Over the last decade, interest rates touched levels never seen before. Under the pressure of central bankers, they mostly stayed put. Low rates have been a blessing to individual, institutional, and governmental borrowers and a curse to every saver, investor, and fixed income retiree. For investors prudently managing fixed income portfolios, balancing risk and return through the challenge of low rates is ever-present. Too often, however, it causes yield-hungry investors to look elsewhere for other possibilities.
The Truth in Labeling Campaign began in 1994 as a nonprofit organization dedicated to securing full and clear labeling of all processed foods. We need something similar for asset classes presented improperly as fixed-income alternatives. Fixed-income serves as the ballast, the safety and security of a portfolio. Too often, promoters pitch the assets below as acceptable alternatives. They are not. Primarily because of an inability to meet expectations for safety and principal protection. Their incremental income comes with additional risks, a point too often ignored or overlooked. Each of these assets can play a specific role in any portfolio. But not as a yield substitute for fixed income.
Dividend-paying common stocks
Securities that pay dividends are stocks and not bonds. While dividend stocks may be more mature and thus less volatile than other equities, they remain subject to the same factors that influence stock prices as a whole. Because they are stocks they are subject to the possibility of permanent capital losses and dividend reductions, the opposite of safety and security.
A stock/bond hybrid, preferred stocks make regular income payments. They rank higher in the capital structure than dividend-paying common stocks, but they rank lower than traditional bonds. This ranking refers to the priority of investors in a bankruptcy reorganization. That lower rank and associated risks explain the higher yields compared to bonds. Preferred stocks carry two additional risks; they will trade like equities, and issuer dividends aren’t guaranteed, leaving investors with no legal recourse when they go unpaid.
Master Limited Partnerships (MLP)
MLPs are investment partnerships designed to provide certain tax benefits. MLPs typically invest in capital-intensive energy assets with a consistent revenue stream such as pipelines, and promoters highlight the relatively high distribution streams compared to fixed income coupon payments.
The reliability of these cash flows allows the MLP to add leverage to its capital structure. In good times that leverage helps the MLP expand operations and support distributions. In bad times such as low energy prices, distributions can go to zero. MLPs trade like stocks, though they have historically experienced higher volatility than both stocks and bonds. Due to their high distribution yields, MLPs are more sensitive to changes in interest rates, declining in value in a rising rate environment.
Structured notes are another stock/bond hybrid security issued by a large bank. Like bonds, they have a limited lifespan and make regular coupon payments, and are unsecured obligations of the issuing bank. However, their stock-like characteristics add complexity, costs, and risks. Notes are structured in multiple ways to meet demand, reducing uniformity and liquidity, making it difficult for investors to understand what they are buying or find a buyer if they need to sell.
Coupons are usually reliant upon an unrelated, underlying asset such as a specific stock or index, the performance of which could mean suspended coupons. Further, whereas holding stocks allows for unlimited upside, structured notes often cap gains driven by stock market changes.