The search for income is always an interesting investment dynamic.
Those that stray too far out into high yield or esoteric securities tend to find themselves experiencing above-average volatility or non-correlated returns. Conversely, if you stay too conservative in duration or credit quality, your total return is likely to be measured in pennies rather than percentage points.
The nexus of those two extremes is ultimately the sweet spot that will produce dependable income and steady returns.
The recent sell off in stocks and high yield asset classes this year has been uncomfortable for those that are overexposed to those investments.
Nevertheless, it has also created an area of opportunity to survey what has held up well, identify underperformers, and make changes as necessary to realign with your risk tolerance and goals.
Let’s take a look at some of the key asset classes that income investors rely on and identify areas that are showing promising characteristics.
The majority of dividend paying stocks have underperformed in 2015 as an overly heavy focus on energy, utilities, and consumer staples companies have weighed on returns.
Nevertheless, after the big drop, we are starting to see signs of life in these sectors that warrants further attention.
One of the largest and most diversified ETFs in this space is the Vanguard High Dividend Yield ETF (VYM). This fund owns over 400 high dividend paying stocks with a current 30-day SEC yield of 3.56%. A fund such as VYM is appropriate as a core equity holding to provide stock correlation with a focus on equity income that is paid quarterly to shareholders.
VYM experienced its fair share of downside volatility, but has recently broken back above its 50-day moving average on the upside to start October.
The higher lows and higher highs in the chart should be noted as a strong sign that momentum is building in this ETF as well.
I currently own VYM for clients in my Strategic Income Portfolio because of its broad diversification and ultra-low expense ratio of just 0.10%. Another fund that can be used as a suitable alternative is the iShares Core High Dividend ETF (HDV), which similarly focuses on minimizing expenses and honing in on high quality dividend stocks.
The bond market has been seeing increasing signs of bifurcation as high yield credit diverges from traditional high quality fixed-income. In addition, bond investors now have to dance around the mine filed that the Federal Reserve is laying in future policy changes. This spread has created a disconnect between riskier assets such as junk and emerging market bonds versus mortgage, Treasury, and investment grade corporate securities.
The iShares iBOXX $ High Yield Corporate Bond ETF (HYG) has been a leader on the downside over the last four months and many investors are worried about the spreading effects of credit contagion on the stock market and other fringe high yield investments.
For those investors in need of yield, but are concerned about the volatility in U.S. junk bonds, I would recommend a look at emerging market debt.
An overlay of HYG and the PowerShares Emerging Markets Sovereign Debt Portfolio (PCY) shows that PCY is performing much better in 2015 and had far less downside volatility. I
In addition, PCY current offers a 30-day SEC yield of 6.14% which is just slightly below the 6.83% yield of HYG.
Most bond investors would only use a fund like EMB or HYG as a tactical holding designed to increase their overall yield. In that case, it’s important to size the position according to the embedded risk.
On the flip side, core bond positions should be made up of diversified or aggregate indexes with broader correlation and higher quality holdings. Rather than taking a flyer on a highly interest rate sensitive fund such as the Vanguard Total Bond Market ETF (BND), I prefer to choose actively managed bond funds with lower overall duration and an emphasis on risk management.
One such example is the SPDR DoubleLine Total Return Tactical ETF (TOTL). This is the first actively managed ETF spearheaded by famed fixed-income investor Jeffrey Gundlach and his team at DoubleLine.
The fund takes a more moderate approach to its positioning by selecting a mix of mortgage backed securities, emerging market bonds, treasuries, and corporate securities. This has produced much lower overall price volatility since its inception compared to the passive benchmark BND. TOTL has a current 30-day SEC yield of 3.15%, over $1.2 billion in total assets, and a net expense ratio of 0.55%.
Alternative income investments are often times assets with uncorrelated returns to traditional stocks and bonds. These can include real estate investment trusts, master limited partnerships, preferred stocks, and convertible bonds. These investments can provide solid income alongside strong capital appreciation potential to greater diversify your overall portfolio.
One of the facets in this group showing the strongest trend this year has been preferred stocks. A look at a chart of the PowerShares Preferred Portfolio (PGX) shows a continued upside bias despite an uptick in volatility that most assets experienced in August. This quick return to the highs demonstrates the resilience of this sector when other high yield assets have fallen by the way side.
PGX sports a 30-day SEC yield of 5.95% and has nearly $3 billion in assets under management. Keep in mind that alternative investments should in purchased moderation to avoid becoming overly skewed towards non-traditional holdings. However, they can add attractive characteristics to enhance your income stream or broaden your portfolio’s exposure.
I have spoken with many investors lately who are sitting on a higher than average cash position. Some were lucky enough to sell near the highs, while others were burdened by overwhelming fear and succumbed to the urge for capitulation at the lows.
No matter what prompted the move to cash, the important thing is to have a game plan to put the money back to work at some point in the future. Cash is a nice place to visit, but I wouldn’t want to live there full time.
Earlier this year I wrote a primer geared toward how and when to put cash to work. I recommend a quick review of some guidelines that may help future trade decisions or set precedent to fix past mistakes.
You don’t have to put the money all back to work at once. Building a watch list and setting triggers to make small adjustments over time will likely be your best ally as the market continues its machinations. Remember that nothing goes up or down in a straight line.
The Bottom Line
The investments and trends mentioned above may not coincide with everyone’s income portfolio plans. However, my hope is that a review of these asset classes will help provide clearer perspective of the opportunities and risks in front of us right now. Evaluating this landscape can be beneficial to evaluating your current positions and determining if changes need to be made in order to close out the year on a successful note.
For clients in our Strategic Income Portfolio, we implement a four-sleeve approach that includes the asset classes mentioned above. As market conditions change, we are able to size each sleeve appropriately in order to capitalize on new opportunities or pair back risk. This also includes minimum exposure limits so that we don’t find ourselves in an unbalanced asset allocation state that would rely on a definitive outcome for a single area of the market.
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