Opportunities in Underfollowed Income Stocks September 2016
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The Global Hunt for Yield: Opportunities in Underfollowed Income Stocks September 2016 Searching for Yield…but in All the Wrong Places The need for current income and quality Meanwhile on the publicly traded equity side, risk-adjusted returns is growing due to a divergent and uncertain monetary policy, number of macroeconomic and demographic fears of slowing growth, currency devaluation pressures. Pension plans are seeking higher and the impact of the energy and commodity returns to close liability gaps, insurance price collapse have contributed to heightened companies are seeking higher returns to and continuing volatility. offset the narrowing spread between their Quantitative easing has fueled high asset assets and liabilities, and more individual valuations, and a surplus of excess capital is investors are entering retirement and looking for returns. Many believe that seeking higher yields to bridge the savings traditional high income equity sectors are gap and to supplement income. either fully priced (utilities, property REITs) At the same time, monetary policy and or have under-performed due to commodity market dislocations have created unique or business model risk (MLPs). challenges for investors seeking yield, as traditional investment strategies fall short Headquarters of providing required returns. Ares Management, L.P. Global central bank policy has driven yields 2000 Avenue of the Stars We are dealing with th on traditional income-generating securities 12 Floor “ Los Angeles, CA 90067 to historic lows, with zero and even negative a marketplace www.aresmgmt.com rates on approximately $13 trillion(1) in global where traditional Company Locations instruments. With interest rates at all-time fixed income and lows, investors can no longer rely on U.S. Los Angeles, New York, Chicago, global equities are traditional benchmark-driven, core fixed- Boston, Atlanta, Washington D.C., Dallas, not offering desired San Francisco income strategies to meet their fixed-rate levels of return. Europe/Middle East London, Paris, and overall return objectives. Fixed-income Frankfurt, Stockholm, Luxembourg, instruments are under extreme pressure, ” Dubai with treasury, investment grade corporate Asia/Australia Shanghai, Hong Kong, bonds and municipal bonds all yielding less Chengdu, Sydney than 4%.(2) Please see the Endnotes and Legal Notice and Disclaimers beginning on page 11. | Ares Market Insights Alternative Yield Securities Offer Attractive Figure 1: Alternative Yield Securities Provide Potential Returns Attractive Dividend Yields Relative to Other Despite these challenges, we believe that there are significant Yield Investments opportunities to earn compelling risk-adjusted returns through public funds investing in alternative assets. These funds, or Alternative Yield Securities, include business development BDCs 11.8% companies (“BDCs”), mortgage real estate investment trusts Mortgage REITs 10.0% (“Mortgage REITs”) and credit-based closed-end funds (“Credit Credit CEFs 8.7% CEFs”). We believe these investments are attractive for the following reasons: High Yield 7.0% • Strong Income and Total Return Profile:Attractive current Lev eraged Loans 5.2% income and long-term total return potential, dividend stability across market cycles and strong historical returns Equity REITs 3.5% relative to risk Investment Grade 3.3% • Attractive Entry Point:Attractive current pricing relative to Utilities 3.1% fundamentals, as well as meaningful valuation discounts to current net asset values due to inefficient markets, S&P 500 2.1% informational asymmetries and market misperceptions 10-year Treasury 1.5% • Diversification:Broad underlying portfolio investments can reduce concentration risk, and volatility may be reduced by 0% 5% 10% 15% correlation differences across asset classes Current Yield • Efficient Tax Structure:Potential for reduced tax leakage at Sources: Bloomberg, SNL, Factset, Morningstar. Past performance is not indicative the investment level, with additional foreign investor tax of future results. Based on the most recently declared dividend/distribution divided by stock price as of 6/30/16. See Endnotes. benefits A Snapshot of the Alternative Yield Security Asset Classes BDCs Mortgage REITs Credit-Based Closed-End Funds Closed-end investment companies required Pass-through vehicles that invest in loans, Publicly traded, registered investment to invest in private U.S. businesses, including bonds and/or securities backed by real companies that invest in liquid senior bank by providing financing for small and medium- estate as well as loan servicing businesses loans, high yield bonds and structured sized U.S. businesses. and equity in real estate properties. products. Aggregate Market Capitalization: Aggregate Market Capitalization: Aggregate Market Capitalization: $30 billion (53 publicly-traded BDCs)(3) $60 billion (41 publicly-traded Mortgage $29 billion (63 Credit CEFs)(3) REITs)(3) Profile: Profile: • Access to top alternative managers and a Profile: • Attractive current income potential, stable diversified pool of illiquid middle market • Potential for attractive current income capital structures and liquid investments corporate assets through dividend yields provide high visibility on equity values • Potential for attractive current income • Secured investments in real estate to limit • Can capitalize on longer-term, less liquid and yield through dividend distributions credit loss securities due to their stable capital • Daily liquidity, portfolio transparency with • Sensitive to interest rates and subject structure detailed holding information to periods of book value and stock price • Subject to periods of book value and stock • Subject to periods of book value and stock volatility price volatility during market dislocations price volatility, particularly in down cycles “ We believe that Alternative Yield Securities offer attractive current income and trade at meaningful valuation discounts to current net asset values. ” 2 | Ares Market Insights Why Are These Asset Classes Attractive? Alternative Yield Securities are also currently trading at higher than average dividend yields. Current yield spreads for Alternative Attractive Total Return Profile and Current Valuation Entry Point Yield Securities relative to other asset classes indicate that while BDCs, Mortgage REITs and Credit CEFs have a range of compelling investors may have exhausted yield in other places, such as investment features, as well as attractive current valuations that treasuries and investment grade corporate bonds, they have not we believe reflect investor misperceptions of risks and technical yet fully capitalized on the opportunity for Alternative Yield factors. From a total return standpoint, they can provide durable Securities. Moreover, we believe that other alternative yield and predictable income through dividends and have attractive assets, such as utilities and Equity REITs, may be overvalued as long term capital appreciation potential. BDC, Mortgage REIT they are trading above historical average valuations based on and Credit CEF structures have built-in distribution requirements, dividend yields and price-earnings (“P/E”) ratios, while Alternative which can enhance dividends paid to investors. Given historically Yield Securities are tracking meaningfully below historical low interest rates and exogenous pressures on Alternative Yield valuations based on these same metrics. Securities, we believe that they are particularly compelling now, with attractive valuation entry points. All three asset classes are currently trading at meaningful discounts to net asset value,(4) Figure 4: Alternative Yield Securities Are Currently which we believe do not generally reflect their underlying Trading Above Historical Average Dividend Yields fundamental valuation. Assuming dividend yields revert to historical averages Figure 2: Alternative Yield Securities Are Currently due to stock price increases, this would result in total two-year annualized returns of 22.6% for BDCs, 20.2% for Trading Below Historical Price-to-Book Levels Mortgage REITs and 19.3% for Credit CEFs.(6) Assuming stock prices revert to historical average levels Current vs Historical Dividend Yields relative to book value, this would result in total two- 12.0% year annualized returns of 15.9% for BDCs, 14.3% for Mortgage REITs and 10.9% for Credit CEFs.(6) 10.0% Asset Class Average Price/Book Current Price/Book BDCs 1.05x 0.97x 8.0% Mortgage REITs 1.02x 0.94x Dividend Yield 6.0% Credi t CEFs 0.96x 0.92x Source: SNL Financial. Past performance is not indicative of future results. Averages 4.0% calculated from 12/31/10 through 6/30/16. See Endnotes. In the case of Credit CEFs, we can easily see the advantage of 2.0% Utilities Investment Equity High Yield Credit Mortgage BDCs below-book valuations when comparing current Credit CEF yields Grade REITs CEFs REITs with the yields of their liquid underlying assets – senior bank Current 5-Year Historical Average loans and high yield bonds. We believe that Credit CEF yields Source: SNL Financial and Bloomberg. Past performance is not indicative of future are higher than the index yields of their underlying assets primarily results. Historical average dividend yields calculated from 12/31/10 through due to their attractive below-book pricing level, in addition to 6/30/16. See Endnotes. other factors such as leverage. Figure 3: Credit CEF Yields vs Given historically low interest Underlying Asset Benchmark Yields “ rates and exogenous pressures