Looking beyond the obvious for yield

A dvisers are looking more broadly at asset classes for income opportunities — but there is more work…

A dvisers are looking more broadly at asset classes for income opportunities — but there is more work to be done. The reality is that investors remain unclear about the opportunities in nontraditional income sources. In a recent BlackRock Inc. Barometer poll of advisers and investors, 83% of advisers agreed that “investing for income” makes clients think “bonds” — as in, just bonds. About six in 10 indicated that “clients understand very little about investing for income.”

Investors, for their part, are concerned about risk: 64% believe income investing is “riskier” than five years ago. It all suggests that advisers have a solid opportunity to provide clients with valued guidance into a new world of income while digging deeper for the creative solutions needed for successful portfolios.

Thankfully, there are numerous, meaningful income opportunities with manageable risk profiles beyond traditional income sectors. Here are some ideas for advisers to consider with clients.

High-yield bonds and bank loans. Conditions remain favorable for high-yield corporate bonds as an attractive income source. With the tail wind of economic recovery and global accommodative monetary policy, the bonds offer strong yield as well as low default rates. At the same time, with greater emphasis on default risk comes greater sensitivity to equity markets, so advisers will want to balance their clients’ portfolio exposure to each asset class. An asset class similar to high yield offering attractive income is floating-rate bank loans. Such loans typically finance lower-rated companies and offer an interest rate that “floats,” or gets reset, on a regular basis based on a benchmark such as the London InterBank Offered Rate, making the loans relatively insensitive to interest rate movements.

Real estate investment trusts. Going beyond stocks and bonds can offer opportunity as well. Real estate investment trusts are tax-advantaged entities that historically have provided attractive income based on investments in real estate, rental payments and gains from property sales. One cautionary note is that current valuations are expensive and yields are low relative to historic levels. REITs also have exhibited higher volatility than other equities, partially due to the leverage typically employed.

Master limited partnerships. Master limited partnerships can offer both attractive yields and dividend growth rates, almost twice that of REITs. MLPs usually develop income from the extraction and transport of natural resources such as oil and natural gas. Like REITs, MLPs enjoy preferential tax treatment. It’s possible, but unlikely, that this treatment could be challenged after the November elections.

Sovereign and emerging-markets debt. Sovereign debt has emerged from the European debt crisis as an appealing new credit sector. Rather than being treated as a risk-free asset, governments now are treated as issuers with credit and default risk, with prices and yields to match. Emerging-markets debt also provides opportunity, with debt from companies in developing nations, denominated in local currencies. Various risks accompany these securities, but they can provide yield and access to developing economies.

Preferred stock. These securities share characteristics of both stocks and bonds, in terms of paying a dividend and offering compensation before stockholders in the event of default, but not granting voting rights to the holder. These different characteristics can deliver diversity to an income portfolio.

Dividend-paying equities. Dividend-paying equities, perhaps underappreciated for income, can offer access to sustainable and growing yield. While equities as a whole are out of favor and volatile, selectively investing in stable global dividend-paying companies can offer consistent income. Importantly, incorporating this equity category remains one of the few ways to increase an income stream to combat inflation’s inevitable erosion of value.

To gain a balance of greater-yielding but manageable risk, advisers and their clients today need to be more flexible and dig deeper in their search for income. Looking beyond the traditional sources presents a range of underappreciated income prospects with manageable risk profiles.

Michael Fredericks is a managing director and head of U.S. retail asset allocation for BlackRock Multi-Asset Client Solutions. He is responsible for the development of asset allocation strategies for individual investor clients.