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Searching for income: Do equities still make sense?

Russ Koesterich, CFA of BlackRock

Where to Seek Equity Income (Part 2 of 5)

(Continued from Part 1)

But with the bull market now more than 5 years old, you may be wondering whether this approach still makes sense. My answer: Yes, assuming you can take the volatility and look beyond U.S.-focused funds.

To be sure, as I pointed out in a recent post, I’d be wary of seeking income at all costs and ignoring valuation. In other words, asset class cross-dressing, or using stock portfolios to generate income while simultaneously building equity-like exposure in bond portfolios, is becoming risky in some scenarios.

Market Realist – Investors seeking income have now started using bond-like stocks as a new investment strategy. This strategy focuses on investing in relatively stable and safe stocks in the utilities (XLU), consumer staple (XLK), and real estate (IYR) sectors, which have bond-like characteristics.

The thing to keep in mind here is that though these stocks have outperformed broader market indices this year, their long-term returns show that they have underperformed. With the threat of stretched valuations looming on the horizon, these stocks have started to look expensive. This outlook might lead to a downturn.

Market Realist – The other strategy gaining popularity with investors is eschewing investment-grade bonds (AGG), which give low yields, and turning to riskier corporate bonds (HYG), which display equity-like characteristics.

According to Del Stafford of BlackRock, there’s a high correlation of almost 0.74 between U.S. equities (SPY) and corporate bonds. This effectively means that investing in corporate bonds defeats the purpose of fixed income investing—namely, diversification—as investors are simply exposing themselves to the same risk twice.

The above graph shows you the high correlation between high-risk corporate bonds and U.S. equities.

Read on to the next part of this series to learn which market segments look interesting in the current context.

Continue to Part 3

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