Big investors hate government bonds right now. Where to turn for income instead

Published Thu, Sep 16 202111:35 AM EDT

Bond investors are searching for alternative sources of income as they anticipate climbing yields and falling prices once the Federal Reserve begins dialing back its asset purchases. Government bonds are quickly becoming one of the most hated asset classes as their safe-haven appeal dampened amid the economic recovery. Meanwhile, the Fed, which has been buying $120 billion in Treasurys and mortgage-backed securities through its quantitative-easing program, may soon embark on its taper process. Bond yields have an inverse relationship to prices. Indeed, Many notable investors said the rise in yields will erode the bonds' value so significantly that they would no longer make a sensible investment. One-time bond king Bill Gross recently called Treasurys trash, saying the 10-year yield will trade around 2% for the next 12 months. Leon Cooperman last week said bonds are "totally overpriced ," calling a big decline in prices. The "big short" investor Michael Burry is betting that long-term Treasurys will fall as his Scion Asset Management held $280 million of puts on the iShares 20+ Year Treasury Bond ETF at the end of June. The ETF has lost more than 4% this year. "More growth-oriented investors … look at the prospects of traditional fixed income and go 'fixed income hasn't been adding much to my portfolio and now it looks like it's only going to create potential risk,'" said Samantha Davidson, U.S. leader of Mercer's outsourced chief investment officer business. Dividend growth stocks Companies that pay high and growing dividends can provide investors with stable income and inflation protection, according to Bank of America's head of U.S. equity and quantitative strategy Savita Subramanian. "Dividend growth stocks sit in between bonds (pure income, no inflation protection) and commodities (all inflation-exposure, no income) and benefit from inflation given that earnings are nominal," Subramanian said in a note. These stocks could be a scarce resource for inflation-protected yield in a low-rate environment in which cost pressure risks are brewing, the strategist said. The bank screened S & P 500 companies with the following criteria for dividend growers: Dividend yield bigger than the 10-year Treasury yield Dividend growth in at least three of the last four years (and no negative years) Less labor intensive than the median S & P 500 company (by employees/sales ratio) Positive relative beta to Bank of America Inflation Composite. A number of energy names make the list, including Chevron , Exxon Mobil , Kinder Morgan , ONEOK and The Williams Companies . REITs Real estate investment trusts are a diversifying source of income that is also leveraged to reflation, according to Lisa Shalett, chief investment officer of Morgan Stanley Wealth Management. REITs own or operate real estate, including retail, commercial office space, apartments and hotels. The sector has benefited from the economic reopening this year. For instance, the Schwab U.S. REIT ETF is up nearly 27% in 2021, while the iShares Global REIT ETF has gained about 20% in the period. "With real interest rates still negative and inflation expectations rising, we expect to be selective opportunistic investors in the sector this year, with a focus on residential," said Shalett. Hedge funds For more sophisticated investors, hedge funds are becoming a popular alternative investment as the return of volatility and rich valuations created a constructive environment for stock pickers to shine. "Using hedge funds as a potential component as your fixed income consideration is definitely something that is a conversation we talk about," Mercer's Davidson said. After a brutal start to the year due to the meme stock mania, hedge funds are making a comeback especially on the short side of the portfolio. Hedge funds' short book generated in July the best alpha since 2010 , according to Morgan Stanley prime brokerage data. After three straight years of outflows, hedge funds saw more than $6 billion client inflows in the first quarter, pushing the industry's total assets under management to a record of $3.8 trillion, according to Hedge Fund Research data. The biggest exchange-traded fund that incorporates hedge fund strategies is the IQ Hedge Multi-Strategy Tracker ETF with more than $800 million in assets under management, according to ETF.com. Another popular fund that gives retail investors access to hedge fund strategies is First Trust Long/Short Equity ETF. Credit In the fixed income space, investors are favoring alternatives to government bonds like leveraged loans and high-yield corporate bonds. Some of the biggest high-yield corporate bond ETFs include: iShares iBoxx USD High Yield Corporate Bond ETF (AUM: $19.25B) SPDR Bloomberg Barclays High Yield Bond ETF (AUM: $9.36B) iShares Broad USD High Yield Corporate Bond ETF (AUM: $8.08B) Wells Fargo strategists are specifically recommending middle-market direct lending for its outsized yield and low duration, while its floating rate nature provides a potential hedge against rising interest rates. "We believe there is an opportunity for qualified investors to invest in middle-market direct lending strategies for alternative or non-traditional income streams," the bank's strategists said in a note.

A trader works on the trading floor at the New York Stock Exchange (NYSE), August 10, 2021.

Andrew Kelly | Reuters

Bond investors are searching for alternative sources of income as they anticipate climbing yields and falling prices once the Federal Reserve begins dialing back its asset purchases.