After a decade of impressive stock market growth, some investors may be looking into investing for income. Demand for reliable income is growing as younger Baby Boomers and older Generation X-ers are approaching retirement, retirees' medical bills are rising, and investors are concerned about protecting their stock market gains, potentially through bond investing. The challenge, however, is that interest rates are on the rise, which could spell trouble for bond prices.
Why rising rates create a challenge for fixed income investors
In recent years, the Federal Reserve embarked on a policy of "normalization" - a retreat from the exceptionally low rates that were intended to stabilize the economy during the financial crisis. Since late 2015, the Federal Reserve has raised rates seven times and has signaled additional increases are still to come.
Higher interest rates seem like they should bring relief for all the savers who have been complaining about low yields on their bank accounts. But for bond investors, the situation is a bit more complex. When interest rates rise, traditional bond prices have typically declined. That inverse relationship may not seem intuitive at first, but on closer examination, it makes sense.
An investor may be perfectly happy with a bond that pays 3%. But if a new bond is issued paying 3.5%, suddenly the older, lower-yielding bond looks a lot less appealing. As a result, demand for the existing, lower-yielding bond falls, and so does its price. Fortunately, there are investment vehicles designed to help weather rising-rate environments - if you're willing to diversify your investments beyond traditional bonds.
These non-traditional sources of income have historically been less sensitive to interest rate changes and, therefore, may better maintain their value in a rising-rate environment. Some, in fact, have had increasing returns when rates have been rising, as this chart illustrates. This can be due to a variety of factors, including a greater sensitivity to the economy, foreign interest rates, or the corporate outlook. While many of these asset classes entail greater risk than traditional bond investments, the potential benefits are worth consideration.
Three ideas for generating cash flow potential now
One way to access these (and most other) asset classes is through closed-end funds. Like most open-end mutual funds, CEFs are actively managed portfolios of securities. Unlike open-end funds, however, CEF shares are bought and sold on an exchange just like a stock. What's more, CEFs are managed with the goal of providing reliable monthly or quarterly income, and they make it easy to gain exposure to many parts of the market that might not otherwise be accessible to you - including assets that may be well suited for a period of rising rates.
If you're looking for a way to generate income and you're willing to try new ideas, you might consider CEFs that invest in:
- Senior loans: Also called floating-rate loans, these are business loans that are often (but not always) secured by assets of the borrower such an inventory, buildings and equipment. Their interest or coupon rates are pegged to a benchmark such as the London Interbank Offered Rate, LIBOR. Since the loan rate periodically resets to stay in step with the benchmark, senior loans can serve as an effective hedge against rising short-term rates.
- Real assets: This category includes real estate related investments as well as global infrastructure that people use (and often pay to use) such as toll roads, toll bridges, cellphone towers, marina berths and more. Real assets can generate an attractive income stream, since many are either monopolies or signed to long-term government contracts, or in the case of real estate, receive regular rental income. Like senior loans, real assets are extremely difficult for individuals to invest in directly.
- Global high-yield securities: While these investments include a wide array of security types of varying credit quality and capital structures, they all generally offer higher yields in exchange for greater risks (most are rated below investment grade). Asset classes within this category may include preferred and convertible securities, and high-yield corporate or municipal bonds from the U.S. and other developed and emerging markets, to name a few.
A final consideration when thinking about investing in these asset classes through a CEF vs. another type of investment vehicle, is leverage. Most CEFs employ leverage, which is designed with the goal of enhancing the fund's income and return by enabling it to gain greater exposure to the market. While leverage increases risks and the volatility of returns, it can and has been largely additive over the long term, and is one of the key ways in which CEFs may offer higher distributions than other types of investments. To learn more about how closed-end funds may help your income portfolio stay afloat, and help you meet your income needs, talk to your adviser.
RISKS AND DISCLOSURES
It is important to consider the objectives, risks, charges and expenses of any fund before investing. Investing in closed-end funds involves risk; principal loss is possible. There is no guarantee a fund's investment objective will be achieved. Closed-end fund shares may frequently trade at a discount or premium to their net asset value (NAV).
Government Bonds are guaranteed as to the timely payment of principal and interest. However, there are other factors that can contribute to how securities react in various interest rate environments. Below investment grade or high yield debt securities are subject to heightened credit risk. Senior Loans may not be fully secured by collateral, generally do not trade on exchanges, and are typically issued by unrated or below-investment grade companies, and therefore are subject to greater liquidity and credit risk. Preferred securities are subordinate to bonds and other debt instruments in a company's capital structure. They combine the features of bonds and stocks, and have credit risk based on the issuer's ability to make interest and dividend payments when due. Certain types of preferred, hybrid or debt securities with special loss absorption provisions, such as contingent capital securities (CoCos), may be or become so subordinated that they present risks equivalent to, or in some cases even greater than, the same company's common stock. The real estate sector involves the risk of exposure to economic downturns and changes in real estate values, rents, property taxes, interest rates and tax laws. Foreign investments involve additional risks including currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks are magnified in emerging markets. In general, equity securities tend to be more volatile than fixed income.
Closed-end fund historical distribution sources include net investment income, realized gains, and return of capital.
Nuveen Securities, LLC., member FINRA and SIPC