The Income Series: Part 2

January 22, 2021

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

PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE RETURNS. Information and opinions provided herein reflect the views of the author as of the publication date of this informational piece. Such views and opinions are subject to change at any point and without notice. Some of the information provided herein was obtained from third-party sources believed to be reliable but such information is not guaranteed to be accurate.  In addition, the links provided within are for convenience only and the provision of the links does not imply any sponsorship, endorsement, or approval of any of the content.  We do not guarantee the content or its accuracy and completeness. The content is being provided for informational purposes only, and nothing within is, or is intended to constitute, investment, tax, or legal advice or a recommendation to buy or sell any types of securities or investments.  The author has not taken into account the investment objectives, financial situation, or particular needs of any individual investor. Any forward-looking statements or forecasts are based on assumptions only, and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision. Any assumptions and projections displayed are estimates, hypothetical in nature, and meant to serve solely as a guideline. No investment decision should be made based solely on any information provided herein and the author is not responsible for the consequences of any decisions or actions taken as a result of information being provided herein. There is a risk of loss from an investment in securities, including the risk of total loss of principal, which an investor will need to be prepared to bear.  Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance.  Exencial Wealth Advisors, LLC (“EWA”) is an investment adviser registered with the Securities & Exchange Commission (SEC).  However, such registration does not imply a certain level of skill or training and no inference to the contrary should be made. EWA may only transact business in those states in which it is registered, notice filed, or qualifies for an exemption or exclusion from registration or notice filing requirements.  Complete information about our services and fees is contained in our Form ADV Part 2A (Disclosure Brochure), a copy of which can be obtained at www.adviserinfo.sec.gov or by calling us at 888-478-1971

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