Displaying items by tag: income

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.

Sure the Fed is beginning to taper, and with that comes rising interest rates. However, for the end of 2021, it was the near-zero interest rates that pushed investors out of fixed-rate annuities, and into variable index annuities and RILAs. Fixed-rate annuity sales plummeted in the final quarter while the aforementioned variable products all grew by 10%. Sales in annuities grew by a staggering 16% in 2021, however, a lot of that growth was generated by a much lower 2020 due to the pandemic. Investors will look to shift back into fixed-rate products if rates begin to normalize or hit higher historical levels.

FINSUM: Look for fixed-rate annuities to make a come back in later 2022 because as interest rate hikes are coming and investors will capitalize on relatively higher real rates.

Many individuals overlook the value of a health savings account as they are preparing for retirement, particularly as healthcare costs are rising rapidly. High deductible plans have a number of tax advantages because they grow tax-free and can be used for out-of-pocket expenses well into retirement. Additionally, these HSA accounts come with many of the options and more than traditional retirement accounts and are easily moveable. Finally, these accounts have no rollover cap if funds move to an additional year.

FINSUM: HSAs are a great retirement vehicle, however, chronic investors with chronic illness should avoid high deductible plans that HSAs benefit.

New survey data is out regarding how investors are utilizing fixed income ETFs and how they are represented in a portfolio. In 2021 Fixed income represented about 18% of global ETF assets under management, and many investors plan on increasing their use going forward. The number one purpose for fixed income ETFs was for liquidity management as 83% of surveyors use them in this way. However, transition management, derivative complementarity, and tactical adjustments were also highly cited reasons for their use. Many draw on fixed income ETFs for liquidity purposes, and this is particularly evident in the bid-ask spreads. Relative to their underlying securities ETF spreads for HYG were 48x smiler than the underlying assets.

FINSUM: It's clear investors aren’t terribly worried about lower yields and rising interest rates, these ETFs are giving freedom and flexibility in investors’ portfolios.

Inflation is picking up as PCE and CPI numbers are setting decade-long records, and the Fed is rapidly trying to regain control. The American people are beginning to show signs of angst as 65% of American’s say that Biden’s admin has not put enough attention on handling inflation and almost 60% say the same thing about the economy. This comes a swathe of low approval rating numbers come in where he has fallen almost 20 percentage points all the way down to the low 40’s. Overall about half of Americans say they feel frustrated and disappointed in the Biden admin. Biden’s focus has been on a series of regulatory and economic-centered packages, and many American’s don’t feel he is focusing on the issues they ‘don’t care about’.

FINSUM: Biden should stop pushing for another big fiscal package immediately if he has any hopes of reigning in inflation in 2022.