Given recent market activity, one might be under the impression that the era of ZIRP is winding down. Indeed, over the past three months, stocks have advanced about 10%. Meanwhile, over the past six months, the 10-year Treasury has bounded higher by a full percentage point.
Of course, with things having stalled for the moment, and President Trump progressing with controversial promises from the campaign trail, it would seem investors are starting to have some second thoughts. I'd concur. There may be a bit of misguided near-term optimism entering the market, as the probability of a robust, expansionary economy over the next four years may be more akin to a three-point or even half-court shot than a slam dunk.
For the longer-term income investor concerned about making efficient near-term capital allocation decisions, the state of the economy and the movement of interest rates should be of utmost concern.
The huge rally that virtually every bank in the country has had over the past three months is evidence of the optimism involved with a widening rate spread.
At the same time, rate increases at the longer end of the curve are proving a sizeable opportunity cost for those that bought bonds immediately after the Brexit vote. Still, the past few years have been a bond trader's paradise, with substantial back and forth volatility between 1.5% and 3% on 10-year federal government paper. It's been almost 5.5 years since the yield sat firmly above 3%.
As a result of ZIRP and the somewhat frenetic pace of trading in both equity and fixed-income over the past several years, high-yield has become somewhat a controversial topic amongst do-it-yourselfers. And probably with good reason.
In my view, investors tend to have a polar - love or hate - relationship with high-yield. Conservative dividend growth investors tend to ignore HY securities due to a typical lack of payout step. Advocates tend to point toward the huge income realization spread between HY and your more popular dividend stocks with puny-deemed payouts in the 1.5-3.5% range. The compounding advantage of a higher payout also is typically pointed to.
For those with less of an income realization or income growth mindset and more of a total return posture, the relationship is probably a bit more balanced and relaxed. I would consider myself in that park - open to solid HY investment thesis, but also cognizant of the various risks involved.
Evaluating The Current HY Climate
Clearly, "high-yield" is not a homogeneous concept, as high-single or double-digit yield can be found in a variety of spaces: REITs, energy, shipping, CEFs, BDCs, and elsewhere.
Although an elevated level of payout can create a hypnotic effect on some investors, I'd caution against developing "yield goggles" on everything you see. Just like every other corner of the market, not every high-yielder you put under the microscope will turn out to be so attractive.
On the other hand, to arbitrarily wholesale discount the group would be a mistake as well, as you're likely to pass up on some attractive risk-adjusted opportunities along the way.
Despite hitting their highest levels since the financial crisis last year (~6.5%) due to the general energy/commodity downdraft, high-yield bond default rates have been edging lower for the past six months. They currently sit somewhere in the 4.6-4.8% range, but one report predicts that defaults will edge back to 3% by the end of the year, representing a significant 18-month improvement.
As the above report notes, the retail sector and, to a lesser extent, healthcare and utilities represent mild hot spots to watch in 2017.
Others are predicting an even more aggressive improvement move to a 2.5% default rate by December 31, 2017.
Generally speaking, I would consider this good news for HY investors, as the once panicky concern regarding domino impact from energy defaults seems to be waning.
Thus, there would be little reason to believe that BDCs and CEFs, in particular, which have large exposure to junk and non-rated debt, will see their NAVs or payouts sliced meaningfully over the coming 12-18 months. Due to the length of ZIRP, however, mild incremental decreases should not necessarily be ruled out either.
Still, the depth of the energy/commodity recession was something not seen by most, and investors should expect the unexpected, as black swan events or trends may erupt with increasing frequency given the growing complexity of global financial markets.
Clearly, data points in a positive direction. However, with many of the more vulnerable energy and commodity stocks having bounced well off end of 2015 lows, if you're thinking about that just now, you may be a little late. Still, for the more conservative investor, it may be better to be a little late and affirm recovery, rather than try to catch a falling knife.
In any case, from a fundamentals-based credit perspective, I think now is not a horrendous time to selectively consider high-yield stocks/securities.
What About Valuation?
The macro-discussion aside, investors shouldn't throw caution to the wind here, regardless of the economic backdrop. Companies that pay out elevated levels of cash flow or are discount priced relative to others in their space carry generally unique and potentially substantial risks.
While you might gloss over the fact that a BDC sells at a 10% premium to net asset value, you should carefully consider whether the premium is warranted relative to another BDC that sells at a 10% discount and 20% higher yield. You should also be factoring into your capital commitment decision whether management is external or internal, what its operating costs are, how much skin executives have in the game, and perhaps most importantly, what their track record has been.
As I note time and time again, it may make sense to pay a premium to be owner in a business that builds shareholder value rather than pay a discount and get a fatter yield, getting stuck with alignment issues and consequently lower annual returns.
In the CEF space, the same can be said for the discount/premium price mechanism and fees that the CEF charges. Paying a premium/par cost or excess fee to own an investment that shows perpetual outperformance may prove a better decision than settling for a serial underperformer selling at a discount valuation and higher yield.
Just How Important Is Yield Capture?
As noted earlier, yield spread and compounding are amongst the most frequently cited justifications for high-yield investment as opposed to a garden variety dividend stock or even a growth stock.
For the investor either desiring or in need of elevated cash flow, HY certainly represents something of a holy grail. The counterpoint to utilizing HY is that investors can create their own income by focusing on price growth and selling shares to generate cash flow requirements.
That sounds good, but if we enter a bear market or otherwise a period of flat equity pricing, capital could dwindle quicker than expected. The most recent example of that phenomenon being the so-called "Lost Decade" from 2000 to 2013.
As the income investor contemplates strategic direction, time may also be a prime component of the consideration. How long will the income need be? Which alternative provides the greatest visibility to the greatest amount of income?
The second question is somewhat rhetorical since it's difficult to foresee one year into the future, much less one decade. Still, investors must make these kinds of projections as determination is made on specific securities and ultimate allocation of capital.
I'd opine in an era of generally bloated equity valuation and stable economic backdrop (like now) investors should utilize HY more than if the situation were the opposite: depressed equity valuation and economic instability. Said somewhat differently and more generally, I'd currently be supportive of strategies that stress cash flow rather than strategies that stress dependence on price appreciation.
Piecing The Current High-Yield Puzzle Together
At the end of the day, investment success is generally predicated on specific investments chosen and avoided rather than the underlying strategy that is practiced. With a cherry-picked backward look, I can make the case vehemently for (or vehemently against) a high-yield heavy portfolio.
All things considered, I think now will not be looked back as a terrible HY buy opportunity. Looking through my portfolio, I have more confidence, in many situations, in my higher-yielders' ability to pay 7-10% than on my lower-yielders' ability to grow price by 7-10% over the next year. At its essence, that is one of the most important comparative considerations that investors contemplating high-yield must make. How durable is the income?
When it comes to specific equity selection, investors wishing to increase allocation efficiency and maximize returns should constantly be considering the macroeconomic backdrop, valuations and fundamentals in the various high-yield spaces, and the risk-adjusted situation relative to other yield and investment choices.
All of these things considered together will help in the decision-making process and hopefully let you sleep better at night, regardless of what specific decisions you make.
On an allocative basis, I generally would be skittish with a conservative investor putting meaningful amounts of capital into BDCs, mREITs, leveraged CEFs and other HY sectors. Risk tolerance and necessity should be careful considerations. High-yield bonds are known as junk for a reason. While the same isn't generally said of high-yield equity, you should consider there being some parallel.
In terms of specific equities, I'm breaking this out into two lists; one I think you should consider buying right now, and another that I think you look to own at lower prices. I also included a mad money idea pick for the braver souls.
- Landmark Infrastructure (NASDAQ:LMRK) - Leases ground to telecom, green energy, and billboard companies - 9% yield
- Communications Sales & Leasing (CSAL) - Pure-play communications assets - 9.15% yield
- New Senior (NYSE:SNR) - Owns/leases private pay AFL/ILF senior housing assets - 10.5% yield
- Jernigan Capital (NYSE:JCAP) - Financier of self-storage REIT assets - 6.75% yield
- Guggenheim Enhanced Equity Income Fund (NYSE:GPM) - Leveraged option-income CEF selling at 4% discount - 11.7% yield
- Monroe Capital (NASDAQ:MRCC) - Internally managed BDC selling at about NAV - 9.12% yield
- Apollo Commercial Real Estate (NYSE:ARI) - Externally managed CRE financier, has been growing the dividend - 10.6% yield
- Hercules Growth Capital (NYSE:HTGC) - Internally managed BDC priced currently at large premium to NAV - 8.61% yield
- UBS 2X REIT Index ETN (NYSEARCA:LRET) - ETN (fixed-income note) market-cap weighted index of REIT equities - 8% TQ yield
- Allianz Convertible/Income II (NYSE:NCZ) - 40% leveraged mix of HY fixed-income and convertibles, 2% discount - 11.5% yield
- Blackstone Sr. Floating (NYSE:BSL) - 2020 term CEF trading at 3% premium to NAV - ~7% TTM yield w/special dividend - high UNII
Mad Money Pick
- UBS 2X CEF ETN (NYSEARCA:CEFL) - ~20% yield based on 8/16-11/16 interest quarter run
Given the lofty levels that "traditional" equity-income continues to trade at, investors would be wise to consider how price stagnation or price dilution, or even slowing dividend growth, might affect their portfolios.
Meanwhile, with the economy holding its own, and probably stabilizing a bit on the sub-investment-grade end of the credit curve, I don't see now as the worst of times to be carefully considering select high-yield names.
This should not be viewed as a free lunch however. Since most high-yield companies are paying out a majority of their operating cash to investors, any business hiccup will likely lead to a dividend drop.
Therefore, I'd advise against high-yield concentration in any one sector, or in any one security.
I leave you with a summary of important questions to consider as you contemplate your knowledge, need, and projected utility for an allocation to high-yield.
- What is your risk tolerance and understanding of the nuances of high-yield in general?
- What are your macro-convictions regarding the future trajectory of interest rates and the economy in general?
- How imperative is it to your overall investment plan that you own high-yield securities? Is "more" income than you need or "greed" a motivation in your portfolio?
- Is the income stream from current or contemplated high-yield allocation more durable than price appreciation or total return potential you perceive from other equities?
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Disclosure: I am/we are long ARI, BSL, CEFL, CSAL, GPM, HTGC, JCAP, LMRK, LRET, NCZ, SNR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: 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.