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Equity Perspectives

The move to higher rates is leading many investors to reconsider their income strategies.

(This article is derived from Lord Abbett Insights, a quarterly shareholder publication providing market, investment, and retirement insights.)   

Investors face a number of challenges and trade-offs in this market when constructing a portfolio to meet their long-term goals. Many are looking for income, but are struggling to find it in this low-yield environment, and they worry about the impact that rising interest rates may have on their fixed-income portfolios. Others are turning to dividend stocks to meet their income needs, but are hesitant to move beyond so-called “bond proxies” and are thereby adding unintended risk to their portfolios. We address both issues here.

Getting more from your core
A traditional core-bond strategy, one that typically tracks the Bloomberg Barclays U.S. Aggregate Bond Index (“Aggregate Index”), may face headwinds during a period of rising interest rates. This is because the index is comprised of 100% investment-grade securities, with approximately two-thirds allocated to U.S. government and government-related securities, which tend to be most affected by rising yields on U.S. Treasuries.

Does that mean that investors should abandon their core bond allocations? Not necessarily. For investors seeking a potential source of income while maintaining a focus on risk, high-quality bonds may play an important role in a portfolio by providing:

  • Portfolio diversification—High-quality bonds historically have been negatively correlated with U.S. equity returns. That is, their returns generally have moved in opposite directions. In fact, since 1977, in each of the seven calendar years that the S&P 500® Index (S&P 500) has had negative returns, the Aggregate Index has been positive, with an average annual return of 8%, according to Morningstar. This may provide balance to a portfolio during difficult equity periods.
  • Reduced volatility—In the 10-year period ended March 31, 2017, the Aggregate Index has had a standard deviation of 3.3%, or only 20% of the volatility of the S&P 500, according to Morningstar.

But a passive approach of simply following the index may not be ideal in today’s environment. The characteristics of the Aggregate Index have changed over time. Its duration, which is a measure of its sensitivity to changes in interest rates, has extended to 6.0 years as of February, 2017, a 30% increase from where it stood a decade ago, according to Bloomberg. Moreover, the average yield in the index is currently 2.7%, a decline of 50% over the same time period, leaving little cushion to generate positive returns in the face of rising rates.

What are the alternatives? Here are a few approaches to consider:

Take an active approach— To better capture the potential investment opportunities in this market, investors might want to consider a more flexible approach that employs active management strategies. Active managers can adapt to the market environment by adjusting a portfolio’s maturity and term structure, credit quality, sector, and industry exposure. Rather than matching the benchmark weight, an active manager can overweight certain bond sectors that may benefit from an improving economy.

Add a little credit risk— Securities with a lower credit rating, such as high-yield bonds, historically have provided opportunities for increased income, higher total returns, and stronger performance during periods of rising rates.

Diversify—Short-term corporate bonds, high-yield corporate bonds, and floating-rate loans historically have fared well during periods of rising rates. Typically, adding exposure to these sectors has increased return potential with less volatility.

Expanding the opportunity in dividend stocks
For many investors, dividend stocks are part of a long-term strategy to enhance income potential.

Historically, companies consistently have increased their dividends. In fact, since 1946, the S&P 500 has seen its annual dividend per share increase 88% of the time. But some investors may be adhering to an outdated perception of where dividends can be found and, in doing so, are introducing a variety of unintended risks into their portfolios, including interest-rate risk.

When many investors picture a dividend-paying stock, a certain type of company may come to mind: a mega-cap, slow-growth company with a high dividend ratio, meaning it returns a large portion of its earnings to shareholders—perhaps a large utility or telecommunications company. However, an unbiased look at where dividends can be found in the market today shows that this view represents only a small slice of the opportunity in dividend paying stocks.

The returns of companies with a high payout can be essentially bond-like (hence, their stock is often referred to as a “bond proxy”) if the earnings of the company are not particularly sensitive to economic growth, as often is the case for regulated utility companies as well as telecommunications and some consumer staples companies, for example. This type of investment certainly has benefits for some types of investors, but for those searching for growth and income opportunities, an overconcentration in bond proxy investments introduces new risks into an equity portfolio, with interest-rate risk being the major one. The income stream of a company with a high, fixed payout would face headwinds in an environment where interest rates and inflation expectations moved upwards, as its stable earnings and dividends would be discounted at a higher rate.

On the other hand, companies that pay a dividend but have a lower dividend payout ratio are usually more leveraged to economic growth. As the economy improves, the prospects for higher returns on earnings reinvested into the company also grow stronger. This can help offset, and in many cases even negate, the detrimental impact of rising interest rates and inflation on the income stream.

This is an important consideration when investing in dividend-paying stocks, because we have seen the definition of equity income change over the last 10 years. The landscape is no longer dominated by bond proxies; in fact, those sectors commonly referred to as “bond proxies” represent less than 25% of all dividend-paying stocks in the Russell 1000® Index. Today, more dividend-paying stocks can be found in the information technology sector than in the utilities sector, and the opportunity has changed fairly rapidly over the past several years.

Conclusion
Investors concerned about rising rates and sources of investment income should consult with their financial advisors to develop an effective long-term strategy for their portfolios. In some cases, that may mean expanding a portfolio to include both fixed-income and equity income opportunities. Others may simply need to refine an existing strategy in one or both asset classes. All investments involve risks, including the loss of principal invested. Investors should consider individual circumstances, risk tolerance, and investment goals when making investment decisions. Hopefully, this article will help you start the discussion with your advisor.

 

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Lower-rated bonds may be subject to greater risk than higher-rated bonds. The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. Historically speaking, growth and value investments tend to react differently during the economic cycle. Since value stocks are often cyclical in nature, they may benefit from the increased spending that usually occurs during an economic expansion. Growth stocks may also perform well during an expansion, but they may also be out of favor during market downturns, when investors pay more attention to price ratios. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. No investing strategy can overcome all market volatility or guarantee future results.

Diversification does not guarantee a profit or protect against loss in declining markets.

Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

Past performance is not a guarantee or a reliable indicator of future results.

A bond yield is the amount of return an investor will realize on a bond.

Duration is an approximate measure of a bond’s price sensitivity to changes in interest rates.

Negative correlation is a relationship between two variables in which one variable increases as the other decreases, and vice versa. In statistics, a perfect negative correlation is represented by the value -1.00, while a 0.00 indicates no correlation, and a +1.00 indicates a perfect positive correlation.

Standard deviation is a measure of volatility. It indicates the variability of an investment’s returns.

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements.

The dividend payout ratio measures the proportion of earnings paid out to shareholders as dividends. The ratio is used to determine the ability of an entity to pay dividends, as well as its reliability in doing so.

The Bloomberg Barclays U.S. Aggregate Bond Index is an index of U.S dollar-denominated, investment-grade U.S. government and corporate securities, mortgage pass-through securities, and asset-backed securities.

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance.

The Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000 Index.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in this commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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