3 Income Alternatives to Consider

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. As interest rates remain stubbornly low, investors maybe seeking alternative income-generating securities. Joining me today to discuss the pros and cons of three such income-producing alternatives is Amy Arnott. Amy is a portfolio strategist at Morningstar.

Hi, Amy. Thank you for being here today.

Amy Arnott: Hi, Susan. Great to be here.

Dziubinski: Amy, you've been writing a series of articles on Morningstar.com that sort of evaluate the various rocks that investors have been turning over in search of income. Let's start by talking a little bit about the backdrop today for bond investors. What's the climate like out there?

Arnott: Sure. It's very difficult. Interest rates have edged up a little bit so far in 2021, but we're still close to an all-time low. The 10-year Treasury is currently yielding about 1.4%, 1.5%. And the Fed has also said it doesn't expect to raise interest rates until at least 2022. So, that means bonds may not even keep up with inflation and a lot of income-oriented investors are looking for more yield.

Dziubinski: One of the articles that you wrote about focused on whether preferred stocks are good income alternatives for bond investors. Let's start by talking about what is a preferred stock and how does it work.

Arnott: They're basically a hybrid between stocks and bonds. Like bonds, they make regular income payments, but they rank lower in the capital structure than traditional bonds. So, you're not necessarily getting a guaranteed income stream.

Dziubinski: What are some of the advantages of preferred stocks today for income seekers?

Arnott: So, the main advantage is yield. If you look at preferred-stock funds, they have an average SEC yield of about 5.3% as of the end of February. There's also some tax advantages because most preferred-stock dividends are taxed at capital gains rates instead of ordinary income tax rates.

Dziubinski: What are some of the disadvantages or risks to be aware of if you're looking at preferred stocks as an alternative?

Arnott: Credit risk is really the major issue. And as I mentioned, the dividends aren't guaranteed. So, in 2020, we actually saw a lot of companies either suspend or eliminate their dividend payments on preferred stocks.

Dziubinski: Amy, you referred to preferreds as hybrid securities, meaning they're a little bit like bonds and a little bit like stocks. So, if an investor is interested in adding preferreds to a portfolio, should we be thinking about them more as part of our bond allocation or more of our equity allocation?

Arnott: They're really not a bond substitute. At the end of the day, they're still stocks, and especially, in market downturns, they're going to behave more like stocks and usually lose about as much as the overall market in a downturn.

Dziubinski: Now, let's pivot and talk about real estate investment trusts, or REITs. That's another alternative that income seekers might be considering. What are REITs and how do they work?

Arnott: So, these companies, short for real estate investment trusts, own or operate real estate, including things like retail, commercial office space, apartments, or hotels.

Dziubinski: And what are some of the advantages of holding REITs in a portfolio?

Arnott: The main advantages are really yield and diversification. The average REIT stock has a dividend yield of about 5%, and they've also historically had a relatively low correlation with the equity market. So, that can help improve diversification.

Dziubinski: So, then, what are some of the cons or the risks here to keep in mind?

Arnott: With real estate, we usually see some pretty pronounced boom and bust cycles. And another disadvantage is it doesn't always hold up that well in market downturns. In early 2020, for example, with the COVID bear market, REITs were down about 40%, which was actually a little bit more than the overall equity market. The dividends are also usually taxed at ordinary income rates, although part of that might be deductible as business income.

Dziubinski: Now, you mentioned earlier that there are diversification benefits to owning REITs, and we hear a lot that they're great diversification tools for most anyone's portfolios. So, the question to you is, should really all of us have a little bit of exposure to REITs in our portfolios? And if that's the case, how big of an allocation are we looking at or talking about?

Arnott: Unfortunately, even though you hear a lot about the diversification benefits, they're not always there. And we've seen correlations actually trend up quite a bit over time. Another important thing to keep in mind is that if you own a broad market index fund, like an S&P 500 index fund, you're already getting some exposure to real estate. So, you don't necessarily need a lot of exposure beyond that.

Dziubinski: Lastly, Amy, let's talk a little bit about core-plus bond funds. What are they and why would an income seeker would be interested in that particular type of bond fund right now?

Arnott: Core-plus funds are bond funds that invest in a wide range of fixed-income securities, so including things like Treasuries, other government bonds, corporate bonds, and then some higher-yielding assets like junk bonds.

Dziubinski: How is that collection of securities different from what, say, a more straightforward core bond fund would invest in, one that doesn't have a plus attached to it?

Arnott: They really have a wider purview. Some of them might invest in international government bonds. And, as I mentioned, credit risk is one of the major differences. So, if you look at the average core-plus fund, they have about 12% of their assets in junk bonds as opposed to something like 2% for a typical core bond fund.

Dziubinski: If we are looking at the risks of a core-plus bond fund, would you say that credit risk is the main risk? Are there others that investors should be aware of?

Arnott: Credit risk is definitely the main risk, and volatility can also be more of an issue. Especially in periods like early 2020, we saw the average core-plus fund lose about 6% versus closer to 2% or 3% for the average core bond fund.

Dziubinski: Well, Amy, thank you so much for your time today, helping us walk through some of these income alternatives for investors who are looking for some yield these days. We appreciate your time.

Arnott: Sure. Great to be here.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thank you for tuning in.