Income Investing Playbook 2023: It’s Time to Invest in Bonds

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 2023

Looking at the 1970s inflation regime as a guide, we believe fixed income may present one of the best opportunities for investors today. When interest rates are super low, an increase in rates can do a lot of damage to bonds, just like we saw in 2022, which was the worst year for bonds since 1976. Looking at the latter half of the 1970s, however, rates increased from 5% to 10%, yet bonds kept making money.

There are two reasons for this. First, an increase in interest rates from 5% to 6% is much less dramatic than a move from 1% to 2%. Second, 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 by historical standards. 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.

Income Investing in 2023: Where to Focus

The bottom line is that the risk/reward tradeoff for bonds has significantly improved in 2023, and the current market environment represents a very compelling entry point. Of course, determining the right mix of bonds 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 fixed income investing landscape.

• Don’t Ignore Floating Rate Instruments
• The “High” in High Yield Makes a Comeback
• Investment Grade Bonds Are Attractive…If You Know Where to Look
• Darkest before the Dawn: A Bright Outlook for Municipal Bonds
• The Grass Gets Greener for Green Bonds
• Oh, You Guys Just Raised Rates? Emerging Markets Are Early to the Party
• Dividend Investing: Stocks Generate Income, Too!
• 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

Rising interest rates have caused major damage to bond investors this year. 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 yields in the current market, while still maintaining protection if rates take a turn higher.

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. 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. 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, and have significantly outperformed at lower rating tiers. CLOs are structured to help mitigate risk, through the strength of their underlying collateral as well as built-in traits such as coverage tests to correct collateral deterioration. This has historically helped them experience significantly lower levels of principal loss when compared with corporate debt and other securitized products. This has resulted in a track record of strong risk-adjusted returns versus other fixed income asset classes, particularly among investment grade rated CLO tranches.

BDCs are another alternative high income source investors should consider when looking to enhance yield in their portfolio while still being mindful of rate sensitivity. BDCs generate income by lending to, and investing in, middle market companies in a variety of ways including equity, debt and hybrid financial instruments. In short, BDCs provide capital to small businesses, and in turn, give investors access to the growth and income potential of private companies that are generally exclusive and difficult to access.

The “High” in High Yield Makes a Comeback

Remember, carry is back. This is especially true as you move out farther on the credit curve into lower quality bonds. As yields have reset, high yield bonds are now offering “high yields” again. This means the current yield level provides a substantial cushion to returns going forward. Although the risk of wider spreads in this uncertain environment is a concern, adding exposure to high yield at much higher yield levels means that carry will likely play a much greater role in driving future returns. We particularly like fallen angel high yield bonds, where yields have jumped to pre-Great Recession levels.

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.

Darkest Before the Dawn: A Bright Outlook for Municipal Bonds

Like other fixed income asset classes, municipal bonds struggled in 2022. However, yields are now higher for municipals than at any time in the past 15 years. And since 1965, a down year in the municipal market has been followed by at least one year (or several) of positive returns.¹

And there is good reason to be optimistic. At the end of April, Moody’s Investors Service released its annual municipal bond market snapshot, U.S. municipal bond defaults, and recoveries, 1970-2021, with updates through 2021. In addition to noting that the muni sector continued to recover from the effects of COVID-19, the report also affirms two hallmark benefits muni bonds offer. First, while they may have become more common over the last 15 years, municipal defaults and bankruptcies remain rare overall. (There were no new rated municipal bond defaults during the period of significant market stress in 2021 resulting from COVID.) Second, muni bonds continue, on average, to be highly rated compared to corporates.

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.

Oh, You Guys Just Raised Rates? Emerging Markets Are Early to the Party

Emerging markets bonds historically do well in rising rate environments—particularly when rates rise due to higher growth prospects rather than a taper tantrum. In addition, compared to the U.S. and other developed markets bonds, emerging markets bonds not only provide significantly higher nominal and real yields on average but also shorter durations.

Notwithstanding China’s more recent policy direction, emerging markets in general have moved much more quickly to increase interest rates compared to the U.S. and other developed market rates in order to stay ahead of inflation. The result has been not only higher nominal yields, but higher real yields. The benefits to emerging markets local currency investors are a more substantial level of income that is not eroded by loss of purchasing power (through a potentially weaker currency) and the potential for rate cuts to stimulate growth, if needed. We believe emerging markets corporate bonds’ strong fundamentals can help cushion the impact of rising U.S. interest rates as recessionary risk grows.

Dividend Investing: Stocks Generate Income, Too!

Dividend stocks are last (but not least) in our 2023 guide to income. 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.

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

To receive more Income Investing insights, sign up in our subscription center.