OVERVIEW

The Search for Income publication is a quarterly guide to our top ideas for income producing securities and strategies. This publication offers active and passive income suggestions from our current mutual fund recommended list, along with suggested exchange-traded funds (ETF). Many of the asset classes/sectors can be used individually or in a diversified portfolio, and several are currently employed in our model portfolios.

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YIELDS DECLINE

Domestic and international economic growth fears, along with European Central Bank intervention and a slower schedule of interest rate hikes by the Federal Reserve (Fed), led to broad declines in global bond yields during the first quarter of 2015. European government bond yields at or near record lows, a stronger U.S. dollar, and uncertainty around oil prices boosted demand for high-quality bonds. Treasury yields fell below recent 18-month lows as a result. Lower-rated and more economically sensitive sectors, such as high-yield bonds, performed well over the quarter amid subsiding fears over energy-related defaults. The result was generally lower yields across fixed income sectors over the first quarter of 2015 [Figure 1].

The fundamental backdrop behind lower-rated higher-yielding bonds remains positive. According to Bloomberg consensus forecasts, the economy grew at a pace of 1–2% during the first quarter of 2015, a deceleration from the 2.2% growth rate of Q4 2014. But this slowdown may likely be temporary due to severe weather in the eastern portion of the U.S., in addition labor disputes at major ports on the West Coast (which are now settled). Jobs data, however, generally showed improvement through the first quarter. Recent data in April have provided some evidence of better growth following weaker data reported in March, including payroll employment.

Yields on high-yield bonds retreated slightly from their near 18-month highs, largely driven by fading fears over the price of oil. Fears related to the sharp drop in oil prices appear to have been overdone, and the high-yield market is now showing reduced sensitivity to oil’s price changes. High-yield continues to be supported by good credit quality metrics and a low-default environment. First quarter 2015 earnings are expected to decline 2.8% year over year, compared with the 7% earnings gain witnessed in the fourth quarter of 2014. Much of this decline is due to the continued drag of a strong U.S. dollar and the decline in the price of oil. We expect these factors to fade over the balance of 2015 and expect only limited impact on corporate issuers’ ability to repay debt, particularly those issuers outside the energy sector.

European economic weakness and a strong dollar have kept inflation expectations low, which may restrain the Fed from raising interest rates at its stated target of mid-2015. A later start to Fed rate hikes may help keep yields low and support high-quality bond prices. Most high-quality bond sectors enjoyed strong performance in 2014 and left valuations high, suggesting that even if interest rates do not rise immediately, longer-term return prospects are still very low. The first quarter continued the trend of strong performance, but we do not believe that the level of performance seen in the first quarter of 2015 is sustainable for the remainder of the year.

We continue to suggest caution for many areas of the bond market due to lower yields and higher valuations following strong performance. A challenging environment still exists for income seeking investors.

Among high-quality bonds, we believe municipal bonds represent a better longer-term opportunity. Municipal bond valuations remained cheap over the first quarter of 2015 as new supply provided a headwind from mid-February through the end of March 2015. Valuations are on the attractive side relative to Treasuries and may provide a buffer against rising interest rates in addition to an attractive after-tax yield.

In general, we prefer to look domestically for income-generating investments given the more favorable economic backdrop, which should continue to support credit quality. Currently, our best ideas for potential income generation are:

• High-yield bonds (taxable and tax-free)
• Bank loans (floating rate funds)
• Preferred stocks
• Investment-grade corporate bonds (intermediate and long term)
• Emerging markets debt (EMD)

High-yield bonds (taxable) remain a way to potentially generate above-average interest income. The high-yield sector’s sensitivity to the price of oil decreased in the first quarter of 2015, helping to push down the average yield to 6.2%. As of March 31, 2015, the average yield comprises a 4.9% advantage over comparable Treasuries but is below the 20-year average of 5.7%.

Bank loans bounced back in early 2015 as reduced issuance and lower valuations attracted investors. Bank loans have historically exhibited much less volatility than high-yield bonds. Therefore, they may be an option for more conservative clients, who seek yield while simultaneously mitigating interest rate risk.

Preferred stocks benefited from the decline in long-term bond yields over the first quarter of 2015. Like the broader bond market, the possibility of rising interest rates poses a risk, but the added yield and good underlying credit quality should help. Bank credit quality trends continued to improve in the first quarter of 2015 and helped to support issuer credit quality. Yields increased slightly over the first quarter of 2015 to about 4.6% on average and are still near a historic low, indicating a potentially much lower pace of returns for 2015.

Investment-grade corporate bond prices benefited from broad bond market strength during the first quarter of 2015 and outpaced Treasuries. Valuations stayed fairly constant, with the average yield advantage to Treasuries ending the first quarter of 2015 at 1.3%, relatively unchanged from last quarter and in-line with the historic average. Investment-grade corporate bonds remain an attractive income-producing option among highquality domestic bonds, especially considering the low yields on other high-grade bond sectors, such as Treasuries and mortgage-backed securities (MBS). The high-quality nature of investment-grade corporate bonds makes them more sensitive to rising interest rates, however.

Emerging markets debt (EMD) was impacted by global growth fears and lingering oil-related concerns, causing some volatility during the first quarter of 2015; but, on balance, prices finished the quarter higher due to the decline in longerterm interest rates, which benefited bonds broadly. Valuations are slightly more attractive than at the end of 2014, with the average yield spread at the high end of a five-year range. The average yield advantage of EMD to Treasuries increased to 4.0% as of March 31, 2015, up from 3.9% at the end of 2014.

The income-focused theme within the Model Wealth Portfolios (MWP) is another strategy to consider, which combines multiple asset classes and sectors. The goals of these portfolios are to seek excess total return and, secondarily, to pursue higher overall yields than the LPL Research blended benchmarks.

FAVORITE SECTOR/ASSET CLASS IDEAS

High-Yield Bonds (Taxable and Tax-Free): Our Preferred Asset Class Within Fixed Income

Oil price uncertainty and its impact on the highyield sector helped drive prices lower during January 2015. During February, however, the sensitivity of high-yield spreads to the price of oil decreased, after these two had moved tightly together throughout 2014, helping to drive spreads modestly lower for the first quarter of 2015. The fundamental backdrop for high-yield remains positive, on balance, as credit quality remains firm and defaults are likely to remain very low due in part to the absence of near-term maturities.

The average yield of the high-yield bond market, based on Barclays High-Yield Index, receded from the 18-month high reached during the fourth quarter of 2014, before finishing the first quarter of 2015 at 6.2%, down 0.4% from the end of 2014, and still well below its long-term average [Figure 2].

The average yield advantage, or spread, of highyield bonds to Treasuries decreased to 4.9% as of March 31, 2015, down from 5.2% at year-end 2014 [Figure 3]. The high-yield spread experienced swings during the quarter, rising to 5.4% at the end of January 2015, falling to 4.5% at the end of February 2015, and settling at 4.9% at quarter end. This yield spread is below the historical average of 5.7%, but may still represent good value given still strong corporate fundamentals and low defaults.

Energy sector defaults have yet to materialize but remain a risk over the balance of 2015. We believe the increase in yield spreads already compensates investors for a potential increase in defaults and defaults are likely to remain low relative to history [Figure 4]. The global high-yield default rate notched up slightly to 2.3% at the end of the first quarter of 2015, up from 2.1% at the end of 2014, according to Moody’s.

Economic growth concerns over Europe and China, in addition to mixed messages from domestic economic data, may continue in 2015 and could lead to bouts of volatility similar to those experienced over the second half of 2014. Oil related weakness in the high-yield energy sector should be monitored for trends of deterioration or increased defaults. However, we find the combination of yield and underlying fundamental support a potentially attractive opportunity for income-seeking investors.

For diversification purposes—and to reduce individual security risk—we strongly recommend investors use a mutual fund or exchange-traded product (ETP) for exposure to this asset class.

Investors, regardless of tax bracket, may wish to consider municipal (tax-free) high-yield bonds. The average yield of tax-free high-yield bonds is 6.3%, according to the Barclays High Yield Municipal Index (as of March 31, 2015), higher than that of the taxable high-yield market. The average yield was boosted in 2014 by the entrance of Puerto Rico debt into the widely followed Barclays Index, after Puerto Rico was downgraded to below investment grade during the first quarter of 2014.

The average yield advantage of high-yield municipal bonds to AAA-rated municipal bonds held at 4.0% (as of March 31, 2015), equal to that seen at the end of 2014. The average yield spread remains slightly above the four-year average but is heavily influenced by volatile Puerto Rican issues, which comprise more than 20% of the index. The greater yield is not without risks. Municipal highyield bonds have longer maturities and therefore tend to be more interest rate sensitive than their taxable counterparts, a risk worth noting should interest rates rise. Interest rate sensitivity was one of the primary drivers of high-yield municipal bond weakness in 2013 but a strong positive
driver in 2014.

Credit quality trends, like those of the taxable market, are largely supportive of the sector in our view. According to the Municipal Securities Rulemaking Board (MSRB) and Municipal Market Advisors data, the number of defaulted municipal issuers fell again in 2014, declining for the fifth consecutive year. In general, municipal defaults remain isolated and have been concentrated in the most speculative sectors.

Please be aware that the vast majority of tax-free, high-yield funds generate income that is subject to alternative minimum tax (AMT). Again, we recommend investors use a fund to gain exposure. Please contact the fund or ETP companies directly to obtain a copy of the prospectus for the percentage of income subject to AMT.

 

IMPORTANT DISCLOSURES

Investors should consider the investment objectives, risks, charges, and expenses of the investment company carefully before investing. The prospectus, and if available, the summary prospectus, contains this and other information about the investment company. You can obtain a prospectus from your financial representative. Read carefully before investing.

Investing in mutual funds, or exchange-traded funds (ETF) involve risk, including possible loss of principal. Investments in specialized industry sectors have additional risks, which are outlines in the prospectus.

All performance referenced is historical and is no guarantee of future results.

Indexes are unmanaged index and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. Past performance is no guarantee of future results.

The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for your clients. Any economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes. The purchase of certain securities may be required to affect some of the strategies.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

Mortgage-backed securities are subject to credit, default, prepayment risk that acts much like call risk when you get your principal back sooner than the stated maturity, extension risk, the opposite of prepayment risk, market and interest rate risk.

Currency risk is a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged.

Commodity-linked investments may be more volatile and less liquid than the underlying instruments or measures, and their value may be affected by the performance of the overall commodities baskets as well as weather, geopolitical events, and regulatory developments.

DEFINITIONS

Credit quality is one of the principal criteria for judging the investment quality of a bond. As the term implies, credit quality informs investors of a bond or bond portfolio’s credit worthiness, or risk of default. Different agencies employ different rating scales for credit quality. Standard & Poor’s (S&P) and Fitch both use scales from AAA (highest) through AA, A, BBB, BB, B, CCC, CC, C to D (lowest). Moody’s uses a scale from Aaa (highest) through Aa, A, Baa, Ba, B, Caa, Ca to C (lowest).

Default rate is the rate in which debt-holders default on the amount of money that they owe. It is often used by credit card companies when setting interest rates, but also refers to the rate at which corporations default on their loans. Default rates tend to rise during economic downturns, since investors and businesses see a decline in income and sales while still required to pay off the same amount of debt.

London interbank offered rate (Libor): An interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market. The Libor is fixed on a daily basis by the British Bankers’ Association. The Libor is derived from a filtered average of the world’s most creditworthy banks’ interbank deposit rates for larger loans with maturities between overnight and one full year.

Municipal Market Advisors is an independent strategy, research and advisory firm.

Spread is the difference between the bid and the ask price of a security or asset.

INDEX DESCRIPTIONS

Barclays U.S. Aggregate Bond Index is comprised of the Barclays Government/Corporate Bond Index, Mortgage-Backed Securities Index, and Asset-Backed Securities Index, including securities that are of investment grade quality or better, have at least one year to maturity, and have an outstanding par value of at least $100 million.

The Barclays U.S. Corporate High-Yield Index measures the market of USD-denominated, noninvestment-grade, fixed-rate, taxable corporate bonds. Securities are classified as high yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below, excluding emerging markets debt.

The Barclays U.S. Treasury Index is an unmanaged index of public debt obligations of the U.S. Treasury with a remaining maturity of one year or more. The index does not include T-bills (due to the maturity constraint), zero coupon bonds (Strips), or Treasury Inflation-Protected Securities (TIPS).

The Barclays U.S. Municipal Index covers the USD-denominated, long-term, tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds, and prerefunded bonds.

The BofA Merrill Lynch Preferred Stock Hybrid Securities Index is an unmanaged index consisting of a set of investment-grade, exchange-traded preferred stocks with outstanding market values of at least $50 million that are covered by Merrill Lynch Fixed Income Research.

The Barclays U.S. High Yield Municipal Bond Index is an unmanaged index made up of bonds that are noninvestment grade, unrated, or rated below Ba1 by Moody’s Investors Service with a remaining maturity of at least one year.

Barclays Corporate Bond Index is an unmanaged index of investment grade rated bonds issued by corporations and quasi-government agencies. Corporate bonds issued by foreign entities but denominated in U.S. dollars are also included in the index.

Barclays High Yield Bond Index is an unmanaged index of corporate bonds rated below investment grade by Moody’s, S&P or Fitch Investor Service. The index also includes bonds not rated by the ratings agencies.

Citigroup 3-Month T-Bill Index represents monthly return equivalents of yield averages of the last 3-month Treasury bill issues.

The JPMorgan Emerging Markets Bond Index Global (“EMBI Global”) tracks total returns for traded external debt instruments in the emerging markets, and is an expanded version of the JPMorgan EMBI+. As with the EMBI+, the EMBI Global includes U.S. dollar-denominated Brady bonds, loans, and Eurobonds with an outstanding face value of at least $500 million. It covers more of the eligible instruments than the EMBI+ by relaxing somewhat the strict EMBI+ limits on secondary market trading liquidity.

Russell 3000 Index measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity market.

INVESTMENT OBJECTIVES

Aggressive Growth will essentially be fully invested in equity assets at all times (with the exception of a 5% cash position). Investors in this portfolio should have a long time horizon of 10 years or more, an understanding of the volatile history of equity investments, and a propensity to add money to the account on a systematic basis. This portfolio is very aggressive by nature and should not be considered by anyone unwilling to take on significant risk.

Growth will be targeted to an allocation of 80% in equity assets and 20% in fixed income assets (including a 5% cash position). Investors in this portfolio should have a long time horizon, an understanding of the volatile history of equity investments, and a propensity to add money to the account on a systematic basis. This portfolio is aggressive by nature and should not be considered by anyone unwilling to take on significant risk.

Growth with Income Investors in this portfolio should have a long time horizon, and an understanding of the volatile history of equity investments. The primary investment objective of this portfolio is growth of principal. Fixed income assets are included to generate income and reduce overall volatility.

Income with Moderate Growth will be targeted to a normal allocation of 40% in equity assets and 60% in fixed income assets (including a 7% cash position). Investors in this portfolio should have a time horizon of more than five years, and be comfortable with the volatile history of equity investments. The primary investment objective of this portfolio is income, with growth of principal an important consideration. Fixed income assets form the core of the portfolio, generating income and lowering the portfolio’s overall volatility. Equity assets provide the opportunity for long-term growth of principal.

Income with Capital Preservation will be targeted to a normal allocation of 21% in equity assets and 79% in fixed income assets (including a 10% cash position). Investors in this portfolio should have a time horizon of more than five years, and be comfortable with the volatility that will occur within the modest equity portion of their investment portfolio. The primary investment objective of this portfolio is income, with growth of principal as a secondary concern. Fixed income assets form the core of the portfolio, generating a steady income stream. A small investment in equity assets provides the opportunity for modest long-term growth of principal.