Investors searching for income have a lot of options in this environment. The Federal Reserve’s rate-hiking campaign has led to near-record level yields on Treasurys, with the 10-year topping 5% in late 2023. Yet there are several places investors can turn to in search of income, especially as interest rates remain elevated and the Federal Reserve prepares to eventually start cutting rates. In this report, we highlight some of those opportunities. Generating income with dividend stocks Dividend stocks have long been a staple of income investors’ portfolios. Not only do the equities offer a payout that investors can use as income or reinvest , but they also often offer stability during times of market volatility. U.S. dividends are climbing, hitting a record high of $164.3 billion in the first quarter of 2024, a 7% increase on an underlying basis, according to the latest Janus Henderson Global Dividend Index. Newly announced dividends from Meta Platforms and T-Mobile, as well as Walt Disney’s post-pandemic dividend restoration , helped fuel the rise higher, the firm said. Some 97% of U.S. companies increased their dividend payment or held them steady, according to Janus Henderson. “Current balance sheet strength suggests this momentum will continue throughout the year,” Amber Milam, client portfolio manager at Janus Henderson, said in a statement. Wall Street is also bullish, according to Jefferies . The firm said the consensus expects dividend growth in the U.S. to accelerate to 6.2% from 3.9% in 2023. Part of the reason is due to the slowing of stock buybacks, which have soared in popularity over the past two decades, Jefferies wrote in a March 14 note. The higher cost of debt is translating to lower buybacks, which has boosted free cash flow cover for U.S. companies for dividends and buybacks to well above 1x, the firm explained. That said, there are different strategies when it comes to dividend investing. Many experts suggest looking for companies with a proven track record of raising dividends. It’s also important to ensure a company can support the dividend with earnings growth, they have said. For instance, Bank of America said with the economy in a recovery now, dividend stocks with above-market yields should outperform. In fact, high dividend yield has led 88% of the time during prior recoveries, the firm’s equity and quant strategist Savita Subramanian wrote in an April 26 note. However, investors should make sure those yields are secure and not stretched. For Subramanian, that means focusing on quintile two of the Russell 1000 by trailing dividend yield. This includes the second-highest tranche of dividend yielders in the index. It’s also important to note that those who don’t need the income immediately will benefit from the power of compounding by reinvesting the dividends. For instance, if you purchased $1,000 of IBM in 2003 and then used the dividend to purchase more shares, your holding would have been worth $3,280.95 by the end of 2023. That reflects a return of 228.1%. Choices within fixed income Corporate bonds are one popular slice of the fixed-income market and often offer attractive yields. The bonds are issued by companies to raise money for different purposes and come in a variety of maturities. Investment-grade corporate bonds are considered the safest within the space. They are issued by companies with a higher credit quality and lower risk of default. For a bond to be considered investment grade, it should be rated Baa or above by Moody’s or BBB and above by S & P and Fitch. Credit spreads have gotten tight, which means the bonds aren’t cheap. However, investors can still nab attractive yields. The effective yield of the ICE BofA US Corporate Index, which tracks the performance of U.S. dollar denominated investment-grade corporate debt, is 5.56%, according to the Federal Reserve Bank of St. Louis. “Those investment-grade bonds, high-quality bond portfolios tend to offer the greatest diversification benefits relative to the equities in your portfolio,” said Morningstar senior analyst Mike Mulach. Then there are high-yield corporate bonds, which are non-investment grade issues and have a higher risk of default. Investors are rewarded for taking on that risk by earning a higher yield. The ICE BofA US High Yield Index has an effective yield of 7.72%, per the St. Louis Fed. Experts tend to urge caution to investors entering the high-yield space, although some pros have found select opportunities. Rick Rieder, BlackRock’s chief investment officer of global fixed income, finds B-rated bonds because he thinks defaults in this part of high-yield aren’t an issue. However, he’d stay away from C-rated bonds because he believes defaults in that area are going to rise. Individual corporate bonds typically have a par, or face, value of $1,000 and can be purchased through a broker. They have varying maturities — that is, the date when the issuer must repay the principal to the bondholder. Because of this, financial advisors may suggest laddering the bonds by staggering the maturities. There are also several bond mutual funds and exchange-traded funds that offer diversification. They have a lower barrier to entry but there is no maturity date. Meanwhile, municipal bonds offer investors the combination of relatively safe yield and tax-free income , making them an attractive play at a time when taxes are expected to go anywhere but down. Yields on municipal bonds hit year-to-date highs near the end of April before inching lower, according to UBS. However, the space is expected to see some price appreciation once the Federal Reserve begins dialing back interest rates. “We believe that yields on quality municipal bonds look attractive at current levels,” wrote Kathleen McNamara, senior municipal bond strategist at UBS Wealth Management. “And, there’s also potential for capital gains as the year progresses if benchmark yields fall (as we expect).” Higher income investors also stand to see juicier yields when comparing tax-free muni bonds to their taxable counterparts. That’s because typically bond interest is taxed at the same rate as ordinary income – which can be as high as 37%. Municipal bonds offer income that’s free of federal tax, however. Further, if an investor resides in the state issuing the bond, the income is generally free of state taxes, too. That’s where tax-equivalent yield comes into play: This is the amount of pretax yield a taxable bond would need to have in order to be equal to that of a tax-free municipal bond. That means an investor in the 32% federal income tax bracket would need to find taxable bond yielding 4.41% in order to generate yield similar to that of a muni bond paying 3%, according to New York Life Investments. There are several ways to dip into the muni bond space, ranging from buying individual issues to using mutual funds and exchange-traded funds. Individual muni bonds, which are typically sold in increments of $5,000, may make sense for investors want to use the issues to build bond ladders and who can hold the issues to maturity, regardless of the price whims of the bond market in the interim. Meanwhile, funds offer investors easy diversification, but there’s the trade-off of volatility as these funds don’t have a definite maturity date and their prices can fluctuate. Alternative ways to generate portfolio income MLPs Master limited partnerships – in particular, pipeline plays – received some recognition from fixed income investing legend Bill Gross on social media platform X, where he referred to “MLP pipelines” as being ” Better than AI .” Master limited partnerships are a way to bet on the exploration, transport and processing of oil and gas. These names trade on exchanges like stocks, and they can offer dividend yields upward of 6%. The secret behind MLP’s yields stems from the way the businesses themselves are structured. MLPs are run by general partners, and the investors – or limited partners – provide the partnership with capital and receive income distributions. The partnership isn’t subject to federal income tax, but limited partners face taxes on the income they receive. C-corporations are subject to corporate income taxes and pay dividends that are taxable to the shareholders. Since MLPs avoid this “double taxation,” they can offer higher yields. The trade-off for this enhanced income is added tax complexity for investors. Partnerships give their investors a Schedule K-1 every year, which spells out the share of income received. These forms may not come until mid-March or later, which can slow down MLP investors’ tax prep and require them to go on extension. Options strategies to create income Derivative income funds , such as the JPMorgan Equity Premium Income ETF (JEPI), gathered some $22 billion in 2023, according to Morningstar. The funds are beloved by investors, as they invest in equities and use derivatives – including selling call options – to generate additional income. Though this derivative income can buffer portfolios from tough times – JEPI posted a negative return of 3.52% in 2022 while the S & P 500 had a return of -18.11% – investors aren’t likely to see the same kind of upside when broader markets rip. Indeed, the S & P 500 had a total return of 26.3% in 2023, but JEPI advanced a more modest 9.81%. Investors considering a covered call fund will need to take a step back and perform some due diligence. For instance, if additional income is what investors are truly after, a dividend-paying fund may be a better fit – and it may cost less. Further, consider comparison shopping, as all “derivative income” funds have their own quirks and differences in strategies could affect their risk/return profile. Cash-secured puts Another options-oriented strategy to consider is the use of cash-secured puts. A put option gives the investor the right to sell a stock at a stated price before an expiration date. Cash-secured puts involve writing a put option and then holding sufficient cash to buy the stock in case the put is assigned. The investor who writes the put option makes money from the premiums received. But there is a catch: Your potential profit is limited to the premium received. If the stock dips and then soars well above the strike price, then you’re missing out on upside, according to Ashton Lawrence, certified financial planner and senior wealth advisor at Mariner Wealth Advisors in Greenville, South Carolina.
