As the U.S. Federal Reserve moves toward ending its extremely accommodative policies, advisors must help their dividend- and income-focused clients navigate a low-yield environment while also protecting their portfolios against rising rates -- and capitalizing on returns when yields do start moving.
While bond prices will drop when interest rates rise, the increase in income can help offset falling prices. And yield-hungry investors should be able to mitigate losses and take advantage of opportunities through a well-diversified and broad range of income-producing and high-quality dividend-paying instruments.
Much will depend on how fast the Fed raises rates, and by how much. A sharp rise in rates over a short time can have an adverse effect on returns, while incremental increases over a longer period can be less detrimental. As the Fed is currently basing its interest rate considerations on an improving economy and not on imminent inflationary concerns, many analysts believe hikes will be slow and steady.
It’s important to note that not all asset classes respond the same to interest rate increases. While longer-dated corporates may get bounced around during the initial phase, high-yield and municipal bonds may benefit from the improving economy and a subsequent decline in default rates.
And floating-rate securities, with their monthly or quarterly reset rates, generate income that stays in step with interest rate changes. While changes in interest rates can and do influence dividend-paying equities, tax, economic and global market factors all interact to effect total return.
Because of the many variables that impact returns in a rising-rate environment, the ages-old planning wisdom of owning a well-diversified portfolio remains the best plan of action.
A historical view can help us understand how different asset classes have responded to interest rate increases. For the three periods shown in the following table, the Fed hiked rates between 6 and 17 times, with the Fed funds rate climbing between 175 basis points (bps) and 425 bps during a 10- to 24-month period. Obviously, the economic variables were disparate, but we can see there were different return patterns for a number of dividend- or interest-paying mutual fund classifications.
So the mere fact that a particular classification contains income-producing funds does not foretell economic loss because of interest rate increases. Many of the recent declines for dividend- and income-producing mutual funds can be directly attributed to global market influences, most recently the Chinese market meltdown.
That said, we have seen year-to-date net redemptions from five of the classifications shown above, with equity income funds suffering the largest, handing back some $19.1 billion year to date through September 30. Meanwhile, the investment-grade debt-focused core bond funds classification remains a primary attractor of investor assets, taking in $39.4 billion year to date.
Until recently, dividend-paying stocks had been quite attractive to investors hunting for yield. While dividend-paying equities on average had relatively competitive yields, they also benefited from the bull market run. In addition, most dividend-paying stocks benefited from a preferential tax treatment that allowed distributions to be qualifying dividend income, subject to a 15% tax rate versus the higher marginal tax rate applied to bond interest income distributions. (This last point does not apply to real estate investment trusts, MLPs and foreign equities.)
However, investors have turned away from dividend-paying equities, perhaps because of their recent run-up in popularity, and thus price. There may also be a fear that yield-seeking investors will find stronger-paying alternatives as interest rates start rising, nudging dividend stocks to the cellar.
Some of the fears appear to be playing out in the current market, with growth-oriented funds (+0.90%) outpacing their core- (-1.86%) and value-oriented (-3.41%) fund cohorts for the year-to-date period ended October 15, 2015.
Three of Lipper’s four dividend-focused equity classifications — equity income funds (-3.05%), utility funds (-5.14%), and energy MLP funds (-20.16%) — have all witnessed negative performance year to date. Keep in mind, though, that the average equity mutual fund is also in negative territory, down 1.87% year to date.
As a result of the recent increase in equity volatility, many practitioners are encouraging their clients to use high-quality and well-diversified dividend payers during these tumultuous times, and to avoid high-yielding and concentrated-sector plays.
Rising interest rates will pressure bond prices, but there are a few strategies investors can use in combination to navigate the winding road ahead, including shortening the duration of bond funds by using ultra-short obligation funds (with maturities from three months to one year) or short-term bond funds (with maturities between one and three years).
Fixed-income funds with shorter maturities are less sensitive to interest rate hikes compared to their intermediate- to long-term brethren, and are able to reinvest dividend income and proceeds of maturing bonds at higher rates.
Since rising interest rates often correspond to an improving economy, high-yield funds are generally less sensitive to rate increases because of improved corporate profitability and a decline in default rates. Of course, risk-averse behavior that impacts equities could impact the returns of high-yield funds as well.
As mentioned earlier, the floating rate-focused loan participation funds classification is positioned to mitigate interest rate risk. While floating rate debt can include corporate bonds, asset-backed securities, adjustable-rate mortgages and senior bank loans, fund investors are generally dependent upon loan participation funds to meet their floating-rate investment needs.
Loan participation funds’ interest rates are pegged to a short-term rate (such as LIBOR) and reset every 30 to 90 days by some predetermined spread. Caveat emptor, bank loans — a staple of loan participation funds — are often rated below investment grade in quality and carry a higher credit risk than investment-grade floating-rate bonds.
That, however, is why their income potential is often competitive with longer-dated fixed-income products while they still mitigate interest rate risk. Of the fixed-income strategies discussed thus far, loan participation funds (+0.87%) have provided the strongest year-to-date performance figure, while ultra-short obligation funds and short investment-grade debt funds have returned 0.22% and 0.71%, respectively, and high-yield funds have lost 0.71% .
Two other fixed-income classifications are worth considering in a rising-interest-rate environment. The flexible income funds classification is the “go-anywhere” poster child of the taxable bond fund universe. These funds focus on income generation by investing at least 85% of their assets in debt issues and preferred and convertible debt securities. There are no stated maturity or quality issues; those are left to the manager to take advantage of the various market tilts that are encountered. Flexible income funds have returned 1.55% so far this year.
Multi-sector income funds are another alternative if you’re looking for a well-diversified, actively managed portfolio that provides exposure to high-yielding sectors and select non-U.S. securities, with a goal of finding the best opportunities in the current environment. However, often a significant portion of the assets are in securities rated below investment grade. Year to date, multi-sector income funds have declined 0.19%.
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