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With the March CPI report showing inflation actually accelerating rather than decelerating as some had hoped, many high-yield stocks (SPYD)(SCHD) have sold off, extending their material underperformance relative to the S&P 500 (SPY) so far this year.
Moving forward, it appears increasingly likely that the Fed will have to be somewhat guarded with the pace of interest rate cuts in order to ensure that inflation does not spike again. This article will examine three important ramifications of that reality, each of which combines to provide an important warning for high-yield investors.
#1. Long-Term Interest Rates Are Quite Possibly Too Low
Since the Fed’s rate-hiking campaign began in early 2022, both short- and long-term interest rates have risen meaningfully. However, short-term rates have risen far more than long-term rates have, giving us an inverted yield curve today:
This appears to reflect the fact that the market expects the Federal Reserve to cut short-term interest rates meaningfully in the coming years, thereby uninverting the curve. However, with inflation seemingly hitting a brick wall well above the Fed’s long term 2% target based on recent data points, it appears that the Fed may not be able to cut rates meaningfully for the foreseeable future. This means that instead of short-term rates declining, long-term rates will quite possibly have to increase materially in order to uninvert the yield curve.
#2. Pressures Will Likely Mount On Counterparties
With inflation proving sticky and therefore interest rates increasingly unlikely to decline (and in fact, long-term rates are likely going to move higher as we just discussed), it is very likely that many counterparties of high-yield stocks will face mounting financial pressure.
For example, REITs (VNQ) like Simon Property Group (SPG), Realty Income (O), and Medical Properties Trust (MPW) could potentially have to deal with increasingly financially challenged tenants due to a deadly combination of rising operating costs from inflation and rising capital costs from high interest rates.
BDCs (BIZD) are also not exempt from this challenge, as their counterparties will also face a challenging environment, with elevated short-term interest rates on many of their borrowings remaining at elevated levels at the same time that operating/input costs remain high from persistent inflation. In fact, BDC blue chip Ares Capital (ARCC) recently warned of this very phenomenon on its Q4 2023 earnings call, with its CEO stating:
We’ve said in the past that we’re likely to see defaults in the industry increase this year. It does take a little bit of time for that to manifest itself, right? So in the bottom quartile of our portfolio and probably everybody else’s, you have some companies that are making interest payments but continue to live off revolver availability, cash, et cetera, but the liquidity is getting tighter and tighter. And so my expectation is that defaults will go up this year.
Utilities (XLU) will also likely face some pressures, especially in more politically liberal jurisdictions, as higher interest expense combined with more challenging base rate cases could pressure profit margins.
#3. A Soft Landing Is Increasingly Unlikely
The economy is beginning to show some fraying around the edges, with savings rates low, consumer debt at record levels, consumer sentiment weakening, and unemployment beginning to rise. If inflation remains persistent and interest rates remain high as well, this will only put further stress on the consumer. If the aforementioned stress on some businesses increases, this will likely drive unemployment even higher, further weakening the consumer.
Moreover, there is a wall of commercial real estate debt coming due in the coming months and years that will have to be refinanced at much higher rates than it was originally underwritten at in the past. This could lead to a wave of defaults and a commercial real estate apocalypse that will likely fuel further challenges for CRE-sensitive regional banks (KRE) that could mirror what New York Community Bancorp (NYCB) just went through.
Ultimately, when combined with the headwinds from already in motion economic weakness in places like Europe, Japan, and China, this will likely be enough to tip the United States economy into recession. While this downturn may be what finally kills inflation, it will also likely take a lot of jobs and businesses with it and bring considerable pain to high-yield investors.
Investor Takeaway: An Important Warning
What this all means for high-yield investors right now is that any investment thesis that rests on interest rates falling rapidly is very risky, if not reckless. For example, NextEra Energy Partners (NEP) is facing a wall of debt and CEPF maturities in the coming years, making it highly dependent on being able to sell a pipeline asset and tap into capital markets to be able to navigate this minefield. While NEP looks attractive with a ~12% distribution yield, its high leverage and sensitivity to interest rates make it an extremely risky bet right now.
Instead, high-yield investors would be prudent to instead pursue opportunities where there is much less dependence on interest rates falling in the near future. For example, midstreams like Enterprise Products Partners (EPD), infrastructure stocks like Brookfield Infrastructure Partners (BIP)(BIPC), and REITs like Agree Realty (ADC) all have very strong balance sheets with little near-term dependency on capital markets to be able to execute their business strategies. Yet, all three still offer very attractive current yields and also have solid long-term growth prospects.
While the weak market sentiment on the high-yield sector has created an enormous opportunity for value investors to buy high-quality stocks at deep discounts, it is crucial for investors to carefully navigate the sector by avoiding opportunities whose investment theses are dependent on interest rates declining substantially.
