Summary
- Higher interest rates have challenged many income investment categories this year, but yield will likely remain appealing to investors given broader market uncertainty.
- Among income investments, MLPs stand out for both generous yields relative to bonds and noticeable outperformance relative to the S&P 500 year-to-date.
- For income investors, MLPs and midstream may be particularly attractive given less sensitivity to rising interest rates and diversification benefits.
With higher interest rates, yield is easier to find than it has been in some time, but many traditional income investments have come under pressure in 2023. Some income categories have been negatively impacted by rising rates, while also facing greater competition from bonds and money market funds providing more attractive yields. Today’s note looks at performance for income investments and why MLPs and midstream deserve a second look in the current environment.
Income investments largely lag the broader market in 2023, except MLPs.
Traditional equity income investments and bonds are mostly lagging the S&P 500 this year, which has gained over 15% on a total-return basis through October 17 thanks largely to the so-called Magnificent Seven stocks. This is a stark reversal from 2022 when income investments largely outperformed the loss in the broader market (read more). The chart below shows year-to-date performance and yields for several income investments.
Rising interest rates have driven some of the weakness seen for income investments. Clearly, rising rates pressure the value of bonds. Meanwhile, higher borrowing costs represent headwinds for closed-end funds (CEFs), which often use leverage (read more). Similarly, more expensive debt is a challenge for capital-intensive utilities, which are investing in renewable energy and see project returns potentially squeezed by a higher cost of capital.
The rise in interest rates has also led to increased competition among yield investments. REITs and utilities are now yielding less than corporate bonds. Unless investors are anticipating a rebound in these sectors, it may be difficult for them to assume the greater risk of these equity investments when quality fixed income investments offer higher yields. Among income investments, MLPs stand out for both generous yields relative to bonds and noticeable outperformance relative to the S&P 500 year-to-date.
Income remains attractive in an uncertain macro environment; consider MLPs and midstream.
Though performance for income investments has been mixed at best this year, investors may continue to be drawn to yield given prevalent market uncertainty. Recession risk is still a concern, the path for interest rates remains unclear, and geopolitical tensions are heightened. In challenging environments, yield can be particularly attractive as it supports total return.
With this backdrop, investors may consider giving MLPs and midstream another look. The outlook for dividends from this space remains very strong, with companies largely growing their payouts ahead of inflation as they generate free cash flow (read more).
MLPs and midstream have not been negatively impacted by rising interest rates and tend to do well in periods of elevated inflation. From a portfolio diversification standpoint, MLPs and midstream have modest long-term correlations with other income investments like bonds (near 0.0) and utilities (~0.3 – 0.4). Even with a three-year annualized total return of 42.6% as of October 17, MLP valuations are not stretched. The AMZI is trading in line with its three-year average forward EV/EBITDA multiple of 8.8×.
Bottom Line:
Higher interest rates have challenged many income investment categories this year, but income is likely to continue to appeal to investors given broader market uncertainty. For income investors, MLPs may be particularly attractive given yields more generous than corporate bonds and less sensitivity to rising interest rates.
For more on energy infrastructure in income portfolios, watch a replay of last week’s 30-minute LiveCast, “Rethinking Income with Energy Infrastructure.” For more on the income landscape and fixed income, be sure to join our Income Strategy Symposium on October 27 at 11 a.m. ET.
AMZI is the underlying index for the Alerian MLP ETF (AMLP) and the ETRACS Alerian MLP infrastructure Index ETN Series B (MLPB). AMNA is the underlying index for the ETRACS Alerian Midstream Energy Index ETN (AMNA). CEFX is the underlying index for the Invesco CEF Income Composite ETF (PCEF).
Related Research:
Examining Midstream/MLP Dividend Growth by Company
Rethinking Income with Energy Infrastructure
Is Your Income Stream Too Dependent on the Fed?
2022 Performance for Income Investments: MLPs Shine, REITs Lag
ETFs of CEFs: Diversification and Higher Distributions
For more news, information, and analysis, visit the Energy Infrastructure Channel.
Vettafi.com is owned by VettaFi LLC (“VettaFi”). VettaFi is the index provider for AMLP, MLPB, AMNA, and PCEF for which it receives an index licensing fee. However, AMLP, MLPB, AMNA and PCEF are not issued, sponsored, endorsed, or sold by VettaFi, and VettaFi has no obligation or liability in connection with the issuance, administration, marketing, or trading of AMLP, MLPB, AMNA, and PCEF.
