After a brutal selloff in bonds, opportunities have emerged for income investors

For many years, dividend stocks were one of the few places investors could find decent returns in a world of ultra-low interest rates. A 10-year Treasury note was trading at a weakened 1.3% a year ago, less than half the 3% yield in dividend-rich sectors such as utilities.

That has changed. Attractive yields are emerging across the bond landscape and in parts of the stock market. “There’s a lot more revenue today than there was at the beginning of the year,” says Kelsey Berro, a portfolio manager at JP Morgan Asset Management.

No free lunch yet. Bond yields move inversely to prices, and that dynamic has constrained yields as falling prices eat away at gains from interest income. “We’ve had a historic sell-off in fixed income,” says Anders Persson, chief investment officer for global fixed income at Nuveen.

The 10-year US Treasury bond is yielding 3.27%, after doubling since January. This has left investors with a total return of minus 11.9%, including interest. Diversification didn’t help much. The


iShares Core US Aggregate Bond

exchange-traded fund (ticker: AGG), a market proxy that includes 24% of its assets in corporate debt and 27% in mortgage-backed securities, is down 10.3% this year.

The headwinds are not likely to abate, with the Federal Reserve recently becoming more hawkish, according to Chairman Jerome Powell’s recent speech in Jackson Hole, Wyo. Markets now expect a “higher for longer” sentiment for interest rates. Investors should also brace for more volatility as markets scrutinize every economic data point for more signs of Fed tightening…or easing.

That selloff, however, opened up opportunities in income-producing assets. “Whether it’s fixed income, equity or anything in between, the income component has become more attractive,” says Mark Freeman, chief investment officer at Socorro Asset Management.

Berro, for one, is moving away from high-yield bonds and emphasizing shorter-dated investment-grade credit. This will help reduce rate sensitivity. She also likes asset-backed securities, such as auto loans. “The U.S. consumer balance sheet is in a relatively good position, with low debt service ratios,” he says, adding that such asset-backed loans yield an average of 4.1 percent.

Gibson Smith, who co-managed fixed income at Janus Henderson and now runs his own firm, sees the front end of the yield curve as the riskiest part. “The $64,000 question is: How much higher will interest rates be on the front end?” He says. “The higher the rates, the greater the risk of a slower growth trajectory.”

Smith and his team manage the


ALPS/Smith Total Return Bond

fund (SMTHX), which has edged up the broad bond market this year with a total return of minus 9.7%. As yields rose, the fund reduced its exposure to credit, particularly investment-grade securities and bonds issued by financial companies. He recently added to the fund’s holdings in longer-dated bonds, especially in the 20- to 30-year range.

Long-term bonds are particularly sensitive to interest rates, which scares many bond managers. Smith takes a contrary view, arguing that the Fed’s aggressive actions now will reduce inflation by supporting long-term bonds. “The more aggressive the Fed, the more supportive the long-term end of the market,” he argues.

Mohit Mittal, its co-director


Pimco Dynamic Bond

fund (PUBAX), sees value in agency mortgage-backed securities, known as MBS. Bonds “have fallen as markets price in the Fed’s balance sheet reduction,” he says. MBS yields an average of 4.5%, though total returns will depend on factors such as housing demand and the Fed’s plans to shrink the $2.7 trillion in MBS on its balance sheet.

Two other ways of investing: o


Vanguard Securities with Mortgage

ETF (VMBS) and the


Janus Henderson Mortgage Securities

ETFs (JMBS). Both yield around 2.5%.

Also in housing, Mittal likes non-agency mortgage securities, which are not backed by a government entity such as Fannie Mae or Freddie Mac. “The home price appreciation we’ve seen over the last couple of years means that loan-to-value ratios have improved in favor of bond investors,” he says, adding that non-agency MBS yield an average of 5.25%.

Another way to play this theme is to


Total performance of Semper MBS

fund (SEMOX), which has a heavy weighting in non-agency mortgages. It has a low duration and a yield of 5.1%.

Carl Kaufman, chief investment officer at Osterweis Capital Management, sees opportunity in dividend stocks. “Over the long term, companies with a history of increasing dividends perform quite well,” he says.

The


Osterweis Growth & Income

the top holdings of the fund (OSTVX) include

Microsoft

(MSFT),

Johnson & Johnson

(JNJ) and

CVS Health

(CVS). Microsoft only yields 0.9%, but it’s steadily increasing its returns, he points out. J & J and CVS both yield over 2%, and he expects steady earnings growth at both companies.

One area that looks risky is real estate investment trusts, or REITs. Real estate companies are under pressure from rising interest rates and fears of a recession. The


Real Estate Select Sector SPDR

the sector-tracking fund ( XLRE ) is off 17.9% this year.

Freeman says he has cut his fund’s REIT holdings in half, to about 8%. “Long-term, we like the asset class,” he says, “but we want to see what happens in terms of recession.”

Write to Lawrence C. Strauss at lawrence.strauss@barrons.com

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