Rock bottom interest rates are terrific if you are, say, refinancing a mortgage. But if you’re looking for income from your portfolio? Not so much.
In the current economic environment, in which interest rates have been steadily rising over the last six months but remain low by historical standards, traditional high-quality bonds aren’t exactly blowing anyone away with their returns.
Meanwhile a recent Fortune report outlined how the S&P 500 could return 0% through early 2028 if interest rates rise significantly. This presents unique challenges to investors looking for income-generating investments.
In a new report titled “The Search for Income,” Jeff Buchbinder, Equity Strategist for LPL Financial, highlights three key equity income ideas expected to perform well in a rising income rate environment. The report emphasizes a preference for stocks over bonds, which— supported by low interest rates— is one of the company’s “highest conviction recommendations for 2021.
Here’s where LPL’s analysts see potential.
1. Energy
The energy sector currently yields about 5% based on dividends in 2020, topping all S&P 500 sectors. According to Buchbinder’s report, there are several factors impacting LPL Financial’s increased optimism in investments into the energy sector.
With vaccine rollouts well underway in the United States and abroad, a fully reopened economy and a return to travel is expected in the coming year, which will likely benefit the energy sector in a big way, according to Buchbinder.
In a recent report in Fortune, Stephane Barbier de la Serre of Makor Capital Markets SA said that among others, oil and gas equities will lead returns going forward, echoing Buchbinder’s outlook.
Additionally, Buchbinder’s analysis expects oil prices at least to hold steady in the $55-60 per barrel range for the remainder of the year, “sufficient for the sector to maintain rich yields while potentially seeing some additional price appreciation—on top of the 17% year-to-date gain.”
Investing in energy is not without risk, as oil markets have proven over the last year to be volatile, and the market for alternative energy is on the rise, especially under a new administration that’s looking to move away from oil. Thus, as Buchbinder writes, this “may be more of a medium-term trade than a long-term investment.”
2. Banks
Back in August, Fortune outlined why bank stocks “looked like great buys” in the pandemic market: “It’s hard to imagine a recovery where the banks don’t rebound in lockstep with the rest of American business.”
That was six months ago, and while banks may come as a surprising entry as an income idea, banks do not carry the interest rate risk that bonds do, according to “The Search for Income.”
“Historically, bank stocks have exhibited positive correlation to interest rates (the stocks have tended to outperform as yields have risen)” wrote Buchbinder. “Bank stocks also tend to like a steepening yield curve—long-term interest rates rise faster than short-term rates—which we expect to see over the balance of 2021 as the economic recovery gains steam.”
And as the country continues to progress in distributing vaccines and inches closer to a fully reopened economy, an economic recovery is inbound. This should bode well for the profitability of the financials sector, according to Fortune and Buchbinder’s report.
Or, as Fortune‘s Shawn Tully memorably put it: “Investors think that banks are dogs that can barely waddle,” he wrote. “If they just manage to stroll, they’ll rank among the market’s big winners.”
3. Bank Loans
The potential volatility of interest rates moving forward presents a legitimate risk for investors. Buchbinder suggests that bank loans “may be an attractive option due to the improving economic environment and limited rate sensitivity” for investors looking to limit interest rate risk. Bank loans are loans issued by below investment-grade companies for short-term funding purposes with higher yield than short-term debt and involve risk, according to LPL’s February Global Portfolio Strategy report.
This is because, as seen in the figure below, bank loans offer potential yields in the 4% range with very low interest rate sensitivity. Bank loans clearly stand out in the chart below, which ranks the major fixed income sectors by income per unit of interest rate risk.
Thus, “bank loans provide an attractive income option relative to other fixed income alternatives for investors looking to limit interest rate risk at the beginning of a possible rising rate cycle,” Buchbinder wrote. Individual investors can most easily access the sector by buying shares in a mutual fund that pools bank loans, such as these.
