While equity investors as a whole had a great year, those weighted toward income-generating stocks and bonds—including many retirees—did not do nearly as well. Canada’s real estate investment trust sub-sector was down 11.5% as of late November, and utilities were off 7.3%. Long-term bonds fell too, dragging the DEX Universe Bond Index down nearly 4% in 2013. You read that right, ye of short memory: bonds can lose value.
This marked a break from the pattern since the 2008 crash, when there was no better investment to own than an income-generating one. The inflection point came in June, when the U.S. Federal Reserve announced that it would start tapering its quantitative easing purchases. The interest rates on long-term debt immediately began rising on the expectation that an improving U.S. economy and creeping inflation would force the Fed to eventually raise overnight lending rates. When rates climb, bond prices drop and certain yielding stocks start looking less attractive, explains Josh Peters, Morningstar’s director of equity-income strategy.
Dividend-paying equities had it worse than bonds because they ran into valuation issues. During the post-crash years, these stocks became so popular as a higher-yielding alternative to bonds that many of them became overpriced. Once bond yields began rising again, the investor exodus affected stock prices more than if they were undervalued.
Defensive stocks generally tend to underperform in a higher-growth environment too. “When the market is expressing optimism, these companies don’t gain as much, and they’re not as profitable,” says Peters.
The most affected companies were those with bond-like characteristics, says Douglas Burtnick, a senior investment manager with Aberdeen Asset Management. “They have stable income streams, and investors value them with the same basic principles as a bond,” he says. That’s a benefit in a volatile environment, but not in a rising-rate climate. “These equities go down the same as bonds do.”
Where income investments go from here largely depends on whether or not rates continue to rise, says Burtnick. Given that rates are still extremely low, investors shouldn’t be surprised if long bonds and dividend payers end up taking another hit. Income stocks are still worth owning, he says, but stick to ones that are reasonably priced and raise their dividend every year.
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