A High Yield Wealth subscriber e-mailed me the following question last week: “Why have high-yield stocks rallied so strongly this year?”
High-yield stocks have rallied strongly this year. Two traditional sources of high-yield income – master limited partnerships (MLPs) and real estate investment trusts (REITs) – have galloped far afield of the broad-market indexes. The Alerian MLP ETF (NYSEArca: AMLP) is up 50% since mid-February; the iShares U.S. Real Estate ETF (NYSEArca: IYR) is up 20%. At High Yield Wealth, we’ve seen 20%, 50%, and even 80% price gains in our high-yield recommendations.
Back to the question, why?
Let’s start with the income alternatives.
As I write, I ponder my passbook savings account at Wells Fargo (NYSE: WFC). My recollection of the account’s provenance or purpose is hazy. All I know is that the account holds $680, and that balance seems to date back to antiquity. What’s more, unless I contribute more money to the account (which I won’t), the balance is likely to hold into the distant future. Interest is credited at the great munificent rate of a penny a month. Earning $0.12 annually on $680 generates a 0.0002% annual yield.
I can generate higher yield if I’m willing to commit a little more money for a contracted period. Wells Fargo will reward me with a 0.01% yield on a $1,000 investment in a three-month certificate of deposit. A one-year CD on the same amount will yield 0.05%. If I’m willing to hang in for five years (and I’m not), Wells ups the annual yield sevenfold to 0.35%.
I can venture out on the risk curve and capture a considerably higher yield.
The SPDR Barclays Capital High Yield Bond ETF, which sports the novel ticker symbol “JNK,” yields 6.2%. But with the Barclays fund, I’m basically trading in securities with equity-like traits – most notably price volatility – though price volatility sans trading liquidity. Trading volume in high-yield bonds is generally low, so bid-ask spreads are generally high. Better to gain liquidity and pick up a few percentage points of yield in a quality high-yield MLP or REIT.
Thanks to the energy-price recovery, MLPs have risen like phoenix from the ashes. Oil prices are up 80% since mid-February; natural gas prices are up 50%. The price surge has vastly improved the risk-reward paradigm for many MLPs. Investors understand the paradigm shift and have repriced MLPs accordingly.
The Federal Reserve is another contributing factor in the high-yield recovery. 2016 was promoted as the year of the interest-rate increase. Pundits predicted the Fed would continue what it started last December: it would continue to ratchet the federal funds rate higher. By this time, we were told in early January, two 25-basis-point increases would easily be banked.
The prospect of higher interest rates was perceived as a capital-structure threat. MLPs and REITs are pass-through entities. Both entities frequently tap debt and equity markets to raise capital in order to grow. If your tap comes with a higher tab, you’ll generate lower returns on invested capital, so investors reasoned.
The reasoning was frequently specious. If the Fed were to raise the fed funds rate, it would do so only if an expanding economy could support it. A quality MLP or REIT should be able to raise revenue at a rate that outruns rising capital costs. Many MLPs and REITs actually experience an uptick in performance when interest-rate increases come tethered to robust economic growth.
But after the three consecutive months of lousy job growth (May saw only 38,000 new jobs), talk of rising rates has waned. Fed officials meet next Wednesday, and traders in fed funds rate futures contracts are pricing a 4% chance of a rate increase. Fed officials convene again in late July; traders are betting with a 24% chance of a rate increase then.
Equity investments will remain the income investment of choice. Few alternatives compare favorably to a quality REIT or MLP with a record of maintaining its dividend or distribution through thick and thin.
The good news is that despite strong price gains, opportunities still abound. We have MLP and REIT recommendations priced to deliver 8%, 9%, and 10% yields at High Yield Wealth. But unlike the paltry yield on my passbook savings account, I don’t expect these high yields to persist into the distant future.