There has never been a more precarious time to be an income-focused investor. Twenty years ago, investors requiring more income, such as those going into retirement, could simply sell down their equities and buy more bonds.
Today, however, with yields near historic lows, bond prices face substantial risk. When the Federal Reserve starts to taper its bond-buying program of quantitative easing, interest rates will rise and bond prices will fall.
In this environment, for example, a 1% rise in rates could cost investors the equivalent of up to three years of bond returns, whereas 20 years ago, it would have cost the equivalent of just six months of returns.
The following strategies can help, and all have exchange-traded funds that can facilitate using them.
Short-duration bonds. Investors with significant bond exposure and who expect rates to rise could reduce their portfolio risk by shortening the duration of their bond holdings.
Many ETFs offer exposure to short-duration, high-quality bonds. These ETFs typically benefit from institutional pricing and broad diversification. Short-duration bonds typically have lower yields than long-duration bonds of the same quality, but they tend to be affected less by rate fluctuations.
Dividend-paying equities. To enhance the yield on the equity portion of a portfolio, investors could consider adding more dividend-paying stocks, particularly from historically dividend-rich sectors such as consumer staples, utilities and financials.
Dividends are costly, though. Investment assets have gravitated to high-dividend stocks, driving their share prices up.
As a result, investors could be paying a large premium for high-dividend companies relative to ones with better fundamentals but lower dividends. The key to dividend stock investing is to focus on quality companies that can sustain stable or growing dividend payouts and to be wary of high-dividend stocks in sectors not typically associated with high dividends.
Preferred shares. This is another high-yielding asset class favored by income investors. The tax efficiency of such dividends is an extra incentive.
Unfortunately, preferred shares aren't immune to rate increases. Because a large number of preferred shares pay a fixed dividend until a reset date, preferred shares effectively have a duration that can be calculated using the reset or call date as the equivalent of a maturity date on a bond.
Just like bonds, shorter duration typically results in less rate risk.
Covered calls. Investors could also consider writing covered calls on ETFs or buying ETFs that utilize covered-call strategies. In both cases, covered calls potentially can generate additional income from a core equity position.
Covered-call writing on a stock portfolio essentially trades some potential upside for immediate income from option premiums. In my view, the most effective covered-call strategy for a buy-and-hold investor is an “out of the money” strategy, such as the S&P 500 Stock Covered Call Index, because it offers the potential for both premiums and some price appreciation in range-bound and moderate bull markets.
An “at the money” strategy, such as the CBOE S&P 500 BuyWrite Index, may generate higher premiums, but it sells away all a stock's upside potential and therefore can drastically underperform in strong bull markets.
Covered-call strategies, which can be complex and time-consuming to run, have been used by professional investors for decades. ETFs have simply made them available to a larger market of retail investors, offering the benefits of professional options management and institutional pricing.
Master limited partnerships. Although they have limitations, MLPs have become increasingly popular with income-oriented investors, given their attractive yields and because they invest primarily in infrastructure and commodities-focused companies.
Completely replacing equity holdings with MLPs wouldn't be prudent.
Moreover, MLP ETFs have an additional tax cost. They are usually structured as C corporations and, as such, must account for taxes on unrealized gains.
The ETF, therefore, has to pay taxes on gains in the fund, and then investors have to pay taxes on the distributions they receive.
The point is that financial advisers aren't powerless in this challenging income environment. ETFs are one of the more convenient and low-cost ways to help clients potentially enhance their portfolios' income, while offering some downside protection.
Howard Atkinson is a managing director at Horizons ETFs Management (USA).