Investors should plan for a likely U.S. recession later this year. Historically, recessionary pressures weigh on earnings growth, with investors focusing on yield for a good portion of their total return. In 2022, higher-yielding areas of the market outperformed the S&P 500 SPY as the Federal Reserve (Fed) aggressively raised interest rates, shifting investors’ focus from future growth potential to current income.
During these times of economic uncertainty, investors ought to weigh the benefits of yield-focused solutions.
Key Takeaways
- Quality dividends that can withstand economic shocks should be well-positioned.
- Defensive sectors with high payout ratios typically outperform during late-cycle and recessionary environments.
- Equity income portfolios must be flexible enough to balance yield and total return throughout business cycles.
Viable Dividends During Market Downturns
Dividend income can provide a margin of safety during times of market stress. But not all dividends are created equal. As the old saying goes, “cash is king,” and some companies may cut payouts to retain cash through economic downturns. However, quality firms with strong balance sheets and free cash flow typically have more resilient payouts. The financial discipline of quality firms can enable reasonable payouts to shareholders while retaining enough earnings to fund growth.
Quality stocks outperformed the broader market in March 2023, reversing prior months of underperformance during this late-cycle environment that began in February 2022, as seen in the chart below.
While substantial multiple compression makes value stocks appear attractive, varying fundamentals may create a “value trap” and could make some companies vulnerable during a recession. Therefore, the earlier mispricing of quality stocks during the challenging economic environment provided an opportunity for investors, especially those seeking stable dividend income. Quality could continue to benefit as the late-cycle stage advances.
Quality Yield Strategies
Exposure to MLPs (Master Limited Partnerships) and REITs (Real Estate Investment Trusts) can also provide higher yields relative to the S&P 500 and the 10-year Treasury yield.
Investors can also find higher-than-average dividend yield opportunities within the telecommunications industry of the Communication Services sector. Companies in this space are older, well-established, and have a history of paying above-average dividends.
Dividend yields have remained below the long-term average of 3% for the past 30 years. The S&P 500’s dividend yield rose to 1.67% over the past year from a low of 1.20% in December 2021, though it remains below average levels, according to Bloomberg data. The index’s dividend yield rose as equity prices fell. Despite historically low dividend yields, investors can still achieve yield by positioning within sectors that have relatively high payout ratios.
Energy offers a relatively high dividend yield of 3.93%. Despite the potential for lower oil prices during a recession, capital discipline and improved cash flows relative to previous cycles could help sustain dividends during a downturn. Utilities offer recession-proof characteristics and a 3.15% dividend yield, though, high Treasury yields can negatively impact this sector. We prefer the defensive nature of Consumer Staples, which offers a 2.50% dividend yield. The table below lists current dividend yields by S&P 500 sectors.
Risk Mitigation & Differentiated Yield
Preferreds
We favor preferred equities due to their position in the capital structure and low beta. Their lower sensitivity to equity market price movements aids in reducing volatility relative to common equities. The dividends on variable rate preferreds float relative to a reference rate, which can be beneficial in a rising rate environment. It is important to remember that variable and fixed-rate preferreds have duration risk due to their perpetual nature.
The preferred equity market may face periods of heightened volatility during episodes of banking stress. As securities that are included in regulatory capital, banks are one of the largest issuers of preferreds. During normal market conditions, this is a boost for preferred credit quality. However, it also means that preferreds are impacted by the overall health of the financial system. The recent regional banking crisis negatively impacted preferreds, although the greater issuance by large banks since the 2008 financial crisis can offer some resilience.
Covered Calls
Covered calls perform best when markets are rangebound. The income generated from selling call options on the S&P 500, Nasdaq 100, or Russell 2000 is paid out to investors in the form of yield. Investors have full exposure to the downside, as calls expire worthless in a declining market. Exposure is capped on the upside, as the underlying security can be called away. When volatility rises, the premium received increases to compensate for market instability.
Holistic Approach for Higher Yields & Total Return
Finding yield through equity income is important, but selectivity is vital given current economic uncertainties. Exposure to quality stocks can provide resilient yield. Covered calls can offer a relatively high premium during volatile and rangebound market environments. And preferred stocks can provide a reasonable income and lower beta.
Each of these areas generally focus on either yield or return potential. Combining equity income solutions can improve a portfolio’s exposure diversification while also diversifying its sources of yield. This can create a portfolio that provides a solid yield while also focusing on total returns. Although the economic outlook includes some dark clouds, opportunities can emerge during recessionary periods. Equity income portfolios must be flexible enough to capture upside while maintaining a decent yield throughout the business cycle.
See our full whitepaper on equity income solutions.
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