The U.S. annual inflation rate reached 8.6% in May 2022, a 40-year high. The Federal Reserve has been on a path to raise interest rates aggressively, in the quest to lower inflation to target levels nearer to 2-3%. The current 10-year U.S. Treasury Bond rate is at around 3%. The S&P 500 index has a current yield of just shy of 1.4%. Where do income investors look for attractive and sustainable yield, and the prospect of income growth that tracks inflation? It requires some digging, but here are a few sectors worth considering:
Public Real Estate Investment Trusts (REITs)
Many public REITs are yielding 4-5%. They engage in the acquisition and leasing of properties used for retail, medical, office, industrial, warehouse, and other operations. Retail tenants include convenience stores, auto services, restaurants, health and fitness clubs, etc. Investors can expect to get 4-5% current dividends with various levels of growth potential. Not all REITs are created equal so look for these characteristics to help mitigate risk: (1) a long-term track record of growing and consistent dividends; (2) triple-net leases, in which the tenant is responsible for property taxes, insurance, and maintenance expenses on top of lease payments; (3) leases structured with inflation escalator clauses, ensuring that lease payments track cost-of-living increases to at least some extent; (4) a large proportion of properties that represent profit centers to the tenants, making it less likely they will relocate away from their current locations; and (5) tenants with strong credit profiles that are less likely to default.
Business Development Companies (BDCs)
BDCs are lenders to private small- to medium-sized companies (SMEs) across a wide range of industries and geographies in the U.S. Due to these SMEs’ size and/or shorter operating history, traditional lending sources such as banks tend to be reluctant to lend to them. BDCs can distribute highly attractive levels of dividends (8-11% currently) because they charge higher interest rates than bank lenders and, similar to REITS, are required to distribute 90% of their income by law. Many BDCs will also benefit from the rising interest rates as they lend primarily based on floating rates. Investors, however, need to be highly selective when performing due diligence on the 40+ publicly-listed BDCs. The key risk is that some of the loans to the SMEs might experience defaults and a high enough level of defaults can result in BDCs losing money and cutting dividends. The underwriting skill and credit culture of BDCs’ management teams are, therefore, the most important factors to consider when investing. A few select BDCs have a successful history of prudent underwriting that has led to low default rates even during recessions, and therefore attractive returns to investors. A number of these are affiliated with larger, successful alternative asset management firms.
Energy and infrastructure companies
No time is like the present as a reminder of the importance of energy in our daily lives and national security. Alternative energy is critical to the planet’s and the free world’s future and investors have access to alternative energy infrastructure companies paying 3-4% dividends with the potential to grow them at above-inflation rates due to the built-in inflation hedges in the contracts between the companies and customers. It is also important to acknowledge that oil and gas are here to stay for the coming decades. War in Ukraine is shedding new light on the meaning of ESG – in particular, the S in ESG – as completely divesting from O&G-related investments can have unintended consequences in a world where democracy is still too dependent on dictatorships. Energy pipeline companies offer very attractive yields in the range of 5-8%. These companies differ among themselves in their exposure to alternative energy, oil, gas, and coal. Similar to investing in other sectors, investors need to be highly selective regarding the management team, company balance sheets, and dividend sensitivity to energy prices, among other factors.