Investors have been crying foul after comments by the Federal Reserve concerning the future tapering of its accommodative polices. The Fed is worried about QE becoming too much of a good thing, leading to the formation of asset bubbles or runaway inflation.
For conservative income investors worried about the principal value of their portfolio, it’s not easy to focus on portfolio yield during times like these. However, strategic changes you make to your portfolio during a correction will have a profound impact on how you inevitably emerge from the crisis.
During any correction, I frequently spend a lot of time in deep thought over how I envision our clients’ portfolios will look when volatility eventually subsides. I think income investors should be doing the very same thing.
There are three areas that I don’t have exposure to today, but know I would like to when the market ultimately reaches a settling point:
Click to Enlarge These wonderful hybrid income instruments carry similarities to both stocks and bonds. Preferred stocks are higher on the capital structure than common shares, and are typically offered by financial companies who favor issuing equity rather than debt. The yields also are often higher than common stocks. However, they carry sensitivity to long-term interest rates due to the inability for dividends to fluctuate, in addition to a specific call or maturity date.
This is a double positive in light of the current equity and interest-rate environment, since both have performed poorly in response to the Fed’s plan. Preferred stocks have given back almost all of the gains they had mustered in 2013.
A great buying opportunity is setting up, and the two ETFs I favor for exposure to this sector are the iShares Preferred Stock ETF (PFF) and the First Trust Preferred Securities and Income ETF (FPE). FPE is an actively managed ETF with higher expenses, and also a more concentrated portfolio.
Click to Enlarge Everything bearing a higher-than-average coupon when compared to the 10-Year Treasury note is getting taken to the woodshed. Thus, now is the time to monitor high-yield bond ETF prices closely so that an allocation opportunity doesn’t pass you by.
Spreads are gyrating all over the place, and if you have lightened up on your exposure during the past several months (or didn’t have any to begin with), you should be paying very close attention to what happens next. I am watching the 5%-5.5% spread level closely. Assuming Treasuries stay over 2%, I think that level would present investors with a good intermediate-term buying opportunity.
With yields becoming more attractive by the day, securing an income stream above 5% at an attractive price should be a priority for every investor. Like many other risk assets, the most opportunity lies when markets fall to desperate extremes. To prevent making a large, ill-timed purchase, I recommend picking the ETF you want to build a position in, then spreading your purchases out over time during the course of the correction. This way, you will be able to average in an attractive cost basis.
My favorite ETF for this category is PIMCO 0-5 Yr High Yield Corporate Bond ETF (HYS). It carries much lower duration and therefore less sensitivity to interest rates than many other popular high-yield ETFs, but it doesn’t have a significantly lower yield.
Click to Enlarge Those folks that thought they would be able to hang out in stocks with low volatility or sideways consolidation while interest rates rise are starting to second-guess that plan.
I would be, too — and that’s one reason why I have been so cautious in recent months with high allocations to dividend-paying equities.
The sectors most investors gravitate toward are defensive names in the healthcare, consumer staples and utility arena … most of which rely heavily on the debt markets to finance their ongoing operations. Naturally, as rates rise, margins and/or dividend growth prospects begin to get called into question.
If you have a minimal exposure to stocks at this juncture, now is the time to review your dividend equity buy list. I believe stocks will offer the best buying opportunity in the midst of this correction that we have seen in more than six months. So be ready, and depending on your asset allocation, take advantage of the lower prices.
Two ETFs I favor for clients in our strategic income portfolio are the First Trust Technology Dividend Index (TDIV) and the iShares Minimum Volatility Index (USMV). Both allow you access to a diversified mix of great dividend-paying blue-chip names.
Michael Fabian is Managing Partner and Chief Investment Officer of Fabian Capital Management. As of this writing, he did not hold a position in any of the aforementioned securities. Learn More: Why I love ETFs, And You Should Too.