The Hunt for Yield Amid a Shifting Fed

This week, it’s all eyes on the Fed.

The Federal Reserve’s policy-making Federal Open Market Committee (FOMC) is scheduled to meet June 18-19. What the FOMC decides will strongly dictate the direction of the markets for the rest of this year. In a note last week, the analysts at Bank of America (NYSE: BAC) predicted:

We think the FOMC will guide markets towards the possibility of a cut, if conditions warrant. We expect the Fed to remove the ‘patience’ guidance in the statement and underscore that it stands ready to offer accommodation to sustain the recovery. Chair Powell will have to thread the needle in sounding sanguine on the outlook, but also discuss that the Fed is ready to ease in order to make sure the recovery continues.

The consensus among economists is that the Fed won’t announce a rate cut this week. But the comments Chairman Jerome Powell makes regarding the state of the economy should hint at Fed policy for the remainder of 2019. Unless the Fed suggests a move toward rate increases, income investments — which have done so well over the past year — should continue to thrive.

Investors Flock to Safety

Over the past year, as volatility and risks worsen, the two top-performing sectors in the S&P 500 are both income-oriented.

According to the Select Sector SPDR exchange-traded funds (ETFs) that divide the S&P 500 into eleven sectors, the top performing sectors over the past year were utilities (+22.5%) and real estate (+18.6%). For reference, the S&P 500 has returned 3.8% over the past year.

However, one consequence of this run-up in these sectors is that yields have become depressed. It is becoming much harder to find yields in the 4% range, unless there is more risk associated with the company. For example, a utility that operates primarily overseas should yield a bit more due to the currency risks, as well as for business risks associated with specific countries.

The Utilities Select Sector SPDR (XLU) currently yields 3.0%. However, that fund contains some troubled utilities like Southern (NYSE: SO), which yields 4.5%. Again, there’s more risk with Southern, so the yield is a bit higher. But another option for income investors in this sector is a Canadian company like Algonquin Power & Utilities Corp (NYSE: AQN). There is some additional risk due to currency fluctuations, but 1). The company offers shares on the NYSE; and 2). The company appears to be in solid financial shape.

In comparison, the Real Estate Select Sector SPDR (XLRE) yields 3.2%. Still, that’s depressed largely because of the low yield (1.7%) of its largest holding, American Tower (NYSE: AMT). But within the XLRE there are plenty of companies yielding above 4%, including the second largest holding Simon Property Group (NYSE: SPG), which currently yields 5.0%.

Keep in mind that these sectors, while defensive, are not entirely without risk. During times of sharply higher interest rates, or during an economic crisis (e.g., 2008-09), these sectors can contract sharply as money flows into fixed income offerings. That’s one reason Chairman Powell’s comments will be important. When the Fed’s tone changes and it looks like higher interest rates are on the way, it will probably be time to lighten up on these sectors.

But the smart money is betting that time isn’t yet upon us.

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