It’s that time of year again: Time for everyone to sit on their hands and wait for the Federal Reserve to raise the federal funds rate in December.
If you’re an income investor, anxiety is on the rise. It all feels vaguely familiar, and it should. We’re witnessing similar price action in high-yield equity investments that we witnessed a year ago.
Investors are selling high yield today for the same reason they sold last year: They’re anticipating the Fed to raise the federal funds rate in December. Conventional wisdom argues that when interest rates rise, income equity investments fall, and high-yield equity investments fall more than most.
So, why do high-yield equity investments fall more than most?
For one, income debt investments are expected to offer higher yield when rates rise; thus, they gain favor vis-a-vis high-yield-equity investments. Second, most high-yield equity investments are pass-through entities (REITs, MLPs, and BDCs); they’re perceived as bond surrogates. These investments are valued on their current income as opposed to their growth prospects.
Because REITs, MLPs, and BDCs are viewed as bond surrogates, they’re valued like bonds. Because they’re valued like bonds, rising interest rates create a problem. A simple example demonstrates my point.
Let’s say that you have an investment that will pay you $100 annually in perpetuity. If your discount rate is 5%, you’re willing to pay $2,000 for this investment ($100/0.05). If your discount rate rises to 10%, you’re willing to pay only $1,000 for this investment ($100/0.10). Bonds and other debt securities values are determined by this discounting procedure. The higher the discount rate, the lower the present value.
The prospect of a dividend or distribution cut always weighs on value. Because REITs, MLPs, and BDCs are pass-through entities, the retained earnings pool mostly runs dry. To grow, these entities must issue either new equity or new debt. Rising interest rates raise the cost of both. If these pass-through entities have to tap capital markets, particularly for debt, their financing costs rise relative to their revenue and cash flow decreases, putting the indispensable dividend or distribution at risk.
A Bit of Perspective
Conventional wisdom, though applicable, should be put in perspective.
If the Fed raises the fed funds rate next month, as everyone expects, it will unlikely raise the fed funds rate more than 25 basis points. The range on the fed funds rate would be lifted to 0.50%-to-0.75% from 0.25%-to-0.50%. The fed funds rate will remain meaningfully below 1%, far below historical norms. As recently as 2007, the fed funds rate was above 5%.
What’s more, the percentage increase of this December increase will be considerably less than it was a year ago. Last December, a 25-basis-point increase represented a 100% increase in the fed funds rate. A 25-basis-point increase this time around will represent a 60% increase. The rate increase, as a percentage of the prevailing federal funds rate, is less dramatic this go-around.
In other words, interest rates will remain low, which means the yields provided by REITs, MLPs, and BDCs will remain high relative to the alternatives.
Today, the iShares Dow Jones US Real Estate ETF (NYSEArca: IYR) yields 5.4%, the Alerian MLP ETF (NYSEArca: AMLP) yields 9%, and the VanEck Vectors BDC Income ETF (NYSEArca: BIZD) yields 9.1%. These yields are as high because of the preemptive selling that has occurred in anticipation of an interest rate increase.
But guess what happened after the December 2015 rate increase? High-yield equity investments subsequently recovered, and they continued to recover until market participants began to fret over another fed funds rate increase, which began early last month.
Post-Rate-Increase Price Action: REITs, MLPs, BDCs
The fear of rising interest rates crushing high-yield equity investments is greatly exaggerated. The good news is that fear creates opportunity. To be sure, we will see elevated price volatility in high-yield investments over the next couple months. But if you can stand the volatility, you can pick up additional yield at a substantial discount to historical value.
Therefore, it’s not time to dump your high-yield investments. To the contrary, it’s time to consider adding to your high-yield investments.