Now is a great time to look at your income investments. Recent interest rate hikes in North America have significantly reduced the prices, making 2023 an interesting entry point. But this is not about market timing or making a quick profit, it’s about taking advantage of structural changes in interest rate policy designed to deal with inflation and to unwind emergency lending rates post pandemic. There are many investments that could fall under the income category, so for simplicity we will define them as investments made with the primary purpose of generating cash flow. Looking at the prevailing conditions in 2023 there are three categories everyone should re-evaluate – bonds, REITs and infrastructure.
Bonds
Although the stock market gets most of the press, the bond market is just as big. Most retail investors will get access to the bond market via mutual funds or ETFs that provide both liquidity and ease of access. The reality is that bonds are highly sensitive to interest rate moves. Actively managing a bond portfolio largely comes down to an interest rate call that is hard for any professional to make successfully over the long term. And since bond returns are generally less than stock market returns, fees for active management can quickly eat away at profits.
For these reasons, ETFs have a material advantage in building a core bond position. There are many bond ETFs and actual choices will come down to an investor’s unique goals. For 2023, strongly consider longer duration investment grade bonds. If you believe that inflation has peaked and coming down from the current rate of 6% to something more benign like 3%, then most of the pricing contraction is behind us. Be cautious with high yield bonds where the primary additional risk is default. Higher interest rates and expected economic contraction will put pressure on many marginal businesses and at a current high yield spread of ~500bps there is little reward for the risk.
Also, be wary of the appealing nature of real return bonds in the current inflationary environment. The pickings are slim. In Canada, there are only eight issuances with 30-year maturities. These bonds will have equity-like volatility with that long of a duration and will be too bumpy a ride for many investors. In short, 2023 is a great time to look at longer duration, investment grade bonds wrapped up neatly in ETFs.
REITs
There is something about investing in real estate; it has a certain appeal to it. But for most, investing directly and getting proper diversification isn’t possible. REITs, and specifically ETFs that hold a bundle of REITs, are great portfolio diversifiers and a source of predictable cash flow. Like bonds, REITs are also sensitive to interest rates and are off their highs making another good entry point. Within REIT ETFs, you will get exposure to different real estate such as residential, commercial and industrial. Commercial has suffered with the hybrid workweek being resilient but other areas such as residential are strong given the current housing shortage.
For those seeking even more diversification, look to US REITs that will include storage facilities and communications towers. Unlike bonds which are debt instruments, REITs are equity investments and have more equity-like volatility. Bond performance is based on the financial strength of the issuer, while a REIT is valued by the performance of the properties. The good news is that your income payments are not impacted by the price volatility. Overall, REITs are a great portfolio diversifier to complement the traditional bond mix and a source of decent income.
Infrastructure
Infrastructure projects are the building blocks of society such as road, ports, pipelines and transmission lines. Like their close relative real estate, these are real assets. Institutional investors like pension funds have been investors in infrastructure because of the long-term nature of these assets, stable cash flows and low to no correlation with economic cycles and other asset classes.
These unsexy investments tend to lag stocks when the economy is on a tear, but they are an important portfolio diversifier and provide good income. As an investor, you need to be forward looking. The world is in transition to lower carbon consumption. So, some infrastructure is going to be caught in a value destruction cycle, like pipelines delivering carbon intensive fuels while other areas will experience growth such as EV charging infrastructure.
The good news is that for investors there are many ETFs that offer exposure to infrastructure and are transparent about their holdings so you can quickly assess if the assets provide a reasonable mix as the world transitions to being carbon neutral. There are also some direct investments such as Brookfield Infrastructure Partners (BIP.UN) that provide exposure to this asset class. Infrastructure investing has long been considered a stable haven for income investors, but the category is not immune to higher interest rates, a pending economic downturn and falling stock market in addition to the structural shifts to clean energy. For income-seeking investors, 2023 represents a good time to look seriously at infrastructure to add further income diversification to portfolios.
Income producing assets are important for any portfolio but become crucial to investors as they approach retirement age. The economic conditions leading up to now have set the stage nicely for long term investors to work with their advisors to re-look at portfolio construction. Not all income is equal, so a mix provides the best outcome. Bonds provide the smoothest ride, but at the cost of lower yields to REITs and well selected infrastructure investments.
If would like to invest in these types of securities, please consult with your Q Wealth portfolio manager to make sure the strategy aligns with your investment goals and objectives.
References
https://tradingeconomics.com/canada/interest-rate
https://www.bankofcanada.ca/rates/price-indexes/cpi/
https://www.investopedia.com/articles/mortgages-real-estate/10/real-estate-investment-trust-reit.asp
