COLUMN-Income investing benefits from spreading the wealth around: Fridson

(The views expressed here are those of the author, the publisher of Income Securities Advisor.) By Marty Fridson

NEW YORK, Sept 15 - At a time when inflation remains elevated and interest rates look set to start falling, generating income is likely to be high on investors' wish lists. But meeting this goal in a sustainable manner will likely mean casting a wide net. Suppose you are an investor who is primarily interested in generating income, but you also care about preserving – or if possible, increasing – your principal. Which of the many types of income investments might you choose?

Judging by the latest month's price performance, you might select Real Estate Investment Trusts (REITs). The MSCI US REIT Index rose by 4.26% in August. By the same logic, you would not want to be in Master Limited Partnerships (MLPs), which fell by 1.83%. If you expand your time perspective, however, you will find that over the past 12 months, REITs weakened by 4.08% while MLPs posted a 6.96% gain.

So I'll ask again, which income category would an investor want to own? The answer appears to be "several."

TRACK RECORD Let's begin by looking at the historical performance of some asset classes an income-focused investor would most likely consider.

During the period 2006 through 2024, the steadiest performers, with just five years of negative price changes, were dividend growth stocks, while closed-end funds fared the worst over this period, with negative price changes in the majority of those years. Does that mean an investor should put all their eggs in the dividend growth basket and chuck the closed-end one?

Obviously no. Dividend growth stocks may offer stability, but they also generated the lowest yield of the seven asset classes. The highest yield, meanwhile, was provided by the more volatile closed-end funds.

BALANCING ACT Satisfying the dual objectives of generating a high income and maintaining a stable principal, therefore, requires a tradeoff.

A reasonable balance between the two objectives could potentially be achieved by owning an equally weighted portfolio of all seven asset classes. With just six down years, that strategy nearly matches the dividend growth stocks' record of only five over the period under discussion, and this number of down years is meaningfully below the median of eight among all of these asset classes.

At the same time, the equally weighted portfolio's 5.63% yield is more than twice that of the dividend growth stocks' 2.48% and is close to the group's median of 5.95%. This outcome – return with an acceptable level of risk – is the sort of benefit one hopes to achieve through diversification.

UNPACKING DIVERSIFICATION Up to this point, the case for diversifying income investments by asset type has been made solely on the basis of historical data.

Kudos to you if the wise investment adage "past performance is no guarantee of future results" is currently running through your mind. You are quite right to question whether the figures discussed above are just reflections of conditions in the years depicted or whether there are underlying reasons why the various asset classes often produce these offsetting ups and downs. With the caveat that asset classes always have the potential to behave differently as the economic environment changes, there are logical grounds for expecting the benefits of diversification to persist in income investing.

In simplest terms, different economic factors drive the price movements of the various asset classes under discussion. For example, investment grade corporate bonds' price movements closely reflect fluctuations in interest rates, as measured by yields on U.S. Treasuries. High yield bonds, on the other hand, have more default risk than their investment grade counterparts, so their prices exhibit greater sensitivity to changes in the macroeconomic outlook.

Just look at the performance records in 2024. The ICE BofA US High Yield Index posted a 1.41% price gain as the Moody's Investors Service U.S. default rate forecast dropped from 4.1% to 2.7%. Over the same period, the more interest-rate-sensitive investment grade ICE BofA US Corporate Index's price change was -1.73%. That reflected the rise in the benchmark ten-year U.S. Treasury rate from 3.89% to 4.58%.

Given these divergent patterns, holding both asset classes should help to mitigate risk in an investor's overall portfolio over time – a classic example of the benefits of diversification. An even more dramatic demonstration of the power of asset class diversification occurred in 2022. The income markets were hit with a double whammy, as the ten-year Treasury yield spiked from 1.50% to 3.83% and Moody's U.S. default rate forecast jumped from 2.6% to 5.9%.

All of the income categories in this study posted negative returns, ranging from 8.47% to 27.33% – except for one. Amid the devastation elsewhere, the Alerian MLP Index recorded a stunning +21.63% gain. The explanation: Master Limited Partnerships' valuations are linked to oil prices, so they benefited from a 10.5% rise in Brent crude prices in 2022. Diversification, then, might not be a novel idea, but in income investing – as in most other areas – it appears to remain the prudent one.

(The views expressed here are those of Marty Fridson, the publisher of Income Securities Advisor. He is a past governor of the CFA Institute, consultant to the Federal Reserve Board of Governors, and Special Assistant to the Director for Deferred Compensation, Office of Management and the Budget, The City of New York. This article is for informational purposes only and should not be construed as investment advice.) (Writing by Marty Fridson; editing by Anna Szymanski)

(This story has not been edited by Devdiscourse staff and is auto-generated from a syndicated feed.)