In a persistent low rate environment, investors and advisors alike have increasingly sought out alternatives to traditional bond investing. But the dilemma for income-seeking investors remains: move up the risk scale and try to achieve more yield that way, or reassess their yield expectations? We ask several managers to discuss the fixed income markets worth watching this year. Today, investors are right to call for a more dynamic approach to asset allocation, particularly when the usual sources of income such as bank loans and high dividend-paying stocks risk dramatic losses of principal in down markets. We rethink the 60/40 equity/bond portfolio split. Finally, we speak to five registered investment advisors to find out how they are approaching income generation for clients. It’s true that options for capturing income are increasingly scarce, but flexible, diversified strategies are helping to exploit inefficiencies in the credit markets. As Max Gokhman of Pacific Life Fund Advisors says: ‘To realize the benefits of diversification, it is important to stay invested through market gyrations.’
Last year brought a host of serious concerns: trade tensions, Brexit and a possible US recession. But those have receded for now, according to Michael Buchanan, Western Asset’s deputy chief investment officer, and 2020 is shaping up to be a good year in capital markets. Buchanan sees reasonably strong fundamentals across corporate credit and emerging market debt. Consumers are in good shape, banks are strong and actively lending, and the US real estate market is performing well. ‘Opportunities will present themselves in periods of market volatility and in the new issue bond market,’ he said.
The following six areas are recommended for fixed income investors in 2020:
With most income-seekers looking for a degree of safety, however, senior portfolio manager Blair Reid cautions against going very low in credit quality to stretch for higher income. ‘At some point defaults will rise and that is something investors need to be mindful of,’ he said.
But he admits this is going to be a more challenging year for bond investors because interest rates are lower and spreads are tighter. ‘Although the first half of the year could be smooth, the second half may introduce bumpier terrain on trade,’ he said. BlueBay Asset Management points to investors taking on more credit risk and migrating down the capital structure in their search for yield. With spreads in the sub-investment grade fixed income markets at 300 to 500 basis points over cash levels, investors can access healthy levels of income relative to central bank rates.
Mellon sees yield potential in municipal bonds (debt securities issued by state and local governments) on the basis of attractive valuations, supportive fundamentals and favorable market dynamics. Net supply projections are low at a time when a state and local tax deduction cap is augmenting retail demand for tax-efficient investments. Interest paid on munis is generally exempt from federal taxes and sometimes state and local taxes too. The taxable-equivalent yield for tax-exempt municipals, at around 2.5%, offers relative value over other US fixed income assets. ‘As the US economy remains on pace to deliver relatively positive performance, municipalities nationwide are fiscally stronger and better equipped to endure future adverse economic conditions,’ said investment strategist Sherri Tilley. ‘Embarking on an election year in the US, future market uncertainty remains high and investors will face the challenge of sourcing income without assuming disproportionate risk. Municipals uniquely continue to provide investors with high levels of current income, preservation of capital, limited volatility and diversification.’
Diamond Hill Capital Management believes US high yield bonds are a reasonable port of call for income-seekers, provided they abide by the Hippocratic Oath: ‘First, do no harm.’ ‘There will be a time to focus more on making money but now is the time to focus more on not losing it,’ said Bill Zox, chief investment officer for fixed income. He likes B-rated bonds, which yield more than 5%. ‘The highest rated BB-tier of the high-yield market is historically overvalued with minimal to no upside and meaningful downside the next time the market is priced for recession,’ he said. ‘The lowest rated CCC-tier of the high-yield market is too risky this late in the cycle, with the possibility of much higher defaults. ‘We are focused on B-rated and BBB-rated bonds with limited downside that should allow us to preserve capital and beat inflation until valuations are more attractive. Volatility will come back, creating opportunity. In the words of Hyman Minsky: “Stability breeds instability.”’
In seeking to take advantage of pockets of opportunity, one area Western Asset favors is bank loans. ‘Investors are justifiably concerned about “covenant light” bank loans and the amount of second-lien issuance in this space, but there are many features we can negotiate to give us a very strong claim on assets in case trouble arises,’ Buchanan said. ‘Despite its underperformance in 2019, we think this asset class will continue to benefit from a lot of the fundamental strength that we’re seeing in corporate credit.’ Related to that, he sees some value opportunities in BB and BBB-rated tranches of collateralized loan obligations, especially when you compare their yields with the high-yield market – typically 5%-9% versus 3%-3.5% for high-yield bonds of the same credit quality. ‘You’ve got to be dynamic to take advantage of these fleeting opportunities – this is one of the ways active managers can distinguish themselves,’ he added.
Mortgage-backed securities (MBS) are more attractively priced than other fixed income instruments and can offer investors incremental yield without as much sensitivity to the corporate credit cycle. Newfleet Asset Management has been increasing its exposure to commercial MBS at the margin versus investment grade corporate bonds given their relative underperformance in 2019. ‘We favor one-off asset types such as commercial real estate collateralized loan obligations and small balance commercial deals,’ said its chief investment officer Dave Albrycht. ‘Additionally, we like the single asset single borrower space where transactions afford us the ability to analyze one property type and invest deeper in the capital structure.’ The residential MBS market is another source of alpha generation for Newfleet. Yields range from 2.5%-4.5% depending on the collateral type, rating and deal structure. It expects the supply/demand environment to remain positive, with gross issuance forecast at $125bn for 2020 – the highest since 2007.
TwentyFour Asset Management likes subordinated financial sectors in Europe, specifically top tier AT1 capital issued by banks and RT1 capital issued by insurers. It points to European markets being in the early stages of recovery; its banking sector is primed to benefit from any economic resurgence given a meaningful improvement in capital bases. ‘We see attractive relative value in the subordinated financial sector, preferring those that are well rated and can offer spread premiums over similarly rated senior debt of a much smaller corporate issuer,’ said David Norris, TwentyFour’s head of US credit. ‘RT1s issued by insurance companies can offer significant premium and some of the highest yields across the investment grade spectrum – 4%-6% depending on maturity and credit quality of the issuer. ‘Post the UK election, some financial issuers are looking to the Sterling market, and investors should continue to look for opportunities where they can benefit from extracting any Brexit premium safely.’
Columbia Threadneedle Investments likes emerging market debt (EMD), which yields 4.88% as measured by the JPMorgan EMBI Global Core index. Joshua Kutin, Columbia Threadneedle’s head of asset allocation for North America, points to EMD being less affected by trade tensions than emerging market equities. ‘One simple reason for this is the high allocation to Asian equities in an EM equity index,’ he said. ‘EM debt indices are more diversified with higher relative allocations to areas like Latin America and eastern Europe.’ EMD generally trades in tandem with US high-yield debt but is less sensitive to energy markets. ‘The US high yield market is still very sensitive to energy, more so than European high yield or emerging markets,’ said Kutin. ‘Not only does EM debt have an attractive yield, but we expect it to be more isolated from trade tensions or oil shocks, an important consideration for investors over the next few years.’
Focusing on quality with Madison Dividend Income
JOHN BROWN, CFA® PORTFOLIO MANAGER, MADISON DIVIDEND INCOME FUND
DREW JUSTMAN, CFA® PORTFOLIO MANAGER, MADISON DIVIDEND INCOME FUND
There are few funds that can draw on a 32-year history of calibrating their investment processes – fewer still once the field is narrowed to dividend income strategies. John Brown and Drew Justman, who co-manage the Madison Dividend Income fund (BHBFX), anchored their investment approach in Brown’s past experience of serving conservative bank trust clients. ‘I’ve been using and fine-tuning the strategy for more than 30 years,’ Brown said. ‘Our relative yield approach came from a background of serving conservative clients who desired equity exposure but were risk-averse. ‘So the question is, how can we achieve good returns, provide an income and growing dividends but avoid big drawdowns in bear markets? Because that helps clients stay invested in the market when they feel like getting out,’ Brown continued. ‘The answer we’ve come up with over the years, is that we buy high-quality, large-cap, blue chip stocks with above average dividend yields when they’re out of favor. ‘These are household names like Procter & Gamble and Home Depot. We buy them when they’re out of favor, which means the price is down and the yield is higher than normal and we get paid to wait for the price to recover.’ At the heart of Madison’s investment process lies the selection of stocks with attractive relative yields. A stock’s relative yield is its dividend yield divided by the market dividend yield. The strategy typically invests in 40 to 50 well-established large-cap companies. Selection criteria include above market yield, with a preference for companies that have historically increased their dividends. To develop confidence that this yield rise is likely to continue, Brown and Justman, along with their research team, look for two key elements in a stock: a sustainable competitive advantage - or ‘wide moats’ - and a strong balance sheet. ‘We are capitalizing on the realization that, historically, a high percentage of the total return in stocks have come from dividends,’ Brown said. ‘We believe that the resulting portfolio should be especially attractive to investors who are seeking yield, particularly in today’s low-yield environment.’ A crucial step in Madison’s investment process is to avoid companies where problems are terminal and not just temporary. This approach is designed to keep stocks that are unlikely to recover out of the portfolio. Diversification is another important factor in the team’s bottom-up selection process. The strategy can invest up to 20% or two times the S&P 500 sector weight into any one sector. Brown and Justman believe this provides enough flexibility to differentiate the fund from the index without being overly concentrated.
Pharmaceuticals company Bristol-Myers is a good example of how Madison’s investment approach works in action. The stock flashed up on Madison’s radar when it started to deliver above-expectation earnings at a cheap equity price. When the team took a closer look, they liked what they saw: the stock had a wide moat at 11 times earnings with a 3.6% dividend yield and high financial strength with an A-plus-rated balance sheet by S&P. When Brown and Justman drilled down into why the stock was cheap, they found that Bristol-Myers had a thin pipeline of new products and a merger proposal with large biotech company Celgene on the table. ‘We thought that, strategically, this makes the pipeline better and would make them (Bristol-Myers) a leader, especially in the cancer area. With a little over two times debt to EBITDA, the stock looked attractive. We thought that there would probably be no other bidders emerging and those expectations all turned out to be correct,’ Brown said. ‘Since we bought it in August, they raised their dividend by 10% and rallied substantially by 45% or so. We’re still getting a 2.7% yield and paying 10 times this year’s earnings for it.’ Risk control and seeking to protect capital in down markets is just as important to the team as achieving solid returns when markets rally. Madison believes that keeping investors in the market through tough times is a key element to achieving long-term results. ‘We attempt to hold up much better in down markets. The fourth quarter of 2018 is a good example,’ Justman said. ‘We were down 6.2% while the S&P 500 was down 13.5%. One important question for investors looking for yield in the current environment is: at what risk are they prepared to get involved?
‘We like to find stocks that have above-average dividend yield with a history of dividend growth – not necessarily the highest yielding stocks in the market,’ Brown said. ‘Some utility companies have high yields, for example, but they don’t have the ability to grow. They may not have a wide moat. They just don’t meet the characteristics.’ Following the 10-year bull market, Madison warns that investors might not be prepared for the next bear market. ‘We focus on protecting during the downside, so whenever the next bear market comes, we expect to hold up better than the index, and that might be a good way for people to stay invested and realize the long-term potential from equities,’ Justman said.
Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only, and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Before investing, please fully consider the investment objectives, risks, charges and expenses of the fund. This and other important information is contained in the current prospectus, which you should carefully read before investing or sending money. For more complete information about Madison Funds® obtain a prospectus from your financial adviser, by calling 800.877.6089 or by visiting https://www.madisonfunds.com/individual/prospectus-and-reports to view or download a copy. Performance data shown represents past performance. Investment returns and principal value will fluctuate, so that fund shares, when redeemed, may be worth more or less than the original cost. Past performance does not guarantee future results and current performance may be lower or higher than the performance data shown. Visit madisonfunds.com or call 800.877.6089 to obtain performance data current to the most recent month-end. ©2020 Morningstar. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. As of 12/31/2019, the Madison Dividend Income Fund was rated against the following numbers of Morningstar Large Value funds over the following time periods: 1091 funds in the last three years, 945 funds in the last five years, and 690 funds in the last ten years. Past performance is no guarantee of future results.
Pharmaceuticals company Bristol-Myers is a good example of how Madison’s investment approach works in action. The stock flashed up on Madison’s radar when it started to deliver above-expectation earnings at a cheap equity price. When the team took a closer look, they liked what they saw: the stock had a wide moat at 11 times earnings with a 3.6% dividend yield and high financial strength with an A-plus-rated balance sheet by S&P. When Brown and Justman drilled down into why the stock was cheap, they found that Bristol-Myers had a thin pipeline of new products and a merger proposal with large biotech company Celgene on the table. ‘We thought that, strategically, this makes the pipeline better and would make them (Bristol-Myers) a leader, especially in the cancer area. With a little over two times debt to EBITDA, the stock looked attractive. We thought that there would probably be no other bidders emerging and those expectations all turned out to be correct,’ Brown said. ‘Since we bought it in August, they raised their dividend by 10% and rallied substantially by 45% or so. We’re still getting a 2.7% yield and paying 10 times this year’s earnings for it.’ Risk control and seeking to protect capital in down markets is just as important to the team as achieving solid returns when markets rally. Madison believes that keeping investors in the market through tough times is a key element to achieving long-term results. ‘We attempt to hold up much better in down markets. The fourth quarter of 2018 is a good example,’ Justman said. ‘We were down 6.2% while the S&P 500 was down 13.5%. One important question for investors looking for yield in the current environment is: at what risk are they prepared to get involved? ‘We like to find stocks that have above-average dividend yield with a history of dividend growth – not necessarily the highest yielding stocks in the market,’ Brown said. ‘Some utility companies have high yields, for example, but they don’t have the ability to grow. They may not have a wide moat. They just don’t meet the characteristics.’ Following the 10-year bull market, Madison warns that investors might not be prepared for the next bear market. ‘We focus on protecting during the downside, so whenever the next bear market comes, we expect to hold up better than the index, and that might be a good way for people to stay invested and realize the long-term potential from equities,’ Justman said.
The Federal Reserve has indicated, both through actions – lowering the federal funds rate three times in 2019 – and commentary, that it intends to keep rates relatively low in the near to medium term. While this is intended to be accommodating to the economy, it poses a challenge for investors looking to generate distributable income. Innovest Portfolio Solutions’ projected average annual total return for investment grade bonds over the next five to 10 years is about the same as their yield at the start of this year – 2.25%. ‘Investors would make a huge mistake if they extrapolated historical returns for high-quality bonds into the future when designing long-term portfolios,’ said partner Scott Middleton. ‘A traditional 60/40 equity/bond portfolio may not be optimal in the future.’ Traditionally, high-yield bonds, bank loans and high dividend-paying stocks have been sources of income but risk dramatic losses of principal when markets turn. ‘Income investors run the risk of being blinded by high yields and fail to realize the impact it may have on their total portfolio value,’ said Justin Boller, director of fixed income at Liquid Strategies. ‘As baby boomers continue to retire, the demand for income will continue to grow and could produce an unintentional bubble in these sources of income. As that bubble expands, spreads will tighten further, limiting the income available as well as increasing the damage should the bubble pop.’ Insight Investment believes investors need to get creative to find compelling yields in today’s market. ‘Those able to leave no stone unturned will be able to unearth the best opportunities,’ said senior portfolio manager Gautam Khanna.
Master limited partnerships (MLPs) are an equity income asset class that is often overlooked by investors, perhaps because it is not well covered or understood, according to Max Gokhman, head of asset allocation at Pacific Life Fund Advisors. ‘With their preferential tax treatment, equity liquidity and stable dividend yields in the high single digits, MLPs are a requisite part of any diversified income portfolio,’ he said. ‘More recently MLPs have undergone a number of prudent changes that bolster their attractiveness, made evident by increased M&A in the sector. MLPs have simplified their capital structures and become increasingly self-funded, with capital expenditures often covered by cash flows, which themselves have been growing. ‘This in turn has allowed MLPs to prudently reduce their debt loads, making them more resilient for the next economic downturn, even as many have been able to increase income distributions to investors.’ Advisors Asset Management, a registered investment advisor (RIA) that operates from headquarters in Monument, Colorado, and 10 other locations, also recommends MLPs as a complementary source of income to more traditional sources.
Investing in companies involved in the transportation, processing and storage of oil, natural gas and natural gas liquids, known as midstream energy infrastructure, is one of a number of asset classes that Innovest uses to broaden portfolio diversification. Historically, publicly traded firms within this space have been structured as either master limited partnerships or C corporations. The Denver, Colorado-based RIA points to investments in midstream oil and gas pipelines, and storage facilities, selling at significant discounts to their long-term average valuations. For the next five to 10 years, it projects a diversified portfolio of midstream energy investments should have an average annual total return of 7%-8%. ‘These investments are quite volatile – about the same as US mid- and small-cap equities – and more than five times the volatility of intermediate term investment grade bonds,’ said Middleton, who sits on Innovest’s investment committee. ‘While the size of an investor’s allocation to midstream energy securities will vary with their overall objectives and downside risk tolerance, a 5% portfolio allocation could be a reference point to begin the discussion.’
Over the past two years Henrickson Nauta Wealth Advisors of Belmont, Michigan, has actively increased its allocation to niche private credit strategies, such as specialty finance, litigation finance, trade finance, real estate debt, transportation finance and film tax credit financing. It has funded the increase at the expense of three areas: more traditional direct lending funds and business development companies, which have higher correlations to equity markets; marketplace lending, to which it was an early allocator but is reducing exposure amid greater market efficiency and compressed yields; and traditional fixed income, which is yielding modest amounts. Its allocation to private credit ranges from 4%-10% for most clients, but some clients who can afford the illiquidity have higher allocations. It is populating these positions through single-strategy funds that focus on a particular sub-sector, multi-strategy hedge funds, funds-of-funds and an interval fund. Expected annual returns are 8%-10% almost entirely from yield. ‘We expect very little standard deviation to the return stream but realize there is risk of a loan or deal blowing up, which necessitates a well-diversified allocation,’ principal Jeff Nauta said.
One of the most underutilized but consistent means of generating income is an option writing overlay, according to Liquid Strategies’ Boller. ‘In essence, an option overlay allows an investor to play the part of an insurance company, collecting premiums on a regular basis while periodically paying claims,’ he said. ‘As long as the levels of premium collected are higher than the number of claims paid, the investor pockets the incremental income.’ He points to option writing as an academically supported and market-tested approach to income generation, but due to operational complexity access has traditionally been reserved for institutions and ultra-high net worth individuals. ‘Those barriers are beginning to break down,’ he said. Liquid Strategies recently launched the Overlay Shares series of exchange-traded funds that package traditional asset classes, such as stocks and investment grade bonds, with an income enhancing overlay into a single, easily accessible investment option for all.
Real estate offers another attractive diversifying income stream. New York Life Investments accesses the asset class through direct investments, such as real estate limited partnerships, as well as liquid securities like real estate investment trusts (Reits), depending on investor time horizon and risk tolerance. ‘We prefer working with managers who can match strong underlying fundamentals – demographic trends such as growing populations, high educational attainment and robust labor markets – with an ability to navigate short-term interest rate conditions and deal flow,’ said multi-asset portfolio strategist Lauren Goodwin. ‘Managers who are locally present and have built relationships to access the best deals and economics can provide high value.’ Virtus Real Estate Capital of Austin, Texas, points to correlations between Reits and broader public equities spiking after the financial crisis and remaining above historic levels. It runs private equity real estate strategies that focus on property types less beholden to the economic climate. ‘Healthcare assets like senior living and medical office [facilities] benefit from a vast cohort of aging consumers with ramping up medical and life care expenses,’ said Zach Mallow, its director of research. ‘These provide investors with exposure to income streams that are robust in expansion times but still resilient during contractions.’
‘In a low-yielding and potentially low-returning environment investors will need to expand how they access income and the investment industry is evolving to deliver accessible solutions to meet those needs,’ added Boller.
Where can we turn for decent income?
ANDREW TOBUREN SENIOR PORTFOLIO MANAGER, CHARTWELL INVESTMENT PARTNERS
What challenges are fixed income investors facing at the moment? Around the globe, interest rates are very low, and in fact negative in many places. That’s frustrating for advisors, investors and managers alike. It doesn’t seem right that many investors have acted prudently, stayed the course with an investment plan, accumulated some degree of wealth or are on the path to accumulating wealth, yet find themselves in an environment of rotten investment choices. Traditional fixed income allocations like the Aggregate Index have performed reasonably well over the last few years, but today they offer a very low yield and a relatively long duration. So, fixed income is not doing what it’s supposed to do? Prior to the financial crisis, there was a more reasonable level of income available from core allocations in the asset class, maybe 5%, but it also provided a certain measure of total return potential or hedge against some riskier areas of a portfolio. A lot of that has changed. The difference today is that it’s hard to envision a scenario where any significant price appreciation is achievable on a go-forward basis. Really, we are just left with the income component. Yet, still, the prospect of price declines could end up flipping total returns negative in many portfolios. What options can investors pursue in this environment? Investors do have choices. They can target longer duration portfolios for more income, but of course that brings greater interest rate risk. They can target lower credit quality for more income, but of course that adds a significant element of credit risk. Emerging market or frontier market debt is another option, but they come with the associated geopolitical and currency risks. Elsewhere, structured notes or derivatives can be considered, although there is a certain amount of complexity and illiquidity risk in those types of investments. One area that’s grown institutionally is the private debt market. This is potentially an attractive area but investors will be rightfully concerned about liquidity. Often, your money is locked up for several years and you are exposed to the credit risk and underwriting standards of a new market that lacks the transparency of public markets. So there are options, but our position is that none are great because each comes with an aspect of risk that investors may be uncomfortable with. The Chartwell Short Duration BB-Rated portfolio is designed to harvest income while limiting risk. Can you talk us through the strategy and its parameters for risk? We’ve tried to be thoughtful in designing an understandable strategy that aims to deliver consistent monthly income. The strategy’s foundation lies on two key risk-control guardrails. The first guardrail is quality, where we focus on BB-rated corporate bonds. These bonds reside in the crossover area between the traditional high yield market and the traditional investment grade market. BB’s have historically held up relatively well in down credit cycles, and this is an area where we’re regularly able to uncover inefficiencies and capture extra income. The second guardrail is that the portfolio is short maturity. We limit the portfolio’s average maturity to less than three years, which helps to mitigate both interest rate risk and credit risk. What we’ve found, is that these two structural risk guardrails can work in combination to help generate reasonable levels of consistent monthly income. Over full cycles, the incremental total return per annum has been 1% - 2% greater than traditional core fixed income allocations. Interestingly, the return profile has not been substantially more volatile than the Aggregate.
From a construction standpoint, we buy US dollar-denominated, publicly traded bonds in a transparent portfolio that is priced daily. We don’t utilize any derivatives, credit default swaps, emerging market securities, structured notes or pay-in-kind / toggle bonds. What challenges do you anticipate for the strategy going forward and for the sector more broadly? Operating a short maturity strategy does present a challenge because we regularly have 30% or 40% of the fund come back to us each year through refinancing activity – bonds being called or tendered for. Our challenge is to continually redeploy funds and recycle exposure out into the market. That’s where our team’s fundamental credit research comes into play. We’ve focused on this space for the past fourteen years, and believe we’ve built up a knowledge base that helps us to stay invested and continue generating income. More broadly, I do believe there is a risk for short maturity strategies that own the full credit spectrum of high yield bonds, which are the majority of assets raised in the space over the last decade. Portfolios that own BB-rated bonds, B-rated bonds, and CCC-rated bonds have enjoyed a tailwind of easy credit conditions. Eventually, we believe we’ll see softness in the economy, or even a recession. If we do, we think strategies without a quality guardrail can really take it on the chin – the underperformance can be substantial, as we saw in 2008. In summary, Chartwell’s approach to the short maturity corporate space employs two risk guardrails and tries to balance the trade-off between more income and risk. We focus on BB-rated securities, and typically don’t own B-rated or CCC-rated credit. It’s definitely a niche, a niche we like as part of an income solution.
Andrew Toburen, manager of the Chartwell Short Duration BB-rated fixed income strategy, discusses the crossover area between traditional high yield and investment grade, and how it can provide value for income-seeking investors
CHERRY TREE WEALTH MANAGEMENT
John O’Connor, an investment advisor at Cherry Tree Wealth Management in Minnetonka, Minnesota, takes a total return approach to income. ‘Constructing a portfolio to hit an income target is not advisable today,’ he said. ‘In fact, it’s not attainable for most investors.’ The S&P 500 index yields 1.9%. Focusing on high-dividend stocks and investing internationally could increase that to 3%. However, O’Connor’s clients typically withdraw 4% in their 60s and 5% in their mid-70s. ‘Those rates are designed to be sustainable,’ he said. ‘When markets drop, we sell from bond funds to allow stocks time to recover. Some clients choose to make adjustments and withdraw less during prolonged downturns.’ Another shortcoming of investing for yield is that it limits your opportunity set. ‘US technology stocks return almost three times as much cash to shareholders in share buybacks as they do in dividends,’ said O’Connor. ‘A simple screen for dividend income will underweight or avoid many technology stocks that are returning profits to shareholders in another way.’ Looking for yield in bonds is ‘even more limiting’ with high quality US bonds paying 2%-3% and international bonds even less. A total return approach enables clients to sell winners to fund their cash needs and have more control over their tax liabilities. ‘You decide when to sell and realize gains,’ said O’Connor. ‘A portfolio focused on income causes tax bills for dividends and interest whether you need the cash or not.’
SEGAL ROGERSCASEY CANADA
Toronto-based Segal Rogerscasey Canada always advocates for active management but believes it is particularly crucial at this point in the credit cycle. Its clients invest in global multi-credit strategies where the portfolio manager has discretion to allocate across credit sleeves – from investment grade, high yield and emerging market (EM) bonds to bank loans and securitized products. ‘These types of strategies allow the manager to decide where the best value is amongst the credit and higher income sectors of the bond market,’ said Kathleen Pabla, its director of research. She points to 2019 being a bellwether year for many areas of fixed income, particularly long bonds and credit. However, with US Treasury yields at 1.77%, returns are unlikely to be repeated. And while she continues to like EM debt as a higher-yielding fixed income solution, she points to idiosyncratic risks, such as currency and geopolitical risk. ‘While credit conditions are still generally stable, there is plenty of reason to be cautious,’ she said. ‘Valuations are fair or overvalued and covenants have been getting looser, particularly for bank loans. ‘In addition, the rise of the BBB-weighted credit in the US over the past 10 years suggests it may be time for investors to dial down risk in credit. It is safe to say the beta play of credit is over. Opportunities in credit still exist, but the importance of security selection and fundamental research has become more pronounced.’
ADVISORS ASSET MANAGEMENT
Advisors Asset Management (AAM), a Monument, Colorado-based RIA, believes the recipe for success when investing in fixed income lies in actively monitoring, passively managing and exploiting anomalies. ‘Exploiting anomalies is when the market prices a premium for those sectors in which risk is understated and prices in too great a negative outcome for other debt classes,’ said Matt Lloyd, its chief investment strategist. AAM has 52% of its investment grade corporate bond exposure at the lowest credit rating. ‘When credit cycles turn, we traditionally see higher credit rating downgrades in the corporate sector than we would see in the municipal arena,’ said Lloyd. ‘Investors should expect more volatility in potential credit ratings and therefore do more credit due diligence to mitigate potential moves required when this event occurs. Downgrades do not necessarily translate to defaults, therefore holding through this – if you believe there is not a credit event – will generate better long-term returns even though there may be underperformance in the short term.’
He advocates being underweight Treasurys amid their sensitivity to duration from below-average coupons, a shift in US dollar demand and increasing supply from rising budget deficits, and diversifying corporate bond exposure with mortgage-backed securities, municipals and other more non-traditional income sources – master limited partnerships (MLPs), real estate investment trusts (Reits) and shares in companies that have high cashflow yields and pay decent dividends, specifically those with a history of maintaining and increasing pay-outs.
CLARFELD CITIZENS PRIVATE WEALTH
Clarfeld Citizens Private Wealth in suburban New York has changed the make-up of its fixed income allocations due to the low interest rate environment. ‘As a result of downward pressure on yields, it’s been incredibly difficult to generate absolute yield through traditional core bond sectors like US Treasurys and agency mortgages,’ said managing director Matthew Ruffalo. ‘In response, we’ve implemented a variety of non-traditional strategies that generate higher relative yields than US Treasurys with lower correlations to interest rate movements.’ Chief areas of focus have been corporate credit, where default rates remain benign; securitized assets, particularly non-agency mortgage-backed securities and other asset-backed securities such as autos and credit card receivables; and EM debt. ‘Non-agency mortgages in particular, both residential and commercial, have been a useful way to generate increased yield with a manageable amount of credit risk,’ said Ruffalo. ‘Securitized assets in general are all impacted by the consumer and recent economic data has shown the resiliency of the consumer through lower debt service metrics, increased discretionary spending and income, and increasing wage growth. Accessing this strength in consumer credit in the form of asset-backed securities and mortgage-backed securities has led to better risk-adjusted relative yields as well as a more diversified portfolio allocation.’ Clarfeld also has a small allocation to EM debt as a pure yield play given the volatility of the asset class, which it accesses through actively managed strategies due to the relatively opaque nature of broad-based emerging markets.
PACIFIC LIFE FUND ADVISORS
The need for income is higher than ever due to aging demographics. At the same time central bank accommodation, which has resulted in $11tn of bonds with negative yields, has hampered the ability of many traditional approaches to deliver sufficient income. It is against this backdrop that Pacific Life Fund Advisors says investors need to set realistic goals and understand they will need to take on a lot more risk for each incremental unit of yield. ‘At the same time, they shouldn’t stretch for yield so hard that they snap a tendon and, staying with the exercise analogy, it’s important to stay hydrated so always keep liquidity in mind,’ said Max Gokhman, its head of asset allocation, based in Newport Beach, California. Instead of looking for a silver bullet, investors should have a ‘globally diversified arsenal’ of asset classes in their income portfolios. These may include high-dividend equity sectors such as Reits, MLPs and utilities, high yield and EM debt, preferred securities and mortgages. ‘One way to reduce the risk required to hit investors’ goals is through diversification and a focus on total return rather than pure income,’ Gokhman said. ‘To realize the benefits of diversification, it is important to stay invested through market gyrations. Professionally managed portfolios, however, will generally over and underweight asset classes to take advantage of opportunities while mitigating risks.’ Within income asset classes Pacific Life currently favors high yield and MLPs and is underweight real estate.
Income Generation In A Low-Rate World
JONATHAN MOLCHAN EXECUTIVE DIRECTOR, LEAD PORTFOLIO MANAGER NATIONWIDE RISK-MANAGED INCOME ETF (NUSI)
With yield increasingly scarce, what are some of the market areas that investors might target to attain the income they need? Amid a persistent low-rate environment, investors and advisors alike have increasingly sought out alternatives to traditional bond investing. These alternatives include high-dividend stocks, real estate, emerging market debt, preferred stocks and high-yield bonds. However, it is important to fully understand the potential benefits and risks that come with these alternative income strategies. Yes, there is the potential benefit of high income; but one must really look below the hood to understand what they are exchanging for that measure of high income. For instance, do these strategies exhibit low volatility, provide portfolio protection or have enough liquidity? How does your strategy differ? Our approach uses an options-trading strategy for income generation. An option is the right, but not the obligation, to buy or sell a security at a specified price and date in the future. They can be used to speculate on the future direction of a security. Specifically, our strategy targets high monthly income with fewer risks relative to traditional income-focused investments. It seeks to provide investors with a measure of downside protection along with the potential of upside participation. The strategy is fundamentally designed with income generation in mind. It seeks to give investors and advisors the ability to generate high monthly income without adding excess interest rate sensitivity, duration-associated risk, inflation, leverage or commodity exposure.
Let’s review in more detail. How can options be used as a source of income? Given that options can be both bought and sold, the primary objective of using the instrument to generate income is by selling an option and in return the seller receives an options premium. Investors can turn to professional, risk-managed options’ strategies to potentially exploit current market dynamics whereby the strategies can adapt to current trading environments to grant a higher probability of success. Success would be defined as the best risk-adjusted return while maximizing income generation combined with a reasonable measure of downside protection. Simply put as the markets change the rules-based dynamic nature of the positioning of the options in these strategies will change as they seek the highest probability of a positive outcome. First, we seek to replicate the Index by purchasing all its underlying stocks. Then we deploy our rules-based strategy and couple the underlying stocks with index options. We sell a near-at-the-money to out-of-the-money call option to generate options premium and use a portion of the premium to purchase a protective put below the current market level. Then we distribute a monthly dividend using a portion of the options premium and seek to reinvest remaining net premium. How does this strategy build in protection for the investor? As described, we use a protective net-credit collar options strategy. This strategy combines two common options strategies but regarding protection we can focus on the protective put. Although this strategy combines two common options strategies – selling calls and buying puts – the primary goal of purchasing a put option is to limit potential losses in a price decline. It’s important to note that this put cannot be exercised and is always present. The profitability of a protective put is determined by the gains in the underlying stock minus the cost of purchasing the put option. However, in exchange for foregoing some of the upside, an investor can potentially benefit from limiting the maximum potential loss. This is because the put option will profit if the stock price declines below the strike price. This strategy is ideal for investors with a bullish outlook who are looking to hedge a long position in an underlying stock in the event of a downturn. How would you expect this strategy to perform in different market environments? Our strategy follows a systematic, rules-based system which allows us to close the short-call option prior to expiration. This, in effect, ‘uncaps’ the portfolio by allowing the underlying equity portfolio to potentially participate in a rising market. So, in a rising stock market, total return will likely come from capital appreciation of the underlying stock portfolio. The covered call component used as a part of the net-credit collar strategy may limit some of the upside growth potential but will still support the monthly dividend. In a sideways market, the strategy will pay its monthly dividend from the net-credit due to the covered call component and benefit from a potential move higher in the equity market while still providing a measure of downside protection from the protective put. In a down-trending stock market, the strategy is designed to seek higher total return than standard covered call strategies as well as the broader equity market. The net-credit from the covered call component will support the monthly dividend while the protective put seeks to preserve portfolio capital if the equity market drops below the put strike price.
Jonathan Molchan, lead portfolio manager of the Nationwide Risk-Managed Income ETF (NUSI), discusses how option-based strategies can provide a foundation from which to generate income while also seeking to protect investors from losses in down markets
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