Only one month into 2018 and the markets have been very kind to broad stock indexes and not very kind at all to most yield-oriented securities. Consider the YTD changes in the ETFs shown in the chart below. The mREIT fund (REM), REIT fund (VNQ), and utility fund (XLU) have all fallen by over 3% while the high yield bond fund (JNK) is about flat. The SPDR S&P 500 Trust ETF (SPY), on the other hand, has already tacked on 6% for the year.
Clearly, high yield has not fared well so far and there are reasons to think that trend is likely to continue. For one, interest rates have been rising and are expected to continue to rise. The Fed raised rates three times in 2017 so that the current benchmark targets a range between 1.25% and 1.5%. An additional three 25bp hikes seem like a reasonable expectation for 2018, which would bring the benchmark up to a range of 2% to 2.25%. Rising rates are typically a headwind for income-oriented equity investments because they become less attractive relative to bond yields. Additionally, real estate and utility businesses are hugely capital-intensive and typically operate with a high amount of leverage. Higher rates increase financing costs should new debt need to be issued or existent debt rolled over. For companies like mortgage REITs and business development companies that make money on an interest spread by borrowing at short-term rates and lending at higher, long-term ones, rising short rates can be an issue as they increase the cost of borrowing and can therefore narrow their spread.
There are some investments that can offer both a high yield and much less vulnerability to rising rates. I would recommend investors searching for yield today take a look at three sectors in particular that should offer relatively better prospects than high yield securities in general.
Business Development Companies
As noted above, BDCs typically borrow money at short-term rates to fund longer term loans to businesses and pocket the spread between those rates. However, some BDCs are well-positioned for rising rates because a large proportion of their debt is fixed rate while a large proportion of their investment portfolio contains variable rate loans. Additionally, improving economic conditions should help most BDCs since their portfolio companies should be less likely to default on their obligations.
A good pick in this area is Ares Capital Corporation (ARCC). Rising interest rates should positively impact interest income, the company is the largest of its breed, and it has displayed great dividend stability in a sector where cuts have been all too common. I've been a shareholder since its acquisition of American Capital and am confident that the company is well-positioned going forward. Ares has a 9.5% yield and is trading at a 3% discount to BV.
Floating Rate mREITs
Giants of the mREIT world, Annaly Capital (NLY) and AGNC (AGNC) have seen their share prices take some significant hits lately. That's understandable considering they basically hold leveraged portfolios of long-term fixed-rate mortgages. Those securities are going to lose value as rates rise and, as with BDCs, their cost of funds rises as short-term rates increase as well. But there are some mREITs whose portfolios are much better-positioned.
Blackstone Mortgage Trust (BXMT) is a standard bearer in this regard as the company invests almost exclusively in floating-rate mortgages. Investors have taken note, however, and the company trades at nearly a 20% premium to book value while most other mREITs trade at a discount. A smaller and much lesser known peer that operates a similar portfolio, Granite Point Mortgage Trust (GPMT) has not been similarly bid up. It trades at a 10% discount to book value and is essentially at its post-IPO lows (the company was spun off from Two Harbors (TWO) last year). GPMT has been loudly touted by one of SA's greats, CWM, and I owe him a thanks for putting it on my radar and doing some great analysis on the company.
BDCs and mREITs can be excellent income vehicles, but holding them is basically like holding a leveraged loan portfolio. They can be very volatile and are probably not suitable for large allocations as a percentage of a portfolio.
Traditional equity REITs are more stable than BDCs and mREITs, but still show sensitivity to rising rates. In general, the longer lease terms are signed for, the worse the effect of rising rates - similar to how longer duration loans are more vulnerable than shorter duration ones.
The good news is that the REIT sector with the shortest lease durations is not terribly expensive today. Hotels can reset the prices of their rooms essentially on a daily basis, so there is no risk of getting locked into a low long-term lease in a rising rate environment. Hotels should also benefit from additional disposable income and business travel if the economy continues to shine and potentially from increased tourism if the dollar falls further relative to other currencies.
My choice hotel REIT is Hersha Hospitality Trust (HT). Hersha is offering a respectable 6% yield and trading at a very attractive 8.7 P/AFFO multiple at the midpoint of its 2017 guidance. It also recently announced a sizable buyback authorization. Hurricane Irma did quite a number on the company's South Florida properties, which negatively impacted Q3 earnings and its outlook for Q4, but sets up the company for easy revenue growth as the closed properties reopen for business.
I believe that select BDCs, mREITs, and hotel REITs represent superior investment options to obtain a high yield today. ARCC, GPMT, and HT are my first choices in those respective categories.
I understand the strategy of some long-term investors to seek out sustainable, growing dividends and hold through pretty much any economic environment. I'm not advocating that such a strategy is inappropriate - if you've held a favorite utility for decades and plan to keep reinvesting the dividends, more power to you. Instead, consider that any money you would have put into typical mREITs might be better off in a business that offers similar yields, but is more favorably positioned to rising interest rates. Funds that you would dedicate to REITs or high yield stocks today might be better off being put into a hotel REIT that is not as interest-rate-sensitive and will likely benefit from a pickup in the economy.
With many high yield investments having a rough start to the year, it might seem like a good time to "buy the dip." But the stocks that I've focused on are not more expensive than their larger peer groups. Picking up some shares of these better-positioned businesses is probably not any more expensive - at least not yet. Fourth-quarter reporting is just getting underway, and the market may reprice these securities soon - especially if managements are able to give guidance above current expectations. I plan to pen write-ups on each of the stocks I've recommended for further research before they report 2017 results, so keep an eye out if any have piqued your interest. Feel free to add additional income suggestions in the comments and thanks for reading.
Disclosure: I am/we are long ARCC, GPMT, HT. 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.