That Was Easy: Fourth Quarter and Year-End 2020 Income Investing Recap

By Matthew J. Patterson, Cofounder HANDLS Indexes

It certainly did not look like it was going to be a banner year for income investors back on March 20, 2020 at the height of the pandemic-driven selloff. On that Friday, with the S&P 500 Index down more than 30% from the beginning of the year and with credit markets in disarray, prospects for a profitable 2020 appeared dim.

After the close of markets on March 20, the Federal Reserve announced it would expand its existing $700 billion quantitative easing program to include purchases of municipal bonds. The following Monday morning, the Federal Reserve further expanded the program to provide liquidity to investment grade corporate bonds and a broader swath of MBS.

The actions by the Federal Reserve shored up credit markets and marked a turning point for equities, as the broad stock market averages bottomed out and began a furious rally that would continue through the end of the year. For calendar year 2020, the S&P 500 Index returned 18.2% while the tech-heavy Nasdaq-100 Index delivered a scorching 48.9% gain. Despite tapering off somewhat in the second half, fixed-income markets also delivered healthy returns for income investors, with the Bloomberg Barclays U.S. Aggregate Bond Index gaining 7.5% for the year.

Heading into the fourth quarter, two questions dominated investor minds. The first concerned the outcome of the presidential election in November, with bulls finding reasons to like both candidates. Four more years of Trump offered the continuation of a business-friendly tax and regulatory environment. Biden promised higher taxes and heavier regulation but came with the potential for a massive reflationary fiscal stimulus package—particularly if a Blue Wave materialized in congressional elections.

Neither outcome quite came to fruition. Despite Biden winning more votes than any presidential candidate in history, the Blue Wave never materialized, and the Democrats actually lost seats in the House of Representatives. While victories in two Georgia runoff elections in January gave Democrats control of the Senate by the narrowest of margins (the vice-presidential tie-breaking vote), prospects for an ambitious soak-the-rich tax package appear less favorable than a record-breaking round of fiscal stimulus.

The second question on investor minds at the start of the fourth quarter involved a potential COVID-19 vaccine, which offered the possibility of a return to economic normalcy in 2021. Prognosticators (including this one) who doubted President Trump’s October assertion that a vaccine was close were proven wrong in December when the Food and Drug Administration issued emergency use authorizations for COVID-19 vaccines from both Pfizer and Moderna.

The prospects of a reopened economy combined with more fiscal stimulus proved a potable cocktail for equities, with broad gains across the board in the fourth quarter. No segment of the stock market responded better than small caps, which shook off years of underperformance relative to their large cap brethren in delivering a 28.4% return during the fourth quarter, as measured by the Russell 2000 Index. In November alone, in the wake of the election, the Russell 2000 Index powered to an 18.3% gain and followed it up with another 8.5% of appreciation in December. The bond market responded to these events less favorably, with yields on the 10-year U.S. Treasury rising from 0.69% on September 30, 2020 to 0.93% at the end of the year as fixed-income investors priced in expectations for more expansionary fiscal policy.

But for the pandemic, perhaps the biggest investing story of the year would have been Tesla, which gained 64.5% return in the fourth quarter on news in November that S&P Dow Jones Indices had decided to add it to the S&P 500 Index after all. For the year, Tesla delivered a ludicrous 743.4% return. Along the way, the company shored up its balance sheet with two at-the-market follow-on offerings that raised $10 billion of fresh equity. Tesla short sellers spent the year counting losses.

Fourth Quarter Performance by Category

While not quite as extraordinary as the second quarter of 2020, the fourth quarter offered few reasons for income investors to complain. The table below provides return data for major income-oriented asset categories for the period from October 1, 2020 through December 31, 2020.[1] Also included are returns for the Nasdaq 7HANDL Index and Nasdaq 5HANDL Index, two multi-asset indexes of ETFs. As was the case in the second quarter, every income-oriented asset category earned positive returns during the fourth quarter.

For the second time in 2020 (the other time being the second quarter), MLPs outperformed every other income-oriented asset category on both an absolute and risk-adjusted basis[2]. More on that below. Other categories with broad equity exposure—dividend equity, growth & income, and core equity—also delivered double digit returns.

With interest rates backing up throughout the fourth quarter, fixed-income categories struggled to deliver positive returns. MBS lagged all income-oriented categories on an absolute basis, eking out a paltry 0.28% return. Build America Bonds performed the worst on a risk-adjusted basis.

The Nasdaq 7HANDL Index, which incorporates all the income-oriented asset categories, returned 5.7% for the quarter.

2020 Performance by Category

The table below provides return data for major income-oriented asset categories for the period from January 1, 2020 through December 31, 2020.[3] Also included are returns for the Nasdaq 7HANDL Index and Nasdaq 5HANDL Index.

Not surprisingly, core equity trounced every other income-oriented category on an absolute return basis, powering to a 37.4% return for the year. Other categories with broad equity exposure also delivered healthy gains, although the dividend equity category underperformed the broader stock market. The active fixed income category generated steady returns with relatively low volatility, resulting in the best risk-adjusted performance of all the income-oriented categories.

MLPs continued to befuddle investors in 2020. Despite delivering the best absolute and risk-adjusted returns of any income-oriented category in both the second and fourth quarters, MLPs somehow managed to lose 34% for the year and lag every other income-oriented category by a country mile on both an absolute and risk-adjusted basis. Like in baseball, there’s always next year, and the MLP category is off to a hot start in 2021. Long suffering MLP investors watch with well-earned skepticism. 

The Nasdaq 7HANDL Index returned 14.3% for the calendar year.

Long-Term Performance by Category

The long-run picture continued to illustrate the power of diversification. The table below provides return data for the same asset categories for the period from January 1, 2009 through December 31, 2020. The highest total returns came from riskier asset categories, with core equity leading the pack. The highest risk-adjusted returns, however, were generated by the indexes of ETFs offering diversified exposure to all the asset categories.

Outlook for 2021

For income investors, the fixed-income markets stand out as a concern heading into 2021. The fourth quarter trend that saw yields on the 10-year U.S. Treasury climb from 0.69% to 0.93% continued into the new year, with the yield on the benchmark issue climbing as high as 1.15% by January 11^th before settling back to 1.12% as of this writing.

Of all the crowded trades over the past decade, bets on rising interest rates stand out as a perennial loser. Despite annual predictions of an impending bond market meltdown since 2010, the 10-year U.S. Treasury earned positive returns every year except for 2013, when it lost 8.6%. Nothing lasts forever, though, and exploding budget deficits and the potential for strong economic growth coming out of the pandemic threaten to put upward pressure on interest rates, which would drive down the value of fixed-income securities.

Equities, on the other hand, continue to enjoy tailwinds as we come out of the COVID-19 crisis. Another round of fiscal stimulus appears virtually certain and many observers predict rapid economic growth in 2021 as the economy returns to normal.

Some concerns for equities come to mind, however. The performance of the stock market in the fourth quarter suggests that the tailwinds alluded to above have largely been priced into equity values. Moreover, equities appear richly valued by virtually every valuation metric that exists. With margin debt having reached an all-time high in November, many investors may be unprepared for a correction or worse. For income investors, well diversified portfolios with exposure to multiple asset classes continues to be the best protection against market dislocations.

[1] Returns for each asset category are based on the returns of the constituent(s) in the Nasdaq 7HANDL Index representing that category.

[2] Risk-adjusted returns are calculated by dividing annualized return by annualized standard deviation.

[3] Returns for each asset category are based on the returns of the constituent(s) in the Nasdaq 7HANDL Index representing that category.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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