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Income Investing Playbook 2022: Alternatives Amid Rising Rates

January 28, 2022

Read Time 8 MIN

The U.S. Federal Reserve (Fed) has kept interest rates low in recent years, holding its benchmark rate at zero since March 2020 to prop up the economy amid the COVID-19 pandemic. With the economic outlook continuing to strengthen, the Fed has shifted its focus away from economic stimulus and towards managing inflation. At the January Federal Open Market Committee meeting, Fed officials kept rates unchanged but indicated that interest rates are likely to be increased in March to address the pace of inflation, as the headline Consumer Price Index reached 7% at the end of 2021.

Coming out of a prolonged era of low rates, investors now need to prepare for a rising rate environment. In this Q&A, we explore where we believe investors can find compelling sources of yield in 2022—including equity income, high yield corporate bonds and floating rate notes—and how they fit within a portfolio.

Q: How will the market react to rising rates?

A: Rather than the pace of the Fed’s rate hikes, we believe the larger risk may be whether the market thinks the Fed has waited too long. Rate volatility, rather than higher rates alone, is what diversified bond investors should be watching.

Interest rate volatility spikes may lead to widening spreads, which may lead to pricing dislocations—and potential buying opportunities—in several markets, such as high yield corporate bonds. Investment grade floating rate notes may also help investors address potential rate volatility without adding as much credit risk, while business development companies (BDCs) may be an attractive equity income option for those willing to take on more credit risk.

Q: Why should floating rate notes be considered in the current rising rate environment?

A: One of the fundamentals of bond investing is that as interest rates rise, bond values decrease. An attribute that sets floating rate notes apart is their variable coupon, which resets periodically with prevailing interest rates, reducing their sensitivity to interest rate changes. They may also offer a higher yield relative to other ultra or short-duration investment grade alternatives. A strong credit environment driven by a positive economic growth outlook may benefit credit spreads and corporate floating rate notes.

Although bank loans also have coupons based on floating rate notes and low interest sensitivity, they are predominantly high yield whereas the floating rate note market is predominantly investment grade. Loans may offer higher spreads to reflect the higher level of credit risk, but tend to be less liquid and have extended settlement periods. Loan returns have historically exhibited more volatility compared to floating rate notes.

Q: How can investors add exposure to floating rate notes in their portfolio?

A: Floating rate notes present a conservative, investment grade allocation with near-zero interest rate duration and the potential to benefit from higher short term interest rates through higher coupons. The VanEck Investment Grade Floating Rate ETF (FLTR) provides exposure to U.S. dollar denominated floating rate notes issued by corporate issuers and rated investment grade.

FLTR’s underlying index, MVIS US Investment Grade Floating Rate Index, is designed to enhance yield potential by including only corporate and financial issuers and by tilting its exposure to longer maturity notes. This enables investors to potentially benefit from higher credit spreads, which has been a key driver of the FLTR’s performance, and the focus on investment grade helps mitigate default risk.

Q: What key attributes of BDCs make them well-positioned for a rising rate environment?

A: BDCs issue common stock and generate income by lending to and investing in private companies that tend to be rated below investment grade or unrated. They gain preferential tax treatment if they distribute at least 90% of their taxable income as dividends to shareholders.

BDCs generate income based on the difference between interest income from portfolio investments and interest expense on borrowings/debt. On average, over 85% of loans in BDC portfolios feature a floating rate1, and this heavy exposure to floating rate notes translates to less sensitivity to rate increases. In fact, the pairing of floating rate loans with the predominantly fixed borrowing costs for BDCs in recent years means that as rates rise, BDCs may see higher net interest margins and increased annual net income. We believe these attributes make them an alternative income source that investors should consider to enhance yield without adding significant interest rate risk.

Q: How can investors add BDC exposure to their portfolio?

A: Publicly traded BDCs offer investors access to what may otherwise be an illiquid asset class via a liquid, dividend-yielding stock. VanEck BDC Income ETF (BIZD) invests exclusively in BDC equity securities. These stocks may be susceptible to equity market volatility and may not be able to replace traditional income exposure, but they may enhance yield depending on an investor’s risk tolerance. As BDCs primarily finance private companies that are historically smaller, middle-market companies, the attractive interest rates associated with these loans comes with the credit risk associated with these companies. BIZD allows investors to access the broad BDC market and limit single BDC credit risk.

Q: How do mortgage REITs fit into portfolios in the current environment?

A: Mortgage REITs provide financing for real estate by buying or originating mortgages and mortgage-backed securities (MBS), and earns income from the interest on these investments. Investors can use mortgage REITs to access the real estate market without having to own, operate or finance properties themselves. Exposure to interest rate- and credit-sensitive assets in combination with leverage allows mortgage REITs to offer attractive yields. However, this also subjects them to elevated risks that investors should consider when making an allocation.

Mortgage REITs have high dividend potential that may provide a boost in yield for investors searching for income, or may fit well into a more aggressive long-term growth portfolio given their total return potential. They historically have low correlation to equities and traditional fixed income instruments, which may add diversification to a portfolio.

Q: How can investors add exposure to mortgage REITs?

A: Mortgage REITs range from those focused on purchasing high credit quality MBS to those that focus on commercial mortgage origination or lower credit quality non-agency investments. There are also many that invest in several areas of the mortgage real estate market in non-static portions that fluctuate over time. The VanEck Mortgage REIT Income ETF (MORT) offers broad exposure to the U.S. mortgage REIT market.

Q: Why should investors consider preferred securities, and how sensitive are they to interest rates?

A: Preferred securities exhibit characteristics of both stocks and bonds, and may offer higher yield potential than a company’s common equity and senior debt. They may offer diversification potential, given their historically low correlation with equities and traditional fixed income instruments.

Preferred securities often feature long-term maturities of greater than 30 years or perpetual, meaning no maturity, so they do exhibit some sensitivity to interest rate changes. Notably, preferreds issued by financial companies have a higher tendency to feature perpetual maturities, and interest rate sensitivity may also be impacted by the portion of a preferred portfolio that are callable or convertible and the timing of the call and conversion features.

Q: How should investors approach allocating to preferred securities?

A: The majority of preferred securities are issued by banks and insurance companies, and we believe an exposure to non-financial preferreds may provide investors with differentiated exposure and greater sector diversification without sacrificing yield. As noted above, financial companies are more likely to issue preferreds with perpetual maturities, so excluding them may result in a lower portion of perpetual issues, which may help lower overall maturity and reduce the impact of interest rate changes.

VanEck Preferred Securities ex Financials ETF (PFXF) targets preferred securities issued by companies that operate outside of the traditional financial sector, offering differentiated exposure compared to most broad-based preferred ETFs without impacting yield potential. Many investors may incorporate preferreds alongside or in place of high yield debt as a complement to their core fixed income allocation.

Q: What should investors be watching for in the high yield bond space?

A: Rate sensitive asset classes are generally negatively impacted by rising rates, but we believe the reasons behind the interest rate moves may provide support for fallen angel high yield bonds.2 Rising rates may reflect stronger economic growth expectations, which tend to be positive for high yield bonds. Fallen angel bonds (as represented by the ICE US Fallen Angel High Yield 10% Constrained Index) have outperformed the broad high yield market (as represented by the ICE BofA US High Yield Index) in 14 of the last 18 calendar years, including 7 of the 9 years in which interest rates have risen significantly, despite having a longer duration versus the broad high yield market.3

The fallen angel high yield bond segment currently has a higher weight towards economically sensitive sectors than the broad high yield market, which may provide the segment stronger participation in continued economic growth. We believe this sector differentiation may be a key driver of performance this year for fallen angel bonds, as well as the higher exposure to “rising stars”, or bonds that are upgraded from high yield to investment grade.

Q: How can investors access fallen angel high yield bonds?

A: The VanEck Fallen Angel High Yield Bond ETF (ANGL) provides investors exposure to corporate bonds that were rated investment grade at the time of issuance before being downgraded to high yield. Fallen angel bonds stand apart from original-issue high yield bonds by offering a higher average credit quality than the broad high yield bond universe.4 They historically are issued by larger, more established companies, which have a higher rate of upgrade to investment grade.5

DISCLOSURES

1 Sources: BDC financial statements as available on the BDCs comprising the MVIS® US Business Development Companies Index (MVBIZDTG). Data as of 9/30/2021.

2 Fallen angel high yield bonds are bonds originally issued with investment grade ratings but later downgrade to non-investment grade or high yield.

3 Source: FactSet. A significant rise in interest rates is defined as a 100 basis point increase in the 5-year Treasury yield or an increase in the Federal Funds target interest rate in a given calendar year.

4 When comparing ICE US Fallen Angel High Yield 10% Constrained Index and ICE BofA US High Yield Index. ICE BofA rating is a proprietary composite of various rating agencies.

5 Source: ICE BofA. Data as of 12/31/2021. Based on average ascension rates to investment grade since 12/31/2003.

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Consumer Price Index measures the average change in price for a basket of consumer goods and services purchased by households.

MVIS US Investment Grade Floating Rate Index tracks U.S. dollar denominated floating rate notes issued by corporate entities or similar commercial entities that are public reporting companies in the U.S. and rated investment grade.

MVIS US Business Development Companies Index is a rules-based index intended to track the overall performance of Business Development Companies (BDC).

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ICE US Fallen Angel High Yield 10% Constrained Index (H0CF, Index) is a subset of the ICE BofA US High Yield Index (H0A0, Broad Index) and includes securities that were rated investment grade at time of issuance.

ICE BofA US High Yield Index (H0A0, Broad Index) is comprised of below-investment grade corporate bonds (based on an average of various rating agencies) denominated in U.S. dollars.

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