Investing for income—without getting burned - J.P. Morgan Asset Management

Investing for income—without getting burned

Contributors Michael Schoenhaut, Joshua Hemmert
Income investors should focus on diversification and downside protection, not just yield say

Humans are predisposed to reach for the bright and shiny-the most decadent dessert, the snazziest sports car. When investing for income, the impulse-reaching for yield-often ends in disappointment.

Don’t be dazzled by the highest yields…

If an investor looked solely at year-end prevailing yields in 2014, he may have allocated more toward areas such as lower-quality high yield and master limited partnerships (MLPs) at the beginning of 2015. However, these shining yield stars, along with many of the traditional income-oriented U.S. equity sectors, were among the worst performers in 2015 as oil prices moved lower and distress spread among energy and commodity companies. Lower-quality high yield securities and MLPs have seen this trend continue and are down a further 4% and 16%, respectively as of January 27, 2016. Moderate- but still attractive-yielding asset classes and sectors provided a better experience in a challenging year (Exhibit 1).

MLPs are a perfect example of what can go wrong when reaching for income. Beneath its sometimes shiny exterior, the MLP universe is concentrated with oil and gas companies that often have sizeable debt loads. During periods of energy market weakness, the typical practice of increasing capital spending and shareholder payouts is often no longer possible. The result can severely affect returns—many investors are not aware that the 2008 return for the Alerian MLP Index matched the S&P 500 at -37%! MLP proponents often say that the asset class should not be impacted by oil price fluctuations because most companies focus on transporting energy rather than exploration and production activities. But, since 1996, the return correlation between the Alerian MLP Index and WTI crude oil has been 0.3 and has tended to escalate when energy prices fall; the 2015 correlation between these two increased nearly 50%.

…nor discouraged by the doomsayers

We have seen that risk assets do not like lower oil prices during the period of decline. That is largely because the losses associated with lower oil – impaired creditworthiness for energy-related high-yield debt issuers and lower earnings for listed oil companies – are concentrated, and come through quickly and obviously, while the benefits – a higher trend in consumer spending – come through slowly. We regard the further drop in oil as a medium-term net plus for the economy, but the market is struggling to balance the positive and negative effects.

The most-referenced storylines that have weighed recently on markets – the decline in oil prices, fears about China or the Federal Reserve starting to hike interest rates – have not changed our underlying views about economies. Our base case is that the gradual healing of developed economies will more than offset weakness across emerging markets, leading to a steady maturing of the mid-cycle phase in which the U.S. economy currently sits.

Investment implications

In our view, generating consistent income requires investors to continually balance yield and capital appreciation potential with expected volatility when allocating among various income-producing asset classes. In the current environment, we favor dividend-paying equities from developed markets and a measured exposure to high yield. Within equities, we would tilt toward Europe with a broadly-diversified sector allocation rather than one focused solely on the highest-yielding sectors such as energy and utilities. We believe high yield is pricing in a far worse outcome for the U.S. economy than our outlook suggests. Absent a recession, which is not part of our base case, we see decent fundamentals and above-average yields of around 8% in the ex-energy/mining high yield market—a rarity in non-recessionary periods. Given that defaults are expected to increase in 2016, we believe an underweight in energy and a tilt higher in credit quality relative to the index are appropriate to actively manage high yield risk.

Traditional sources of income will be hard to come by, even as the Federal Reserve continues to hike interest rates in the coming years. But investors need not be dazzled nor discouraged. Rather, they will be well-served by a dynamic pursuit of yield, a focus on downside protection and a diversified, global multi-asset class opportunity set.

There is no guarantee that companies will declare, continue to pay or increase dividends.

Diversification does not guarantee investment returns and does not eliminate the risk of loss. Diversification among investment options and asset classes may help to reduce overall volatility.

International investing involves a greater degree of risk and increased volatility due to political and economic instability of some overseas markets. Changes in currency exchange rates and differences in accounting and taxation policies outside the U.S. can affect returns.