Income investors must feel like they are swimming against the current. Over the span of 10 years, bond yields are lower than they once were* and those reliant on investment income have potentially struggled to generate adequate cash flow. Consider the yield on seasoned Aaa corporate bonds—a proxy for high-quality corporate bonds as rated by Moody’s. As of October 2021, the yield on such a portfolio was hovering over 2.6%, which is about half of what investors would have received 10 years prior**. Doing the math on any bond portfolio is both straightforward and rather alarming, and the resulting loss of income has not been insignificant.
What are the choices for investors facing this upstream struggle to generate adequate income? Some investors may choose to take on greater credit risk, moving money into lower-quality bonds in the hope of capturing incremental yields. Others have shifted assets into equity strategies that offer attractive dividend income, even though the volatility carried by equities has historically been higher than bonds. Both of these moves can be prudent in the right circumstances (if done judiciously), but investors need to be mindful of the added risks.
Given the current backdrop now facing investors—very low Treasury yields; equities at lofty valuations by historical measures; and an economy fueled by unprecedented amounts of fiscal and monetary accommodation that may ultimately usher in a new era of inflation—investors might benefit from a strategic approach to supplement their income by seeking dividends while also managing equity risk. Is this too good to be true? Perhaps not.
A three-step approach
Despite the fact that equities typically carry a higher risk profile than most fixed income asset classes, dividends can be a viable source of income when properly managed for volatility risk. One way to do this is to use equity index futures to try to neutralize equity. And even though derivatives can make some investors nervous, it’s important to remember that many fixed income portfolio managers commonly employ various types of derivatives to control duration, credit risk, and other exposures.
So how, exactly, could one potentially improve an income portfolio’s efficiency by seeking dividends while working to reduce risk? Here are three steps:
1. The first step is to build a portfolio of potentially high-dividend paying stocks. However, this should be done in a way that doesn’t just chase high-yielding stocks, but rather allocates across various sectors, regions, and market caps for balance.
2. The second step is to seek to neutralize the risk that typically comes with investing in these dividend-paying stocks. This can be done through various derivatives, which are contracts based on the value of underlying securities and often used to hedge risk. But the manner in which one hedges risk matters. A put option* is one type of derivative used to hedge equity risk. However, various external events can affect the availability and pricing of put options. We believe a better alternative may be to use very liquid broad market equity index futures that correspond to the asset classes of the high-dividend equity portfolio.
3. The third step is to balance any potential sector, style or region biases. Portfolios of high-dividend-paying stocks typically have a value tilt, so adding complementary growth exposure could help balance the portfolio.
Admittedly, building and executing this type of sophisticated income strategy can be challenging — likely beyond the capabilities of the typical individual investor. However, there are alternative income vehicles available that may be able to capture attractive equity dividends and offset the equity risk in a prudent manner. But remember, how this hedge is implemented matters, and evaluating these strategies is critical.
We believe, under the proper circumstances, it just might make sense for investors to carve out a place in a diversified income-oriented portfolio for market-neutral income strategies. This could be a strategic tool to supplement income in many market environments.
*Glossary of Terms:
• Derivatives: A financial contract whose value is dependent on an underlying security. Derivatives are commonly used to hedge risk, or in some cases to speculate on the future prices of securities. Options contracts, futures contracts and swaps are all examples of derivatives.
• Futures: Futures are derivative financial contracts that obligate the parties to transact an asset at a predetermined future date and price. The buyer must purchase or the seller must sell the underlying asset at the set price, regardless of the current market price at the expiration date. Underlying assets include physical commodities or other financial instruments. Futures contracts detail the quantity of the underlying asset and are standardized to facilitate trading on a futures exchange. Futures can be used for hedging or trade speculation.
• Put options: A type of derivative in which the buyer assumes (or will profit when) the future value of the underlying security will decrease. Investors often buy put options on individual stocks they already own to provide downside protection in the event that the underlying security falls.
* As represented by the Bloomberg US Aggregate Index (9/30/2010 – 9/30/2020); Source: Bloomberg
** Source: Bloomberg
The opinions expressed are those of the author and are subject to change without notice. This material does not constitute a distribution, offer, invitation, recommendation, or solicitation to sell or buy any securities; it does not constitute investment advice and should not be relied upon as such. Investors should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision. There is no guarantee that any investment will achieve its objectives, generate positive returns, or avoid losses. Victory Capital Management Inc. is an SEC-registered investment adviser headquartered at 15935 La Cantera Parkway, San Antonio, TX 78015.