Two High-Yield Plays In A Tricky Market

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Share Facebook Twitter Linkedin Reddit Premium Content Two High-Yield Plays In A Tricky Market By Editorial Dept – May 20, 2022, 12:00 PM CDT Join Our Community I am a bit confused. The recent move down in the stock market makes perfect sense in a lot of ways but moves in other markets do not. The Fed announced a major policy shift, and a stock market that had become a bit overbought on massive liquidity had to adjust as policy was reversed and money was drained from the system. Add in the profit-eating impact of the inflation that prompted that change, and trailing P/Es in the high 20s were simply not sustainable. As I said that all makes sense, but where the market has lost me recently is in the movement of bonds and other yield-bearing securities.

The Fed is raising rates and has frequently voiced its opinion that it will continue to do so for some time. Just this week, Fed Chair Jerome Powell said that they would continue to hike until inflation was under control, suggesting that no matter how much damage they do to the economy in an attempt to undo their mistake in hiking too late, they wouldn’t stop squeezing until backward-looking data say they have gone too far in the opposite direction.

That isn’t exactly encouraging for stocks, but neither is it good news for bonds. Higher interest rates on bonds mean lower bond prices, so with the Fed pushing rates higher, yields on bonds should go up, and prices fall. That is what happened initially, but this week, the opposite has been true. The yield on the 10-Year at first did what you might expect in a rising rate environment, climbing from below 2% to above 3%, but this week the direction has reversed, dropping back to around 2.8%.

Obviously, that isn’t a massive move, but when we know that the Fed is still hiking, it makes little sense. What has happened is that traders and investors have fled to the relative safety of Treasuries as stock market losses have increased. That is logical most of the time, but does it really add up when the Fed has basically said that they are going to force yields up? Not really.

That creates a problem for investors who want or need yield from their portfolio. If bond yields have made an illogical move down, they are probably going to correct before too long, so buying now would entail locking in a relatively low yield and risking capital losses before too long. So, where should you turn for yield?

The main places to look for fixed income other than investment grade bonds are high yield bonds, dividend paying stocks, REITs, and MLPs. One can make a strong argument against all of the first three, however. High yield bonds will be subject to the same forces as Treasuries, with the added risk of rising defaults as economic growth slows. Stocks of any kind aren’t a good place to go as that market adjusts either, and there are signs that the real estate market has topped out and will fall back as mortgage rates climb.

That leaves MLPs, or similar investments. One could argue that they may suffer because oil prices will have to fall from here but that is by no means certain and, if they do, it will be at least in part because of higher output. Crude has to be moved, so more crude output means more business for pipelines. In other words, the very thing that might push oil lower would actually benefit pipeline companies, dampening the potential impact of a fall in crude oil prices. So, pipelines seem like a good place to be for yield-seekers.

My choices there would be Energy Transfer Partners (ET) and Kinder Morgan (KMI). ET is a traditional MLP, which means that it is a pass-through entity, rather than a conventional company. That has tax implications that make it a little complex, but otherwise makes little difference to investors. It offers a forward annual yield of 6.82% at current levels which, with free cash flow of $2.2 billion, looks sustainable. Kinder Morgan was once the company that led the way for oil and gas pipeline companies becoming MLPs, but a few years ago, they moved away from that and changed back to a conventional corporate structure. However, they still pay out a chunk of their profits, and the stock has a 5.8% forward yield.

As you might expect, as oil and gas prices have soared, pipeline companies’ stocks have done well, but there are reasons to believe that they are still undervalued. The gains have been held back by rising Treasury yields, which make the yield on anything else less attractive, and the current White House has shown a lack of desire to approve pipeline projects up until now. However, with Treasury yields now dropping back, the former looks like less of a problem. As for the politics, a President beset by accusations that he is responsible for higher gas prices will presumably be very reluctant to continue beating up on pipeline companies. So, with the two main negatives around pipeline providers receding, there is a chance of some capital gains to go along with a decent yield.

Primarily, though, it is the yield that is attractive here. Around 6% is a good return, however you look at it, and especially when the outlook for price is better there than it is for «safe» US Treasuries. Right now, I would rather be in stocks like ET and KMI than in Treasuries yielding less than half that amount, and for those seeking yield, they may be the best answer around.  

Disclaimer: The author is long KMI at the time of writing

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