As the clamor surrounding the Fed's next move in its ongoing quest to levitate the domestic economy and return to normalized monetary policy persists, many income investors continue to find themselves between a rock and a hard place. While many have hesitatingly moved into longer maturity bonds and income equity to generate elevated cash flow in a ZIRP world, many may now be questioning that decision given the dramatic move over the past month. Indeed, though we are likely more than twelve months away from any Fed tightening bias, a near-term bond market "blip" has sent interest rate sensitive equities and broader credit markets into a tailspin.
Hit especially hard were pockets of the REIT and mREIT space as well as high-yield CEFs which saw large premiums quickly replaced with discounts. Even "safe" investment-grade bond products such as BND have seen several years of yield erased by swift asset price diminution. While one might argue that this was somewhat of a knee-jerk reaction, I think to a large extent what we saw, and continue to see, is an orderly exit from securities where pricing and yield was not commensurate with risk, in other words, a sane, healthy sell-off. Though the downside seems to have subsided for the moment, trading volume remains brisk as investors assess forward prospects, yield, and risk.
Dow Jones REIT Index - 6 months
Though there have been a few nervous blips for income investors over the past couple of years prior to the most recent selling, most notably last fall, the low rate environment, by and large, has fostered a favorable total return climate. The downward spike over the past month, however, should be a reminder to all that securities investment, even in bond funds like AllianceBernstein Global High-Income (AWF), a mundane real estate entity like Realty Income (O), or a more esoteric mREIT like American Capital Agency (AGNC), entails heightened capital risk. I mention those three because they are widely held by retail investors and have lost respectively, about 15%, 25%, and 35%, from their recent highs.
And while I would agree with those that often profess that volatility is not risk, more often than not spelling opportunity, chasing after investments that possess heightened yields without consideration for their valuations, fundamentals, or the broader macroeconomic environment is unquestionably risky behavior. Hopefully those that have been burned on paper over the past month will see this episode as more of a learning opportunity and a catalyst to create a diversified portfolio than a reason to totally abandon an income focused strategy.
Looking Forward And Plotting Strategy
While I'm not particularly keen on near-term prognostication, macroeconomically speaking we continue to see mixed data on the home front as we sail through a period of uncharted Fed policy. Though a rising rate environment is clearly a risk to rate sensitive equity and the entire fixed income space, it's hard to imagine that the Fed will be able to taper QE and quickly transition to a tightening stance without disrupting the delicate recovery it is attempting to orchestrate like Nik Wallenda over the Grand Canyon.
But, as we saw over the past month, anything can happen with long rates. Given the market's sensitivity to even an inkling that QE will end, the Fed will likely go about this more judiciously than they have let on. And if investors are so sensitive, imagine what is going on in corporate boardrooms. Like everyone else, executives are doing some watchful waiting, hunkering down, building up their balance sheets in anticipation of something, anything that would signal a recovery. While data shows that unemployment has been steadily decreasing over the past several years and that the housing market is recovering, is the middle class, the lifeblood of our country, really gaining as equity markets trade near their highs? One would question that as median household income and net worth stagnate.
Still, while the average income investor may not like to dwell on macroeconomics, I believe now is the time to become more tuned to if, when, and how fast rates move. Whatever thesis one comes up with should play a role in portfolio strategy over the near- and intermediate-term. If one thinks rates will ramp precipitously higher over the next 3-5 years, then only short maturity bonds and non-rate-sensitive equity should be considered. On the other hand, if you're like me, and you think rates will probably remain low, maybe you're willing to go out a bit on the yield curve and allocate a bit more to income equity.
Whatever economic outlook you have and portfolio composition you choose, I still believe diversification to be the keystone of any income-dominated portfolio. I encourage you to take the time to read an article I wrote on the importance of diversification for income portfolios. To make a long story short, I argue that position concentration is a risky, foolish strategy for those looking for a dependable stream of income.
Taking my own advice, I try to own a bit of everything - BDC's, MLPs, utilities, technology, and yes, bonds - when it comes to my income basket. Like many of you, I took a hit on many of the REITs in my portfolio, but also seized the opportunity to jettison some comparatively expensive positions including Healthcare Realty (HR), rotating into other positions that I am more constructive on long term like American Realty Capital (ARCP). I also decided to take some small losses and move on from the mREIT space, increasing my position in diversified Northstar Realty Finance (NRF) with the proceeds. I also added to my position in the Eaton Vance TM Global Equity Income Fund (EXG), which writes call options, in my view an optimal high-income security for a volatile market.
While the significant downside move in many income stocks may have been uncomfortable or painful for many, it appears to have been a rational, orderly move to re-price risk in some overheated sectors of the market. Though Fed speculation will undoubtedly continue to overhang rate sensitive securities, investors should take this opportunity to fine-tune positions, creating a well diversified portfolio that minimizes overall volatility during future downturns. This near-term wakeup call should engender long-term inspiration on how to manage market risk.
Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.