Sensitivity to rising interest rates may vary across income investments, with some vehicles being more directly affected than others. For example, interest rates are a key determinant of bond performance, but the same is not true for MLPs. The other income categories are sensitive to rising interest rates because of their reliance on debt. Income equity investments face greater competition for investor dollars from new bond issues as rates rise and bond yields become more competitive. Following the announcement of another 75 basis point hike from the Fed yesterday, it’s time to take a look at how different income categories have fared as rates have risen this year. Specifically, this note examines the performance of income investments from relative lows to relative highs in the yield of 10-year Treasury bills and during short peaks in yield.
As the chart below shows, there have been two long periods this year when the 10-year Treasury yield has generally risen, from early March through mid-June and from early August through most of October. Additionally, there are three good examples of yields jumping sharply to new relative highs, marked in mid-June, late September and mid-October in the chart below. This table provides useful context for the performance discussion that follows.
The price performance of income investments varied as rates gradually rose, with MLPs outperforming and REITs recording the largest losses over both periods in the chart below. MLPs have benefited from a strong macro backdrop for energy and tend to do well in times of high inflation, not to mention company-level tailwinds from strong free cash flow generation. Utilities tend to be defensive and held up relatively well from March to June, but underperformed significantly from August to October as the 10-year yield hit new highs above 4.0%. Utilities are sensitive to higher interest rates due to their high indebtedness. Closed-end funds (CEFs) typically use leverage, and rising interest rates can lead to higher borrowing costs, which could lead to lower earnings and potentially reduced distributions (read more). CEFs experienced notable weakness in both periods. Bonds have a direct inverse relationship with rising interest rates, which is evident in their performance. REITs stand out as significant laggards in both periods. Like other income-generating investments, REIT distributions become less attractive as interest rates rise. Additionally, REITs tend to have a higher correlation to major equity markets, which have struggled this year, and REITs may also be more sensitive to concerns about the health of the economy.
The performance of income investments during the short peaks in the 10-year Treasury yield has been more uniformly negative this year. As the chart below shows, income investments have generally underperformed the S&P 500 in periods when yields have risen sharply. REITs and Utilities were particularly weak during the periods shown. The impact of higher borrowing costs and increased bond competition may be factors that weigh more on REITs and utilities than MLPs, which have higher yields and focus on debt reduction (find out more).
Income investments have varying sensitivities to rising interest rates, depending on their use of debt, yield levels and other factors. Income investments have generally underperformed the broader stock market during sharp peaks in 10-year Treasury yields, but performance has been more mixed during the longer periods of gradually rising rates seen in 2022.
AMZI is the underlying index of the Alerian MLP ETF (AMLP) and the ETRACS Alerian MLP Infrastructure Index ETN Series B (MLPB). CEFX is the underlying index of the Invesco CEF Income Composite ETF (PCEF) and the ETRACS 1.5X Leveraged Closed Fund ETN (CEFD).
Current returns versus history
After a good October for energy infrastructure, current yields are below their historical averages. The energy remained a bright spot in a difficult band.
Returns for the Dividend Dogs Index Suite are above their five-year averages. SDOGX recorded the best performance since the beginning of the year, down only -3.38% against a loss of -17.70% for the S&P 500, which is the index’s starting universe.
Multiple screens for dividend sustainability, including assessing cash flow, EBITDA, and debt ratios, help ensure reliable income from sustainable dividend indices.
Closed-end funds have been under pressure from rising interest rates, and current returns for all three CEF indices are well above their historical averages.
Income Opportunities: Taking Stock as Fixed Income Yields Rise
Revenue Opportunities: The Reliability of Intermediate/MLP Dividends
Income Opportunities: CEF and Rising Rates
Income Opportunities with International Equities
SDOGX Achieves Higher Returns and Outperformance YTD
Income opportunities: MLP, CEF and return of capital
Income Opportunities: Finding Income in an Inflationary Environment