Though many income-generating investments, like Treasuries, municipal bonds, and dividend-yielding stocks, have posted strong relative returns over the past year, interest rates on high-quality bonds are at historic lows, and the valuations on dividend-producing stocks are at historic highs.
To help investors and planners consider new ways to combine income and total return potential, Fidelity recently gathered several veteran fund managers to discuss this theme. Among the experts’ ideas on generating income and protecting against inflation are: Asian dividend-yielding stocks, Latin American sovereign debt, convertibles and real estate investment trusts (or REITs).
Joanna Bewick of Fidelity Investments urged investors to “be selective if you move out the risk spectrum.” She notes that two long-term secular shifts are combining to force investors away from both ends of the risk spectrum and toward the middle.
The first trend, Bewick says, is that central banks across the world are buying government debt and keeping interest rates low. “This is crowding private investors out of the Treasury market and pushing them further out on the risk spectrum, toward investments like corporate and high-yield bonds,” she explained.
The second trend is that the two major bear markets in the past 10 years have left investors cautious and looking for lower-volatility options. “An investor who might previously have invested in a growth equity portfolio might now want a more defensive income-equity portfolio,” she concluded.
With the markets “awash in liquidity,” Bewick foresees a less than 10% risk of recession in the United States in the next three months. For 2012, she believes select risk assets can outperform riskless assets such as Treasuries; still, “the best returns for the year may be behind us,” Bewick explains.
The Fidelity expert remains bullish on high-yield bonds and convertible bonds. As for REITs, they also look good in the current market environment, she says. “By law, REITs are required to distribute 90% or more of their profits to shareholders in the form of dividends, and their cash flows have been strong,” Bewick stated. Plus, there’s potential for increasing dividend yields.
Todd C. Ahlsten of Parnassus Investments likes to use dividend growth to help outpace inflation. “Bond yields are at historic lows, and this environment makes it difficult for income investors to beat inflation over the long term. I believe that owning companies with strong, time-tested businesses that can increase dividend payments over time is an attractive way to potentially generate income that can stay ahead of inflation over time,” he shared.
Beware too much current yield, Ahlsten said: “If you go after only high-yielding stocks, it can be like sailing a ship too close to the rocks: The risk is that a company with a high yield might not be able to sustain its dividend. I’d much rather invest in a company that’s yielding 3% with strong potential to grow its dividend than in a company yielding 5% that has poor growth prospects. The best companies are those that can grow their income stream while also being able to withstand economic shocks.”
The fund manager said that he has criteria for investing in a business: products that could prove to be increasingly relevant, have a sustainable competitive advantage and are run by companies with a “quality management team.”
Consider the case for income from Asia, said Robert Horrocks, CIO of Matthews International Capital Management. “Dividends in Asia have been higher than those in the United States, and they typically have grown at a faster rate. Right now, Asia’s dividend yield is quite high relative to its own history” he explains.
John Carlson, senior portfolio manager of Fidelity Investments, believes “low rates are likely here to stay for longer than the market expects, which makes me bullish on bonds.”
Carlson looks to emerging markets and certain countries in particular, for outperformance: Colombia, Indonesia and the Philippines, especially.