For income investors, the bright side to the bear market in the first half of 2022 is that yields are higher than they have been in quite a while.
Income investors have truly been through a long bout of yield starvation thanks to the combination of unprecedented low interest rates and easy money policies as well as skyrocketing stock prices in 2020 and 2021. At one point, yields got so low that even Bill Gross, the “bond king” and former head of Pimco, called bonds garbage. The yield of 10-year U.S. Treasury bonds even dipped below 1% for the first time in history.
Taking inflation into consideration, current yields are still low; in order to be higher than inflation, a dividend or bond yield would need to surpass 8.6%, which is quite a high mark that can currently only be met by inflation-protected I bonds or Treasury Inflation-Protected Securities (or perhaps the riskiest of junk bonds).
However, high-yield investments are still returning more than most stocks at the moment. With the economy bordering on a potential recession, income investing also has the benefit of providing returns even in difficult market conditions while investors wait for the macro situation to improve.
Let’s take a look at the different classes of income investments to see which of these income options have the best outlooks with a bear market on the horizon.
Bonds are no longer trash
While typically not as high-yield as equities, bonds do provide protection against the downside, which can make them useful to hold during recessionary conditions in case an investor has an unforeseen need to cash out part of their portfolio.
Since inflation is the highest it has been in decades, it’s a rare chance for Series I Savings Bonds to shine. Available via Treasury Direct, investors can buy up to $10,000 in electronic I bonds per calendar year. These bonds provide reliable protection against inflation by yielding more than the inflation rate, as measured by the consumer price index. For example, as of July 1, I bonds have a yield of 9.62% that is applied for the six months after purchase. The bonds can be cashed out after 12 months, though if they are cashed within five years of purchase, the past three months of interest are deducted.
Investors can also get inflation protection from Treasury Inflation-Protected Securities (TIPS). TIPS are available through TreasuryDirect in terms of five, 10 and 30 years, as well as via the iShares TIPS Bond ETF (TIP, Financial) for those seeking more flexibility. The TIP ETF has a current yield of 15.2%.
The yields for Treasury bonds still aren’t particularly high, but they are no longer near zero, hovering just around the 2.8% mark for 10-year notes and 3.0% for 30-year notes. If inflation comes back under control to near the Federal Reserve’s long-term goal of 2% per year, Treasuries could regain their status of being better than cash.
When it comes to investing in corporate bonds, the rule of thumb is similar to stocks: the greater the risk, the higher the reward. The safest way to invest in corporate debt is through big-name exchange-traded funds that either buy corporate debt alone, or a mix of corporate and Treasury bonds.
The largest exchange-traded bond fund is the iShares Core U.S. Aggregate Bond ETF (AGG, Financial), consisting of more than 10,000 individual bond holdings with a 60/40 split between investment-grade corporate bonds and U.S. Treasury bonds. It has a yield of 2.9% and a net annual expense of 0.03%.
An all-corporate bond ETF option is the Vanguard Intermediate-Term Corporate Bond ETF (VCIT, Financial), which focuses on U.S. blue-chips like Bank of America (BAC, Financial) and AT&T (T, Financial). This ETF is less risky than junk bond ETFs while still providing a respectable yield of 4.3% at a net annual expense of 0.04%.
Are junk bonds still worth the risk?
Interested in corporate bonds, but not impressed by the yields of the investment-grade options? Investors can get higher corporate bond yields from junk bonds, which represent the debt of financially unstable companies that have no choice but to issue bonds with higher interest rates because they are at a higher risk of defaulting on said bonds.
Historically, junk bonds have proven to be worth the risk as an investment class, even if investors have been wiped out on individual company junk bonds. This is thanks to interest rates in the U.S. having been on a steady decline since the 1980s, making it easier for many companies to avoid defaulting on their debt by paying it off with new debt.
Even the junk bond market suffered when the Federal Funds rate was near zero. The average junk bond yield dropped under 5% at the beginning of 2022, which is peanuts compared to the risk of this asset class. As of June, the average yield had risen back to around 8.5%.
The largest junk bond ETF, the iShares iBoxx USD High Yield Corporate Bond (HYG, Financial), yields around 5%, while a higher-risk name, the First Trust Tactical High Yield (HYLS, Financial) ETF, yields over 7%.
An important thing to note with junk bonds going forward is that the Fed is out of room to provide companies the benefit of long-term interest rate declines. Sure, it can lower the base rate back to zero, but then what? Unless the U.S. follows in the footsteps of Sweden and Japan and introduces negative interest rates, junk bonds could face a much higher risk of default.
Pipeline stocks
In terms of equity income, there’s a lot of buzz in the markets right now about oil and gas pipeline stocks. Thanks to Russia’s invasion of Ukraine and resulting Western sanctions on the exports of the world’s third-largest oil and gas producer, energy prices have skyrocketed, and profits and stock prices all across the energy sector have followed suit.
Among energy stocks, some of the most attractive investments from an income standpoint are pipeline stocks. The operations of pipelines are more predictable, less dangerous and less capital-intensive than exploration and extraction operations, resulting in better margins and higher dividend payments.
Notable pipeline stocks include Enterprise Products Partners LP (EPD, Financial), which has a 7.76% dividend yield, and Magellan Midstream Partners LP (MMP, Financial), which sports a 9.03% dividend yield.
The big risk with commodity stocks is they can be at the mercy of sudden and drastic market changes, as evidenced by the Covid-19 pandemic and the war in Ukraine.
Defensive dividends
Investors looking for inflation-resistant businesses that also offer decent yields can now find quite a few stocks in defensive sectors that are offering dividend yields upwards of 3%.
Defensive stocks offer products that customers tend to not reduce their spending on even in times of economic trouble. Examples include food and beverage companies, utilities, couriers, consumer health care companies and consumer packaged goods producers.
For example, 3M (MMM, Financial) and Walgreens Boots Alliance (WBA, Financial) yield 4.58% and 5.07%, respectively. Unilever (UL, Financial) yields 4.2%, The Kraft Heinz Co. (KHC, Financial) 4.19% and Dominion Energy (D, Financial) 3.26%.
Certain telecommunications stocks can be considered defensive because, even though they are tech stocks, they are essential in the modern-day world and offer high dividends (though it should be noted that some don’t offer dividends). AT&T (T, Financial) sports a forward dividend yield of 5.26% (it is slashing its dividend following a spinoff), while Verizon’s (VZ, Financial) forward dividend yield is 4.96%.
REITs
Real Estate Investment Trusts, or REITs, are widely considered to be some of the best kinds of income stocks to hold, especially during recessions and periods of high inflation. That would make them seem like the ideal stocks to hold in current market conditions, at least on the surface level.
Real estate tends to hold its value well over time, and REITs also have the benefit of getting most of their income from rent rather than property sales, giving them reliable and predictable income streams. Due to how profitable their business model is, these stocks are required by law to return 90% of their taxable income to investors, resulting in hefty dividends.
The natural side effect of high and reliable dividend income is that shareholders have bid up the prices of the most renowned REITs, reducing yields somewhat. For example, Realty Income (O, Financial), one of the largest REITs in the U.S., yields 4.2%. However, some of the lesser-known REITs still offer high yields.
We may see the share prices of residential REITs stagnate or decline as the hot housing market cools off, slowing the growth of rental rates, but data center REITs like Digital Realty Trust (DLR, Financial) with a 3.7% yield and warehouse REITs like Stag Industrial (STAG, Financial) with a 3.66% yield could still see higher demand for their properties.
