Two Ways to Find Income Despite the Bond Rally

by Bryan Perry | June 6, 2014 10:08 am

In retrospect, the motto this year should have been “buy in May and get out of the way.” The price action of the past four weeks caught the majority of investors off-guard. The high-beta meltdown that characterized the front end of the year was seen as an anchor that would take the rest of the market into a steep correction … but this bear-case scenario just didn’t play out.

Instead, we are entering what is typically the slow time of the year with the Dow Jones Industrial Average and S&P 500 notching new all-time highs. What’s more, the simultaneous rally in stocks and bonds has caused tremendous confusion among all classes of investors, defying historical patterns of prior economic recoveries. Today, the yield on the benchmark 10-year Treasury Note is trading at 2.6% , well off the 3% level seen at the beginning of the year, but an improvement on last Thursday’s low of 2.41%.

Based on empirical and anecdotal evidence, I think we’ve seen the low point for the cycle — and as the Fed looks to exit QE by October and raise the fed funds rate in early 2015, I would expect interest rates to edge higher back toward 3% by year-end.

But even if that does happen, a 3% yield would hardly be a victory for income investors. The Fed has declared war on consumers in its effort to hold down interest rates to service the $18 trillion in U.S. debt at rates that don’t unhinge the budget. To that end, I don’t see a major threat of upside rate adjustments for at least a year — especially since U.S. bonds are still paying out more than debt from Japan, Germany, France, Spain and Italy.

So what is a yield-seeking investor to do? Well, I’ve found certain high-yield sectors to be a great alternative to fixed income. Here are just two of my favorites that I expect to thrive in this persistently low-yield environment.

Energy MLPs

Investors have focused on acquiring energy-related income securities, as they come with a threefold bullish theme: participating in the boom phase for U.S. oil and gas production, providing a nice hedge against overseas interruptions in production and affording some built-in inflation protection.

When you can invest in the domestic energy boom and earn yields of 10% or more for your trouble, all the better — and that’s has made energy master limited partnerships (MLPs) more and more popular. I expect MLP leadership to continue; for one thing, I expect the global energy crisis will worsen in the years ahead based on population growth and the depletion of resources around the world. Secondarily, as the politicians continue to battle the federal deficit, taxes probably will trend higher in the long term; if they do, then all the more reason to buy in to MLPs[1] beforehand and enjoy their tax-advantaged status.

Covered Call ETFs

The bullish tone has returned to some sectors of the market, but many moving parts could vanquish recent gains just as quickly as they were registered. Most of the first-quarter reports from blue-chip companies took a neutral stand on forward guidance — not talking up or down future prospects.

Last year, the market had the “Bernanke put” in place, where any bad news meant an injection of more fiscal stimulus. That’s just not the case for 2014. The Fed is withdrawing $1 trillion, and equity valuations are being reset to reflect growth without artificial assistance from a dovish monetary policy. With the transition away from QE already priced in, the investing landscape is in pretty good shape; I expect it to be a back-end loaded year — in which the market ends higher for the year, but not without corrections along the way.

In that type of market, there’s plenty of volatility out there that allows income funds to generate hefty income from equity strategies that involve selling premium into the market. Looking at the universe of equity funds that own strong blue-chip names, what I’m interested in are managed closed-end funds that sell calls and thereby bring in option premium as income — so that investors in these funds[2] can make 9%-10% in dividends, no matter what happens in the bond market or anywhere else.

Bryan Perry is the editor of Cash Machine[3], a newsletter focused on high-yield income investing with the goal of maintaining a blended total yield of 10% across two portfolios. Bryan is also the editor of Extreme Income[4], which uses the power of historically cheap money to create a leveraged “baby hedge fund” strategy that paves the way to massive profits and 4x greater income.

  1. buy in to MLPs:
  2. these funds:
  3. Cash Machine:
  4. Extreme Income:

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