[This article appears in our November/December 2021 issue of ETF Report.]
Interest rates have been at rock-bottom lows for years, and there’s no sign that rates will rise substantially enough to satisfy a fixed income investor’s hunger for yield. To feed that appetite, financial advisors need to find alternatives.
But there are risks. Staying in traditional debt markets means accepting lower-to-negative returns for stability, while seeking income in stocks or credit brings different risks. It comes down to what type of risk advisors and investors can accept, market watchers note.
How Did We Get Here?
Interest rates peaked in 1981, with the U.S. 10-year Treasury note yielding 15.8% that September, and have sloped downward since. As recently as November 2018, benchmark yields topped 3%, and a year later, they were at 1.8%. When the global pandemic happened, rates dropped sub-1% for the first time, falling as low as 0.55% in July. Rates are creeping up, but remain below pre-COVID levels.
Pat O’Hare, chief market analyst at Briefing.com, says that the pandemic caused a confluence of factors to weigh on rates as buyers snapped up U.S. Treasurys, spooked by global recession worries, and the Federal Reserve bought government and corporate debt to stabilize markets.
Foreign buyers have long sought U.S. debt, appreciating meager yields here versus negative interest rates offered in some of their home markets, he adds. Finally, short-covering—buying back previously sold positions—may be suppressing rates.
O’Hare notes there’s a mindset that rates are artificially low, which enticed fixed income short-sellers, particularly in Treasurys. Yet yields continue to fall, triggering short-covering, which further pressures those yields.
All three factors are why rates can be so low, even with an economy showing 6%-plus gross domestic product growth. “That’s how we got here,” O’Hare observed.
How investors and advisors approach the fixed income market depends on their view on interest rates, O’Hare suggests. Inflation expectations play a big factor in this, especially with the Consumer Price Index at 5.3% as of August 2021.
Fed Chairman Jay Powell and U.S. Treasury Secretary Janet Yellen have both said that inflation is temporary and should run its course once the U.S. gets through the supply chain bottleneck. If deflation occurs, U.S. Treasurys should still be OK to hold, O’Hare believes.
But he notes some people think rates should rise for a variety of reasons, including the Fed tapering its extraordinary monetary policy, and that inflation may not completely retreat. Even if inflation cools to a 3% annual rate or even meets the Fed’s stated 2% target, U.S. 10-year Treasury yields should be higher than the current 1.5% yield, O’Hare posits.
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A standard approach for principal protection while addressing inflation concerns is to buy Treasury inflation-protected securities, such as the iShares TIPS Bond ETF (TIP), O’Hare says.
Chris Shea, chief investment officer of WealthSource, still uses some Treasurys, and reminds clients that fixed income is a ballast against equities in a portfolio, at least from a principal-protection perspective, and advocates that investors consider total return, not just yield. He’s also selective about credit and duration, but he admits fixed income isn’t easy.
“I wish there was a really good answer,” he said. “When you’re thinking long-only, liquid solutions, it’s challenging.”
Some advisors and exchange-traded fund providers are using a variety of strategies to handle low yields, including options strategies designed to offer risk management and income.
Garrett Paolella, managing director and portfolio manager at Harvest Volatility Management, subadvisor for the Nationwide Risk-Managed Income ETF (NUSI), explains the ETF uses covered calls and puts to create high income while offering protection when stock markets are falling.
The actively managed ETF fully replicates the Nasdaq-100 Index, and each month it sells a Nasdaq-100 call option against that replicated portfolio. The ETF takes a portion of the income generated from the call to buy an out-of-the-money put. The fund has a managed monthly distribution of 0.65% to ensure consistency for investors, which works out to a 7.8% distribution yield.
“It’s a net credit collar, so that you always have a degree of income to be distributed to your shareholders through the cash generated from that net credit,” Paolella said, noting most investors are using it as an enhancement to their overall asset allocation.
David Miller, chief investment officer of Strategy Shares, which issues the Strategy Shares Nasdaq 7 HANDL Index ETF (HNDL), designed the ETF as a total portfolio solution for the investor looking for a 7% return or higher.
Half of the ETF is a fixed allocation core portfolio of 30% large cap U.S. equities, and 70% Bloomberg Barclays bond aggregate. The other 50% is allocated to a “Dorsey Wright Explore Portfolio,” a tactical allocation that uses a relative strength algorithm to allocate to whatever asset class demonstrates the best relative strength at any given point in time. Those asset classes include U.S. fixed income, U.S. blend, U.S. equity and U.S. alternative assets.
The ETF works as a total portfolio solution, although Miller sees investors slot it into portfolios by reducing part of their equity and fixed income asset allocation, or by reducing their corporate bond exposure.
Lori Van Dusen, founder and CEO of LVW Advisors, sticks with high quality, shorter duration investments since there’s “no substitute” for the safety those offer.
In the past, she’s used the First Trust Low Duration Opportunities ETF (LMBS). The fund holds 90% bonds rated AAA or government-backed debt. It has a 12-month distribution of about 2% with a duration of two months. “It’s not very exciting, but if somebody says, ‘I want to get more income than what I’m getting in cash or bonds,’ it’s potentially a good alternative,” she said.
With a relatively good economy and the outlook for rates cloudy, some advisors are taking higher credit risk for their clients who seek income. Senior loans are one way to wade into this part of the market.
John Ingram, chief investment officer at Crestwood Advisors, recommends the SPDR Blackstone Senior Loan ETF (SRLN), noting in December 2020 and in January, his firm increased exposure to floating-rate notes. Historically the firm was wary of credit-risk vehicles such as high yield bonds since they act like stocks in troubled times, but the pandemic changed that.
“We’ve taken on a little bit more credit risk just to get some yield, and also shortened duration. Floating-rate notes have been great in that area,” he said, noting this is more of a tactical view because of the higher risk.
Van Dusen also has used a senior loan ETF, the First Trust Senior Loan Fund (FTSL).
Briefing.com’s O’Hare says firms that issue bank loans may not be in the best financial shape, but those loans are also at the top of the capital structure, and typically they’re collateralized loans. Bank loan ETFs might also benefit from inflation because they’re floating-rate structures.
“It’s another type of inflation hedge that could work well for investors,” he noted.
Van Dusen suggests preferred stocks could be an alternative for fixed income investors, and ETF investors should seek an actively managed fund such as the First Trust Preferred Securities & Income ETF (FPE): “All preferreds aren’t created equal.”
Because FPE invests in preferred securities, its dividends are “qualified,” and therefore taxed at the long-term capital gains rate. These tax savings boost its current 12-month yield to 4.5%, with an average duration of four years.
“That’s a tool for someone who’s looking to get higher income, and not extend a lot of risk,” she said.