond in the local currency gives it an extra return boost if the dollar is falling. But it cuts into returns if the dollar is rising, as it has been this year.
Ms. Padilla, whose fund can invest in both dollar- and local-currency-denominated debt, sees more value in dollar-denominated debt now.
“At around 6% yields, you're not getting paid for the extra risk of the local currency,” she said.
Dollar-denominated emerging-markets debt has almost identical yields at 5.9%.
Rett Dean, a principal at River Chase Financial Planning LLC, looks for funds that are focused on emerging-markets debt with high credit quality and consistent yields.
Mr. Dean reminds advisers to keep a closer eye on emerging- markets debt than on other holdings.
“News moves a lot faster and is a little bit harder to come by out of the emerging markets,” he said.
High-yield bonds
Current yield: 7%-8%
High-yield-bond funds took in $14 billion last year, but the road was bumpy.
In June, the category had record single-month net outflows of $6 billion. Then, in October, a record $9 billion flowed in, according to Morningstar.
“The market started out really strong in 2011 and then kind of fell off a cliff,” said George Strickland, co-portfolio manager of the Thornburg Strategic Income Fund (TSIAX).
Sentiment about default is the main driver of high-yield-bond-fund performance, said Doug Forsyth, portfolio manager of the Allianz AGIC High Yield Bond Fund (AYBAX).
Midyear, junk bond investors were spooked by Europe's troubles and the downgrade by Standard & Poor's of the U.S. credit rating, he said. High yield did bounce back toward the end of the year and finished with a return of more than 2%.
A growing economy (even this slow-growth one) and companies that have taken advantage of low interest rates to refinance junk debt at bargain prices have combined to lower expectations for defaults, Mr. Forsyth said.
That should lead to better performance this year, even if Europe starts to get into trouble again.
A European recession is already priced into the market, Mr. Forsyth said.
It isn't all clear skies for high yield, though, Mr. Strickland said.
“We feel good about the high-yield market, but there are some clouds out there,” he said.
Although corporate earnings have been coming in strong, if you look at some of the underlying numbers lately, it is a little weaker than expected, Strickland said.
Mr. Siegmann is staying away from high-yield-bond funds because he is worried about the effect of another crisis.
“They behave too much like equities; in 2008, they fell anywhere from 30% to 50%,” he said.
To get a sense of where high-yield-bond funds are heading next, Mr. Strickland suggests that advisers follow the flows.
“There's almost perfect correlation between outflows and negative returns,” he said.
jkephart@investmentnews.com
