Income Alternatives

3/13/2017


A lot of people ask us why we don't recommend more high-yield investments or why our stock portfolios don't generate higher yields.

First, the short answer: We focus on total return, not yield. To us, a portfolio that gains 9% in value and yields 1% trumps one that yields 4% and grows 4%.

Next, the long answer, which involves the nature of high-yield investments: While some stocks pay generous yields, the S&P 500 itself yields 2.0%. In our view, structuring a stock portfolio to generate a substantially higher yield than the S&P is likely to expose you to more risk than you realize, as you'll end up with a basket of stocks highly concentrated in a few sectors. Thus, we focus on diversified portfolios that deliver solid total returns.

We advise most readers who seek fixed-income exposure to go with the bond funds in our recommended mutual fund portfolios (www.DowTheory.com/Go/Fund). But if you don't mind taking on some different types of risk, in this issue we also present three other types of income investments. See below for a review of bonds, preferred stocks, real estate investment trusts (REITs), and master limited partnerships (MLPs).


Preferreds follow their own path

Preferred stocks represent ownership in a company and trade on exchanges like common stocks. But preferreds are also a lot like bonds — many
pay fixed dividends, and their share prices are sensitive to an issuer's creditworthiness and interest-rate fluctuations.

Most investors in preferreds are attracted to their generous yields. The S&P U.S. Preferred Index, which has nearly 300 holdings, yields about 6.1%, compared to 2.0% for the S&P 500 Index. Many preferreds generate qualified dividend income taxed at rates up to 20%. Preferred investors take a back seat to bondholders if a company declares bankruptcy.

There are other reasons to consider preferreds. They tend to be less volatile than common stocks. The S&P U.S. preferred index has a standard deviation of 4.3% based on 60 months of returns ended February, versus 10.2% for the S&P 500. Preferreds can help diversify a portfolio of common stocks. Only 32% of the return of the preferred index is explained by movements in the S&P 500.

The table below lists five preferred stocks and five exchange-traded funds (ETFs), which are likely the better choice for many investors. iShares S&P U.S. Preferred Stock ($38; PFF), which tracks the S&P index, is a good all-weather pick. The second-oldest and largest preferred ETF, with assets of $17.0 billion, the fund is invested roughly 72% in financials and 11% in real estate. The ETF has a five-year annualized return of 6.0%.

PREFERRED STOCKS
Company (Price; Ticker)
Div.
($)
Yield
(%)
Call
Price
($)
Discount/
Premium
(%)
Call
Date
Moody's
S&P
Rating
Allstate F ($26; ALL-F)
1.56
6.0
25
5
10/2019
Baa2/BBB-
Charles Schwab C
($26; SCHW-C)
1.50
5.8
25
4
12/2020
Baa2/BBB
DTE Energy B ($24; DTJ)
1.34
5.6
25
(4)
6/2021
Baa1/BBB-
J.P. Morgan Chase AA
($26; JPM-G)
1.53
5.9
25
3
9/2020
Baa3/BBB-
NextEra Energy K ($23; NEE-K)
1.31
5.6
25
(6)
6/2021
Baa2/BBB
--- Total Return ---
Company (Price; Ticker)
Div.
($)
Yield
(%)
12
Months
(%)
3-Year
(Annual.)
(%)
Assets
($Bil.)
Exp.
Ratio
(%)
First Trust Preferred & Inc.
($19; FPE)
1.11
5.7
11.8
7.6
1.8
0.85
iShares U.S. Preferred ($38; PFF)
2.19
5.8
5.7
5.9
17.0
0.47
PowerShares Fin'l Preferred
($18; PGF)
1.05
5.7
6.1
7.7
1.7
0.63
PowerShares Preferred ($15; PGX)
0.85
5.8
6.1
7.7
4.5
0.50
VanEck Vectors Pref.Ex-Fin'ls
($20; PFXF)
1.15
5.8
6.7
5.8
0.4
0.41

Don't fear bond funds

On the surface, higher interest rates do not paint a pretty picture for bond investors. That's because bond prices tend to move in the opposite direction of Treasury yields. The yield on the benchmark 10-year Treasury note stands at 2.5%, up from 1.9% on Nov. 8 — the day before the presidential election. With the Federal Reserve expected to raise interest rates three times in 2017, should investors avoid bonds?

We don't think so. Bonds ultimately help preserve wealth by reducing the volatility of a stock portfolio. And while rate hikes could weigh on bond-market returns in the short term, over the long run investors may benefit by reinvesting and compounding their interest income at higher yields.

To be sure, the timing and impact of interest-rate hikes are difficult to forecast. To help reduce risk, investors are encouraged to hold a variety of bonds or bond funds. Most investors should focus on short-term bonds. The shorter a bond's duration, the less potential to be stung by rising rates. A fund with an average duration of four years will see its share price fall roughly 4% in response to a one-percentage-point increase in interest rates. Besides holding up better when rates rise, short-term bond funds replace their holdings more often than long-term funds, allowing them to take advantage of rising rates.

The table below lists 10 attractive exchange-traded funds (ETFs). All 10 ETFs boast solid track records and low expenses, averaging only 0.17%. Vanguard Short-Term Corporate Bond ($79; VCSH), which charges only 0.07%, is a solid core holding for most conservative investors. Yielding 2.1%, we use this fund for the cash portion of our buy lists. The ETF, which has a duration of 2.8 years, has gained 2.8% over the past year.

TOP BOND FUNDS
-- Total Return --
Fund (Price; Ticker)
Yield
(%)
12
Months
(%)
3 Year
(Annual.)
(%)
Dura-
tion
Exp.
Ratio
(%)
Category
iShares iBoxx $ High Yield
Corp. ($87; HYG)
5.2
13.5
2.9
3.9
0.50
High yield
iShares Nat'l Muni. ($108; MUB)
2.2
(0.3)
3.1
6.3
0.25
Tax-free
Schwab U.S. Aggregate
($51; SCHZ)
2.3
0.8
2.5
5.8
0.04
Total market
SPDR Barclays Convertible
($47; CWB)
4.3
17.5
5.2
NA
0.40
Convertible
SPDR Barclays TIPS ($56; IPE)
1.9
2.8
1.7
5.7
0.15
Inflation
Vanguard Inter.-Term Gov't
($64; VGIT)
1.6
(1.1)
1.9
5.2
0.07
Gov't interm.
Vanguard Interm.-Term
($83; BIV)
2.6
0.9
3.1
6.5
0.09
Interm. term
Vanguard Mortgage-Backed
($52; VMBS)
1.8
0.0
2.4
4.7
0.07
Gov't bonds
Vanguard Short-Term Corp.
($79; VCSH)
2.1
2.8
1.9
2.8
0.07
Corp. bonds
Vanguard Short-Term Gov't
($61; VGSH)
0.8
0.3
0.6
1.9
0.07
Gov't bonds

Don't let REIT rally suck you in

Over the last year, the S&P U.S. REIT Index returned more than 17%, reflecting a strong real estate market. It's almost enough to make you forget that over the last 10 years, the index returned an annualized 4.6%, well below broad stock indexes.

Real estate investment trusts (REITs) own, and in most cases manage, portfolios of real property. Their special tax treatment allows most of them to pay unusually high yields, which appeals to many investors. Over time, real estate hasn't proven to be an impressive growth industry.

The group as a whole has weak fundamentals, as reflected by Quadrix Overall scores, and trades at an unappealing valuation. Our Alternative Income Watch List (www.DowTheory.com/Go/Alt) contains 46 REITS, of which 14 earn A (above average) ratings. While an A rating implies we think better of them than we do of most REITs, there are reasons why no REITs make it onto our buy lists. Interpret these A ratings (and those of the MLPs in the story below) as more of a comparison to the group than as a recommendation to purchase.

A-RATED REAL ESTATE INVESTMENT TRUSTS
At the moment we rate 14 REITs A (above average) in our Alternative Income Watch List.
---------------- Quadrix Scores ----------------
---- REIT-Specific ---
Company (Price; Ticker)
Div.
($)
Yield
(%)
Value
Overall
12-
Factor
Reranked
Overall
American Tower ($113; AMT)
2.32
2.0
36
55
62
38
Apartment Investment
($45; AIV)
1.44
3.2
31
46
61
32
Camden Property  Trust
($80; CPT)
3.00
3.8
47
64
52
44
CoreCivic ($32; CXW)
1.68
5.3
61
79
97
99
Equity Lifestyle Pptys.
($78; ELS)
1.95
2.5
20
54
29
79
Extra Space Storage ($79; EXR)
3.12
4.0
42
67
64
55
Host Hotels & Resorts
($18; HST)
0.80
4.4
60
72
98
79
Lamar Advertising ($76; LAMR)
3.32
4.4
36
62
85
55
LaSalle Hotel Properties
($29; LHO)
1.80
6.3
71
90
98
96
Liberty Property Trust
($38; LPT)
1.60
4.2
57
70
85
88
Omega Healthcare ($32; OHI)
2.48
7.8
84
73
45
54
Summit Hotel Properties
($15; INN)
0.65
4.2
76
93
100
91
Ventas ($61; VTR)
3.10
5.1
50
47
70
65
Welltower ($67; HCN)
3.48
5.2
36
50
75
35
Notes: Quadrix scores are percentile ranks, with 100 the best. 

MLPs looking better

Most master limited partnerships (MLPs) operate in the energy sector. And as energy stocks regained some of their fundamental momentum over the last few months, MLPs have benefited.

The average MLP in our Alternative Income Watch List earns a Quadrix Overall score of 59, after spending most of the last few years in the 40s. We currently recommend one MLP, EQT Midstream Partners ($78; EQM) on our recommended lists. EQT Midstream and two others, CONE Midstream Partners ($23; CNNX) and Star Gas Partners ($9; SGU), are components of our Top 15 Utilities portfolio
(www.DowTheory.com/Go/Top15).

Because of their partnership structure, MLPs avoid taxation at the corporate level, freeing them to pay fat distributions. However, that income-generation potential comes at a price — tax complications for investors, who will receive a Form K-1.

MLPs, similar to REITs, don't operate like traditional corporations, and as such traditional statistical analysis doesn't always work for them. To help us better assess MLPs (and REITs), we developed special Quadrix scores that compare these stocks to others within their group, similar to our sector-specific scores but more tightly focused.

A-RATED MASTER LIMITED PARTNERSHIPS
Below we present the 15 master limited partnerships (MLPs) in our Alternative Income Watch List that earn A (above average) ratings.
---------------- Quadrix Scores ----------------
---- MLP-Specific ---
Company (Price; Ticker)
Div.
($)
Yield
(%)
Value
Overall
12-
Factor
Reranked
Overall
Alliance Holdings ($28; AHGP)
2.20
7.9
99
98
95
98
Alliance Resource Part.
($22; ARLP)
1.75
8.0
99
99
98
100
AllianceBernstein Holding
($23; AB)
2.68
11.7
81
92
90
91
Boardwalk Pipeline Part.
($18; BWP)
0.40
2.2
90
94
64
93
Cedar Fair ($68; FUN)
3.42
5.1
63
87
71
75
CONE Midstream Part.
($23; CNNX)
1.09
4.8
83
78
31
80
Energy Transfer Equity
($19; ETE)
1.14
6.1
91
91
99
95
EQT Midstream Part.
($78; EQM)
3.40
4.4
83
86
72
89
Holly Energy Partners ($34; HEP)
2.43
7.1
65
59
59
60
Oaktree Capital Group
($45; OAK)
2.52
5.7
90
97
74
97
Phillips 66 Partners ($54; PSXP)
2.23
4.1
74
91
80
88
Star Gas Partners ($9; SGU)
0.41
4.4
81
67
89
70
Tallgrass Energy Partners
($52; TEP)
3.26
6.2
68
88
77
82
Tesoro Logistics ($55; TLLP)
3.64
6.7
65
77
79
69
Valero Energy Partners
($47; VLP)
1.63
3.4
61
88
100
83
Notes: Quadrix scores are percentile ranks, with 100 the best. 

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