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Winning the Hunt for Yield

What's an income investor to do when yield is hard to find? Look to dividend-paying stocks or move out the risk curve when it comes to bonds.

A decent yield has been hard to come by over the last six years, thanks to unprecedented central bank intervention to keep interest rates near zero in Europe, Japan, the U.K., and the U.S. Things look to remain much the same in 2015, and there's even the added wrinkle of a rate hike from the Federal Reserve looming on the horizon. What's an income investor to do? Look to dividend-paying stocks or move on out the risk curve when it comes to bonds. Treasuries are not the answer to this question.

High Tolerance for Risk Can Result in Attractive Yields 

Credit Suisse's Private Banking and Wealth Management (PBWM) division suggests two specific paths that investors seeking yield might take. "Dividend stocks offer the possibility of long-term outperformance and have a history of positive returns even during rate-hiking cycles," says Fan Cheuk Wan, Chief Investment Officer for PBWM in the Asia-Pacific region. "Those who have a higher tolerance for risk can find attractive yields in selected corporate hybrid securities and subordinated securities issued by banks."

Dividend Stocks: Tried and True

No one needs to be told why high-dividend stocks can provide compelling returns. But this might come as a surprise: dividends account for fully two-thirds of the S&P 500's total return since 1963. And while dividend stocks don't always do better than the market as a whole when interest rates are rising, they tend not to lose money, either. PBWM analysts Kaufmann and Scott note that dividend stocks generated positive total returns in four recent rate-hiking cycles – 1983, 1987, 1999, and 2004 – outperforming broad global equity indices in the first two cycles and underperforming in the second two periods. What's more, with $2.1 trillion in cash available on corporate balance sheets, dividend payouts on the MSCI World index are lower than historical averages, leaving plenty of room for increases.

Corporate Hybrid Credit: Moving Out the Risk Curve

Hybrid securities offer yields that can be 200 to 300 basis points higher than those of senior unsecured debt. (To assess relative value of a corporate hybrid security, it's best to compare its yield-to-call with the yield of an unsecured bond maturing around the same time and issued by the same company.) But investors take on more risk in exchange for the higher payout. For one thing, these securities are further down the redemption totem pole if the issuer fails. In addition, issuers have the right to call them away after a fixed amount of time, typically about five years. If they don't, however, investors can get stuck earning a lower interest rate than they might otherwise demand for a fixed-income asset with a long-term (or even perpetual!) maturity date. Credit Suisse recommends only considering those issued by companies with both diversified cash flow profiles and a solid track record of making dividend payments.

Subordinated Bank Bonds: Betting on Bank Risk

Like corporate hybrid bonds, subordinated bank securities offer higher yields in exchange for a greater risk of losses in a default. The analysts point out that the risk of bank bail-ins, which would expose investors holding subordinated securities to heavy losses, has diminished in recent years, thanks both to significant deleveraging and more onerous capital requirements. "For banks with a solid credit profile, we think the rewards for moving down the capital structure outweigh the higher risk," PBWM analysts wrote in a recent note. In both Europe and the U.S., PBWM analysts favor Tier 2 bonds, which have a fixed maturity and rank higher on the repayment scale than other classes of bank-issued subordinated debt. Analysts also see opportunities among the preferred securities issued by U.S. banks.

This article has originally appeared in The Financialist