The investment environment is changing, but what isn’t changing is the need to generate investment income. How to achieve the latter during the former comes down to focusing on equity income and certain areas in fixed income.

At least that’s the game plan offered by a trio of money managers from Thornburg Investment Management who spoke on a panel at this week’s Schwab Impact conference in Philadelphia. That panel discussion looked at investment opportunities in what’s described as a new era of income.

Their overarching message was that a regime change is taking place on the investing scene, which presents investors an opportunity to recalibrate their portfolios to profit from current conditions.

As they see it, the end of near-zero interest rates represents a return to a more normal environment.

Ben Kirby, Thornburg’s co-head of investments, noted that rock-bottom interest rates caused distortions that will be corrected as the markets and investors adjust to higher interest rates. For example, small companies that easily accessed low-cost capital when rates were super low now face a higher cost of capital. That, in turn, could have implications on investment portfolios.

“The types of businesses that were able to thrive in the prior decade will have a much harder time thriving during the next decade," Kirby said.

Thornburg’s message was that higher interest rates mean that investors should shift their focus to big companies that can generate cash flows and pay dividends.

Dividends have played a huge role in the total return profile of equities over the long term.

“On average, dividends are roughly 50% of your total return,” said Matt Burdett, a Thornburg portfolio manager. “In the ‘90s in the U.S., price returns were more than 80% of your total return. The following decade, it was the opposite where dividends mattered a lot more.”

He added that successful dividend investing depends on what your starting multiple is. Lower-priced assets result in both greater potential price appreciation and more shares being bought, enabling greater compounding of dividend income over time. He pointed out that the S&P 500 Index multiple was 10.5 times earnings in 2011, or roughly half of the current multiple of 20 times earnings. Such a high multiple will likely curb price appreciation in coming years, which means dividends will likely matter more.

Kirby noted that dividend-paying companies historically have outperformed the market over time. And companies with track records of growing their dividends have done even better while offering lower volatility.

“You get higher returns and lower volatility, and they’re at a tremendous discount today,” he said. You can buy a lot of very high-quality dividend payers at 11x-12x earnings. Again, it gets back back to valuations being critical to your long-term return expectations.”

And, he added, the income stream from dividends can cushion the blow of inflation.

The Thornburg team offered that investors can find much better equity income ideas outside of the U.S. where valuations are lower.

Skeptics would reply that international stocks on the whole have been cheaper than U.S. stocks for a long time, yet U.S. stocks have continued to outperform their overseas counterparts.

But Kirby believes that the dominance of the U.S. over the past 15 years has been an anomaly, and he anticipates a pivot could occur between international and domestic markets.

“We think this current environment creates some exciting opportunities, but very few investors are positioned for that because there has been a lot of complacency,” Kirby said. He noted that the prevailing attitude has been to buy the S&P 500 and the Nasdaq and just chill because that’s what has worked and will likely keep working.

“We think the next 10 years won’t look like that, and there will be a lot of money in motion as a result,” he said.

Fixed Income
Thornburg as a firm has a positive view on fixed income.

Kirby pointed to high-yield bonds that currently are paying 9% versus 4% two-and-a-half years ago. “That’s an equity-like return on a contractual obligation.”

He also mentioned Treasury Inflation Protected Securities, or TIPS, that offer a 2.3% real yield. “That used to be a negative number,” he said.

Jeff Klingelhofer, co-head of investments at Thornburg, said that municipal bonds on the long end of the yield curve offer negative correlation to other risk assets while providing a relatively high income component from a tax-exemption basis.

He also said that today’s rate environment leaves fixed-income indexes priced at a discount with room for meaningful price appreciation. He displayed a chart showing the average price of the Bloomberg U.S. Universal Index (comprising USD-denominated, taxable bonds that are rated either investment grade or high yield) was currently below $90. That means bond prices on the whole are trading comfortably below par value, or face value of $100.

The concept of “pull-to-par” speaks to the propensity of fixed-income securities to move toward their par value as they near maturity. “Today the pull-to-par is dramatic,” Klingelhofer said. “Pull-to-par dampens volatility.”

Another Thornburg chart showed that fixed income has largely outperformed cash when the Federal Reserve stops raising interest rates.

Kirby said that fixed income is more attractive now than it has been for the past 15 years, and probably deserves a bigger place in a portfolio as a result.