Income Outlook: Q1 2022 – Fed liftoff triggers rate hike

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The Global X Income Outlook for Q1 2022 may be viewed here. This report aims to provide macro-level data and insights across multiple income-seeking asset classes and strategies.

We discussed the Federal Reserve’s (Fed) dovish stance and the likelihood of more persistent inflationary pressures last quarter. These trends continued into 2022 as market expectations of aggressive monetary tightening prevailed and inflation data printed at extremely high levels by developed market standards. We believe there are some key issues and solutions for investors to pay particular attention to in the income investing markets.

The central theses:

  • The potential for multiple rate hikes by the Fed and other central banks and aggressive balance sheet repair looks increasingly likely for the remainder of the year.
  • Low-duration instruments, such as floating rate preferred stocks, can be an alternative for fixed income investors looking to reduce interest rate risk but still have income objectives.
  • Energy assets with strong fundamentals, such as master limited partnerships (MLPs) and energy infrastructure stocks, look attractive in an environment of rising oil prices.
  • Options-based strategies such as covered calls could be attractive given the heightened volatility and defensive stance in equity markets.

Hawkish central bank policy makes further interest rate and credit spread rises more likely

Persistent inflation in the United States and limited monetary policy response left the Fed in a precarious position early in the year. The Fed was forced to catch up after maintaining loose monetary policy despite inflationary pressures spreading to the global economy. However, the Fed reacted sharply in the first quarter, raising interest rates for the first time in three years. However, the Fed was not alone. The Bank of England and the Bank of Canada, among others, raised interest rates, opening the door to broader global monetary tightening this year.

Moreover, this pace of rate hikes and tapering is unlikely to slow. The European Central Bank (ECB), which has historically been dovish compared to other developed central banks, said it could end its bond-buying program in the third quarter.1 The futures market is currently forecasting a move from negative 50 basis points (bps) to zero interest rates by the end of the year.2 The US and UK central banks are forecast to be even more aggressive with 125 basis points in UK hikes and 200 basis points in US hikes forecast for the futures market.3 This would clearly be the most aggressive policy action in the short span of time we have seen this cycle.

For example, we believe the Fed is being forced to catch up as inflation rates hit 8.5% in the US in March. The last time headline inflation in the United States reached this level was in the 1980s. The bond market is already moving in step with inflation, so tightening policies have been priced into government bond yields.

Credit spreads are also more likely to widen given central bank rate hikes and further monetary tightening. Credit spreads widened in the first quarter as equity markets sold off and the rate hike path began. Rising geopolitical tensions could also make funding conditions more difficult for high-yield issuers.

Variable Rate Preferred as a fixed rate alternative

Aggressive monetary policy moves pose two risks for fixed income investors: rate hikes, which are already permeating the market, and a potential widening of corporate credit spreads. For income investors, the key in this environment is to balance interest rate risk with yield needs.

Real (inflation-adjusted) yields turned negative in the midst of the pandemic, leaving income investors in a challenging position. The recent rise in government bond yields mitigates some of this risk, but real yields are still barely on the verge of turning positive. Persistent inflationary pressures such as supply chain issues and labor shortages keep headline inflation rising, with the March reading coming in at 8.5%. This increases the need for real income levels to keep pace.

Floating rate preferred securities have historically held up well in rising interest rate environments due to their lower duration. The outperformance of variable rate preferred stocks also occurred relative to broader fixed income securities.

Master Limited Partnerships as an income game with commodities

Commodity investment has been one of the highlights of the market this year as global supply constraints and inflationary pressures have pushed commodity prices higher. For income investors, however, the non-yield nature of commodity futures makes this avenue less attractive for generating cash flow. The equity of companies in the commodities business is more attractive given the potential to return capital through dividends or share buybacks.

Master Limited Partnerships (MLPs) are a way for income investors to potentially both generate income and profit from commodity trading in oil. These pipeline companies could be well positioned for an increase in US energy production, and this year’s rise in oil and gas prices has also boosted natural resource assets such as MLPs. That tax-advantaged nature of distributions and yield spreads relative to other asset classes could make MLPs a compelling option for income investors.

Increased volatility makes covered call strategies attractive in a rising interest rate environment

The tightening by the central bank not only led to a rise in yields and an impact on lending. Increased volatility began to flow in equity markets as investors began repricing valuation multiples and growth stocks began to sell off in favor of value.

After the stock market sell-off at the beginning of the first quarter, all major indices saw a significant increase in volatility. For income investors, covered call strategies on major indices like the Nasdaq 100 or S&P 500 could be a way to generate income outside of traditional dividend stocks and fixed income.

The potential for earnings growth can leave investors wanting some upside potential for stocks while also enjoying a potential stream of income. With the S&P 500 expected to post earnings growth of 6.5% for the second quarter and 11.1% for the third quarter, some income investors may want to maintain their exposure to equities.4 Below we see a comparison of the option premiums generated by writing covered calls both at-the-money with 100% notional coverage and using 50% notional coverage to obtain upside potential. For more information on option premiums for Global X’s covered call strategies, including the Russell 2000 and the Dow Jones Industrial Average, please click on the report in this document shortcut.

Conclusion

The rise in government and other government bond yields around the world means that income investors need to be on the lookout for the impact on their income portfolios. Broader fixed income assets are likely to come under pressure as central banks tighten aggressively, and high-growth equity assets could be volatile for the foreseeable future as interest rates rise. Floating Rate Preferred Stock offers a balanced approach to duration risk and preferred stock earnings levels. Sectors that can withstand supply chain-driven inflation could bode well in this environment relative to other segments of the market. Energy-related assets like MLPs and options strategies like covered calls that are able to monetize volatility could be solutions in this rising interest rate environment.

footnotes

1European Central Bank. (2022, April 14). monetary policy decisions.
2Saphir, A. (2022, April 18). The Fed’s Bullard wants interest rates up to 3.5% by the end of the year.
3Inman, P. (2022, April 9). High prices and low growth are likely to nip rate hikes in the UK and the eurozone in the bud. The guard.
4FactSet research systems. (nd). Insight into FactSet earnings. facts. Accessed April 19, 2022.
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