May 22 was not a kind day for income investors. It would appear that this was the day that income investors collectively realized that the Fed’s QE infinity really wouldn’t go on…well…for infinity.
Fears that market yields would rise became a self-fulfilling prophecy. The 10-year Treasury yield, which had reached a new low just above 1.6% in late April had started to creep upward in early May and on May 22 it shot above 2%.
Income focused investments got absolutely clobbered as a result. MLPs and REITs, as measured by the JP Morgan Alerian MLP ETN ($AMJ) and Vanguard REIT ETF ($VNQ), respectively, fell by 11% and 9% from their May 21 closing prices through June 5. Utilities and mortgage REITs, as measured by the Utilities Select SPDR ($XLU) and Market Vectors Mortgage REIT ETF ($MORT), respectively, shed a good 7% each.
As a point of comparison, the S&P 500 was off by less than 5% at time of writing.
So, what should investors do now? Use the recent sell-off in all things income as a buying opportunity? Or view any rebound as a dead-cat bounce that should be sold?
It’s a little of both actually.
But before I go any further, we need clarify a few points:
- Bond yields won’t be shooting to the moon anytime soon. In fact, they are already starting to ease; at time of writing the 10-year Treasury yield had slipped from its recent high of 2.16% to just 2.05%. As Japan has proven for over 20 years, in the wake of a credit meltdown yields can stay far lower than anyone expects for far longer than anyone expects.
- There was a lot of speculative froth in the income-oriented market sectors; REITs, MLPs, and other income-focused sectors had massively outperformed the market throughout 2013 at a rate that was not at all sustainable. What we just experienced was a much-needed correction that brought the prices of income securities closer in line to the rest of the market.
I expect to see the 10-year yield fluctuate within a fairly tight band of 1.8% to 2.8% for the next 1-3 years and perhaps longer. In this sort of environment—one in which yields rise slowly and stay low by historical standards—dividend growing stocks should perform just fine.
But that is the key point: notice I said “growing” and not “paying.” In order for income investors to remain interested, these stocks need to provide a competitive current income stream but also one that will grow to keep pace with inflation.
Most equity REITs and MLPs meet this requirement easily. With the US property markets continuing to heal, equity REITs should enjoy several years of improving occupancy and higher rents, not to mention appreciating property values. All of this bodes well for higher REIT prices and dividends.
And with America’s domestic energy boom still firing on all cylinders, there should be plenty of demand for high-quality midstream pipeline assets for years to come. This should mean continues strong distribution growth among MLPs as an asset class—and higher prices for MLP shares.
I also see value in “non-traditional” dividend stocks, such as Old Tech giants Microsoft ($MSFT), Intel ($INTC) and Cisco Systems ($CSCO). All have been aggressively growing their dividends in recent years and all healthily yield more than the 10-year Treasury will any time soon.
What about utilities and mortgage REITs?
Though I expect both might enjoy a nice short-term bounce, I’m a lot less enthusiastic about their prospects. Utilities, as part of a highly-regulated industry, cannot be expected to keep up with MLPs and REITs in terms of dividend growth. And considering that, even after the sell-off, utilities trade at an earnings premium to the rest of the market, this is a sector best avoided.
Mortgage REITs also leave a lot to be desired. While equity REITs are backed by real property and thus have built-in inflation protection (not to mention growth potential), mortgage REITs are essentially single-strategy “hedge funds” that borrow short-term funds cheaply and invest the proceeds in longer-duration mortgages. If market yields rise even modestly, it is going to crush the book values of the mortgage REITs’ long-duration mortgages.
The yields on mortgage REITs are attractive—MORT yields just under 10%—but it is not realistic to expect much in the way of dividend growth going forward, and dividend shrinkage might actually be the more likely scenario.
Bottom line: Once the dust settles, income investors should load up on high-quality equity REITs, MLPs and “non traditional” dividend stocks in the technology sector. But utilities and mortgage REITs are best avoided, and investors looking to reallocate their portfolios should use any short-term strength as an opportunity to sell.
Disclosures: Sizemore Capital is long MSFT, INTC, CSCO, VNQ and AMJ. This article first appeared on InvestorPlace.
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