Income Investing Playbook 2024: Navigating the New Interest Rate Regime

Introduction to Income Investing

Income investing is a strategy that aims to generate a steady stream of income from investments, typically through interest payments or dividends. Income investing is often favored by investors who prioritize regular cash flow. Income investments include a range of assets such as bonds, dividend-paying stocks, and real estate investment trusts (REITs). While income investing may offer less potential for significant capital gains, it can provide a reliable source of income and help diversify an investment portfolio.

Types of Income Investments

Below are three of the most common types of income investments:

• Bonds: Fixed income securities issued by corporations, governments, or municipalities that pay a predetermined rate of interest to investors.
• Dividend-paying stocks: Stocks of companies that pay out a portion of their earnings to shareholders in the form of dividends.
• Real estate investment trusts (REITs): Companies that own and manage income-generating properties such as office buildings, shopping centers, and apartment complexes.

Opportunities for Income Investing in 2024

After a decade of extremely easy monetary policy, zero rates may feel like a baseline to some investors. However, it’s important to realize that 2022 marked the end of the “easy money” era and signaled a regime change in rates. The Fed’s recent round of rate hikes has simply brought treasury yields back to their long-term average, and investors who piled into bonds at the beginning of 2023 hoping to catch a quick reversal in rates are still waiting. We believe capturing opportunities in the current market environment requires a longer-term view.

Income Investing in 2024: Where to Focus

Investors looking for a “trade” in 2024 shouldn’t expect rates to fall. That said, the good news for those with a longer-term view is that yields have reset higher across fixed income markets, which means bonds are well positioned in a range of different economic and interest rate scenarios. As we highlighted last year, when rates rise, investors benefit from higher yields, and indeed carry has come back to the fixed income market, leading current income to play a more significant role in bond returns. For example, at current yields, the income earned on the current 10-year Treasury note provides a return buffer even if rates continue to rise next year. As you move farther out the credit risk curve, the carry is even higher. This is enabling fixed income to be more resilient in the face of a wide range of potential market movements, including ones with even higher yields, credit spreads or volatility.

Of course, determining the right mix of income investments for a broader strategic allocation will depend on each investor’s individual risk appetite. In the sections that follow, we provide the resources you need to better understand the risk and opportunities across the income investing landscape.

• Don’t Ignore Floating Rate Instruments
• Emerging Markets Remain Well Positioned
• Dividend Investing: Stocks Generate Income, Too!
• Municipal Bonds Are a Staple of Any Income Allocation
• Investment Grade Bonds Are Attractive…If You Know Where to Look
• High Yield Benefits from “Fallen Angels”
• The Grass Gets Greener for Green Bonds
• We’ll Take All that to Go, Please: Benefits of a Multi-Asset Income Strategy
• VanEck Income Investing Solutions

Don’t Ignore Floating Rate Instruments

While the risk of rising rates has decreased with yields resetting higher, investments with less sensitivity to rate movements are still an important part of any broader fixed income allocation. Floating-rate instruments are an excellent way to gain exposure to the attractive short-term yields in the current market that remain significantly higher than longer term yields, while still maintaining protection if rates take a turn higher. In addition, interest rate volatility has remained elevated, and because the prices of floating rate securities are not impacted by movements in interest rates, they can provide meaningful diversification within a broader fixed income portfolio.

In our view, these are three compelling ways to gain exposure to floating rate instruments:

1. Investment grade floating rate notes (FRNs)
2. Collateralized loan obligations (CLOs)
3. Business development companies (BDCs)

FRNs have coupons that are based on a short-term base rate such as the London Interbank Offered Rate (Libor) or Secured Overnight Funding Rate (SOFR), which reflect short-term funding costs, and an additional fixed spread that reflects the credit risk of the issuer. In the current “higher for longer” environment, investment grade corporate floating rate notes may continue to offer an attractive combination of enhanced yields and safety. The floating rate nature of FRNs means they have low or negative correlation to rate-sensitive fixed income asset classes, such as Treasuries or fixed coupon investment grade bonds. This may allow FRNs to fulfill two primary roles that fixed income can have within a balanced portfolio: income and diversification. Further, this is achieved without adding significant credit risk since the bonds carry investment grade ratings. This contrasts with leveraged loans, another floating rate asset class, which provide higher yields but with much higher credit risk.

We believe CLOs are a better way to access leveraged loans. A CLO is a portfolio of predominantly senior secured bank loans (aka leveraged loans) that is securitized and actively managed. CLOs are not just a hedge against rising rates. They also have historically provided higher levels of income for a lower level of risk – making a clear case for a strategic allocation. Over the long term, CLOs tranches have historically performed well relative to other corporate debt categories, including leveraged loans, high yield bonds and investment grade bonds. The ability to capture attractive opportunities throughout the CLO rating spectrum can provide attractive income and total return opportunities in different market environments. CLOs are structured to help mitigate risk, through the strength of their underlying collateral, active management, as well as built-in protections such as subordination coverage tests to correct collateral deterioration. This has historically helped investment grade rated CLOs experience significantly lower levels of principal loss when compared with corporate debt and other securitized products.

BDCs are another alternative high income source investors should consider when looking to enhance yield in their portfolio by tapping into private credit, which can otherwise be hard to access. BDCs generate income by lending to, and investing in, middle market companies. BDCs provide capital to small businesses, and in turn, give investors access the high income potential of middle market loans that are generally exclusive and difficult to access. While not without risk, BDCs have historically offered yields well above other high yielding asset classes.

Emerging Markets Remain Well Positioned

Emerging Markets Debt (EMD) offers a compelling investment case, particularly in the current global financial landscape. EMD’s appeal lies in three main areas: First, emerging markets demonstrate stronger fiscal responsibility with lower debt-to-GDP ratios and higher yields compared to developed markets, making them a beacon of fiscal prudence. Second, historical performance data from 2003-2022 reveals that EMD, particularly in hard currency, delivers similar returns to U.S. High Yield but with half the volatility, suggesting it should be more prominently featured in strategic allocations. Lastly, EMD’s liquidity, lower default rates, and recovery values challenge the perception of higher risk, revealing it as a potentially safer and more rewarding option than its developed market counterparts.

Dividend Investing: Stocks Generate Income, Too!

Dividend paying companies have been en vogue for much of the last 15 years as investors searched for yield beyond traditional income investments throughout the prolonged low-rate environment. As the tide turns and the market adjusts to elevated inflation, rising rates and increased market volatility, we believe it is best to focus on high dividend yielding U.S. companies with strong financial health and attractive valuations. This allows investors to gain exposure to high yielding companies, but hones in on those that have less of a likelihood of cutting their dividends and aren’t trading at excessive valuations.

Learn how to develop a dividend investing strategy that generates a steady stream of passive income. Follow these actionable tips and advice to start building your portfolio today.

Municipal Bonds Are a Staple of Any Income Allocation

In a slowing economy, municipal bonds stand out as an attractive investment for three key reasons. Firstly, they generally have higher credit ratings, with about 70% in the top two categories of the Bloomberg Municipal Bond Index, offering stability and low default rates even during recessions. Secondly, improved credit conditions are evident, as state and local governments possess robust rainy-day funds and sustained tax revenues, enhancing financial stability. Lastly, municipal bonds have historically shown positive returns post-recession, demonstrating resilience in economic downturns, with their performance being context-dependent. These factors collectively make municipal bonds a compelling option for investors seeking stable, secure investments during economic uncertainties.

Investment Grade Bonds Are Attractive…If You Know Where to Look

With investment grade corporate bond yields providing meaningful income and with elevated market volatility, we believe there are now opportunities in mispriced bonds with attractive valuations. That said, selectivity matters. Given the size and diversity within corporate bonds, we believe being selective can provide better outcomes for investors. In particular, focusing on attractively valued bonds has historically provided significant outperformance. The market is not homogenous, and there is significant scope for mispricing to exist.

High Yield Benefits from “Fallen Angels”

Fallen angel high yield bonds, downgraded from investment grade to high yield status, offer a unique value in the bond market. They tend to be undervalued prior to downgrade and often recover afterward, leading to historical outperformance compared to the broad high yield market. Their distinctive attributes include systematic investment in oversold bonds, differentiated sector exposure, and higher credit quality. This has resulted in consistent outperformance across various market conditions, including different interest rate and spread environments. Fallen angels, typically issued by larger, established companies, also have a higher upgrade rate to investment grade, presenting a contrarian investment approach with a quality focus. For an overview of recent performance, listen to VanEck’s Product Manager Nico Fonseca discuss fallen angels in the third quarter of 2023.

The Grass Gets Greener for Green Bonds

Green bonds are financing projects all over the world that have a positive environmental impact and provide a pathway to sustainable development. The green bond market’s explosive growth over the past decade has coincided with increased rigor and transparency. As the market matures, standards continue to tighten as recognition grows that increased ambition is needed along with greater green investment to meet global climate goals.

In the current environment, we believe green bonds offer investors a way to build sustainable core fixed income portfolios without significantly affecting risk and return. In addition, the green bond market offers emerging markets an opportunity to fund ambitious sustainability goals, and some countries are already leading the way. Emerging markets will require annual investments to more than triple from $770 billion in 2022 to $2.8 trillion by the early 2030s in order to meet rising energy needs while fulfilling climate goals set by the Paris Agreement.¹ We believe that the global emerging markets debt market can play a crucial role in satisfying this financing need. With a strong fundamental investment case for emerging markets debt and the asset class demonstrating relatively strong returns over the last two years versus developed markets fixed income, there is an opportunity for emerging markets to tap into the growing green bond market, in our view. Green bonds have proven themselves to be an attractive solution for both sovereign issuers and fixed income investors. They have the same characteristics as a traditional bond, and thus a similar risk/return profile all else equal, but only finance environmentally friendly projects.

We’ll Take All that to Go, Please: Benefits of a Multi-Asset Income Strategy

Take the guesswork out of trying to manage a high yielding portfolio. A multi-asset income strategy offers professional management designed to help investors navigate the underlying risks associated with high income investing. Active management can also help investors navigate turbulent capital markets. By tactically shifting allocations, the portfolio management team may be able to enhance downside protection as well as upside participation.

VanEck Income Investing Solutions