This is a guest post by Tom Hutchinson, Chief Analyst, Cabot Income Advisor
Trembling with fear: Interest rates are sky high these days, folks.
The benchmark 10-year government bond yield rose 90% in the first three months of this year. This stratospheric jump brought the rate of the Bellwether bond down to … 1.75%. And those higher interest rates filter through the bond and bond markets.
Now you can get around 0.75% on a two year CD. The iShares iBoxx Investment Grade Corporate Bond ETF (LQD) is now generating a whopping 2.71% return. The yield on a 20-year municipal bond with AAA interest is up to 1.5%. And understand that: interest rates are likely to rise even further as the year progresses.
Prizes like these could keep you beer money for a year if you invest enough. Sure, after taxes and inflation, you are likely to lose money. But that’s the brave new world. It looks like those pitifully low rates on traditional fixed income will stay here.
Fortunately, even in this low-interest world, there are other places where a decent return and income can be earned – namely in high-dividend stocks.
The returns on certain income-related securities are higher than they have been in a decade. As the S&P 500 approaches an all-time high, many income-related stocks have taken a blow during the pandemic and are still well below pre-pandemic levels.
Solid companies have kept their dividends through the turmoil. And the returns are still extremely high at these low prices. At the same time, businesses are rebounding strongly and the outlook should improve significantly as vaccines spark a full economic recovery.
You can still make safe and juicy income in a low income world if you know where to look. Here are two of the best high-yield stocks I’ve seen in the past decade.
High Yield Stock # 1: Enterprise Product Partner (EPD)
Enterprise is one of the largest Midstream Energy Master Limited Partnerships (MLPs) in the country with a huge portfolio of service assets connected to the heart of American power generation. The company has annual sales of $ 36 billion from an unprecedented reach in the industry connected to every major US shale basin and 90% of US refineries east of the Rockies. It also has export opportunities in the Gulf of Mexico.
The main feature of this business is that it is very stable, much like a utility company. The result does not depend on the development of volatile oil and gas prices. It’s like a toll collector collecting fees for pipelines and oil and gas storage. In fact, 88% of income is chargeable and backed by guaranteed contracts.
Unit price turned creamy when demand for oil and gas fell off a cliff during the pandemic lockdowns. The EPD fell 40% from just before the pandemic to early November. However, this crash was largely tied to the rest of the sector as many commodity price sensitive companies experienced a profit crash.
In one of the most difficult years in the industry, corporate profits only fell about 10% over the course of the year. Now the stock is moving back up. The EPD has risen 42% since the vaccine was announced in early November. But it’s still around 25% below the pre-pandemic price level.
During the major rally in energy stocks between early February and mid-March, the EPD didn’t rise nearly as much as most energy stocks. It wasn’t seen as “sexy” enough as profits weren’t falling as quickly as they weren’t falling as much at all. But the stock is trending in the right direction and that enormous return is absolutely solid.
In 2020, the distributable cash flow (DCF) covered the distribution by 1.6 times. This is an industry leader and is considered very safe. And this is one of the worst years ever. Since going public in 1998, the company has not only kept the payout, but increased it every year. EPD’s long history of annual payout hikes makes it a blue chip stock for income.
High Yield Stock # 2: AGNC Investment Corp. (AGNC)
AGNC is a mortgage real estate investment trust (mREIT) that invests primarily in US government-sponsored residential mortgages. It pays a high dividend yield, currently 8.3%, and pays dividends monthly. This makes AGNC a monthly dividend stock.
While typical REITs own actual physical real estate, charge rent, and pass that revenue on to shareholders, mortgage REITs are a different tier. They buy mortgages and earn income from monthly mortgage payments. A mortgage REIT borrows money at low short-term interest rates and uses that money to buy mortgages that pay a higher interest rate and make a profit on the interest differential or net interest markup.
AGNC invests almost exclusively in mortgages backed by Fannie Mae and Freddie Mac, so there is virtually no credit risk. However, there is certainly an interest rate risk. It’s all about spreading. As the difference between the short-term rates at which the money is borrowed and the mortgage interest paid increases, so does profits.
There are good times and bad times to own these securities. I think now is a very good time. Here’s why: Interest rates are rising and the stock price is trending higher.
The Fed has a lot of control over short-term interest rates as it sets the Fed funds base rate, which is currently near zero. The central bank has indicated that short rates will remain at current levels for some time to come. The bank has less control over long-term interest rates as the economy strengthens.
In fact, the 10-year interest rate, a measure of longer-term interest rates including mortgages, is already on the rise. It has more than tripled from a low of 0.5% in the middle of the bear market to 1.57% today. Obviously, once the full economic recovery the market is already pricing in takes effect, interest rates should continue to rise. And there is room to run. The 10-year rate was over 3% in 2018.
With longer-term interest rates and mortgage rates rising and short-term interest rates constant, net spreads and profits at AGNC are likely to increase. The share has also risen steadily in the past year, but is still a long way from prepandemic.
A fat return with a good forecast for the stock price should make AGNC a big winner for high income investors.
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