The Income Series: Part 2

By Tim Courtney, Chief Investment Officer

In the first installment of this series, we examined the current income environment and the role traditional strategies like cash and bonds are playing today. In this piece, we will explore alternative options for generating income and where they fit into a diversified portfolio.

Historically, investors have relied on traditional, high-quality bonds as a source of income. With the 10-year Treasury yielding about 1%¹, well below stock dividend yields, bonds today are used more for stability and risk management than meaningful income generation.

As such, the market is being scoured by investors “chasing yield.” Investors usually first look for higher yields in other areas of the fixed income market, such as bonds rated below investment grade or longer-term bonds. These areas too though have seen yields drop significantly over the last decade, and they involve risks such as greater default and term risk.^2,3

Investors who make highest income generation their primary goal eventually find that their portfolios end up concentrated in some of the smallest, illiquid and potentially riskiest areas of the market. At Exencial, we aim to construct diversified portfolios that generate an acceptable total return and income, while not the highest goal, is a part of that return. Some assets and strategies that we consider when looking to generate income within diversified portfolios are:

1. Equity income. These are assets that behave somewhat like bonds, and somewhat like stocks. These hybrid investments (like preferred stocks, real estate investment trusts and high-dividend stocks) may provide higher yields than traditional bonds but also carry stock risks that must be managed.
2. Floating-rate debt. This is a type of debt that can pay variable interest as interest rates move.⁴ Traditional bonds have an inverse relationship with interest rates (as rates go up, their prices decrease), but floating-rate debt may see interest and possibly prices rise as rates rise so it can be a diversifier and hedge against interest rate increases.
3. Merger arbitrage. This strategy buys stocks of companies that are being merged or acquired with a goal of making a small gain between the current price and eventual acquisition price of the stock.⁵
4. Private debt. Private debt can come in many forms but is not publicly traded and therefore is usually less liquid. This illiquidity though also provides the potential for higher yields.⁶
5. Alternative/hedged strategies. Holding stock and bond assets complemented by holding or selling options may provide income and/or downside protection.⁷

Each of these strategies (and others) that we utilize offer potential unique advantages but also have higher levels of risk than high-quality bonds (i.e., there is no free lunch). This risk should be managed within a well-diversified portfolio. Don’t hesitate to contact your Exencial advisor if you wish to discuss income and whether strategies like these might make sense in your portfolio.

Next week, we will wrap up this series with a third piece evaluating how to manage income and risk within your investment portfolio. Stay tuned!

Sources:
1. MarketWatch (1/20/21) – U.S. 10 Year Treasury Note
2. Investopedia (10/23/20) – High-yield bond
3. CNN Money (1/19/21) – Should I buy short-term or long-term bonds?
4. The Balance (12/15/20) – Investing in floating-rate bonds
5. The Wall Street Journal (11/3/14) – Merger funds: More tame than reputation
6. Barron’s (4/25/15) –The search for yield leads to private debt
7. Investopedia (7/14/20) – Essential options trading guide

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