[This article appears in our October 2017 issue of ETF Report.]
Generating income is an ongoing challenge for investors everywhere, whether it’s someone nearing or at retirement, or someone simply looking to extract consistent income from their asset allocation.
ETF strategists and asset managers are faced with compressed bond yields—at 2.13%, 10-year Treasury yields are hovering near their lowest levels since mid-June. They know the challenge well, as they work with advisors and retail clients to meet income needs. Here, some of them offer their favorite income-generating ideas right now.
John Davi, founder & CIO, Astoria Portfolio Advisors, New York City:
The iShares U.S. Preferred Stock ETF (PFF) is my preferred income vehicle. It's a play on the enormous demand for income given global quantitative easing dropping bond yields to generational lows along with a bullish play on financials, banks in particular.
In the immediate period following the credit crisis, banks weren’t able to build net interest margins in a low-rate, flat-curve environment where there was little organic growth demand and muted inflation.
However, in an environment of higher growth with potentially less regulation, banks are well-positioned given their greater margin of safety compared to the broader U.S. equity market.
Banks make up 40% of PFF. As of July 31, the 12-month trailing yield was 5.6%, and 33% of the bonds are rated AAA.
At the time of writing, Astoria Portfolio Advisors owned positions in PFF. For a list of relevant disclosures, please click here.
Ben Lavine, CIO, 3D Asset Management, East Hartford, Connecticut:
The income question can be broken down into two components: fixed-income strategy and fixed-income portfolio.
Our favorite income strategy is time segmentation. That’s where an individual’s investment account is segmented into multiple “buckets” of, say, five years apiece, assuming a 20- to 30-year time horizon—a reasonable time horizon for retirees, given current longevity trends.
Each bucket would comprise its own asset allocation, with more conservative, guaranteed products comprising the current income segments up to 10 years, and traditional equity/fixed-income asset allocations comprising the later-dated segments. Time segmentation allows for both current income and growth of future income.
Now, our favorite income portfolio for, say, a five- to-10-year time horizon is to build a laddered bond portfolio with defined maturities using ETFs. The Guggenheim Bulletshares or the iShares iBonds ETFs provide investment-grade and high-yield bond portfolios with defined maturities, as opposed to traditional evergreen bond ETFs that never mature.
As the bond portfolios approach maturity, the portfolios become less sensitive to interest rate volatility, or the portfolio duration declines over time. Investors can then use the yield-to-worst (at entry) as an approximation of the rate of return, assuming the portfolios are held to maturity.
Investors can supplement this laddered bond ETF portfolio with higher-income-producing ETFs if they can stomach the market volatility associated with a reach for yield.
Our preference is to take credit risk in areas that have less equity market sensitivity, such as senior bank loans and variable-rate preferred securities. Our fixed-income ETF portfolios currently hold the First Trust Senior Loan Fund (FTSL) and the PowerShares Variable Rate Preferred Portfolio (VRP) for exposures to those areas.
[Here’s how FTSL and VRP are performing year-to-date]:
Mack Courter, founder, Courter Financial, Bellefonte, Pennsylvania:
This is such a tricky environment for income. With the Fed beginning to tighten, I’m finding myself limiting duration in bond portfolios. In addition, spreads between investment-grade and junk bonds are so narrow that junk bonds aren’t appealing either.
So, I’m putting the return of capital ahead of the return on capital with bond ETFs such as the iShares iBoxx $ Investment Grade Corporate Bond (LQD), the iShares MBS Fund (MBB) and the Schwab Intermediate-Term US Treasury ETF (SCHR).
I do, however, find consumer staples stocks appealing right now. I’m using the Vanguard Consumer Staples (VDC) in portfolios. It yields 3%, and is down 5% from its high in June.
David Haviland, managing partner & portfolio manager, Beaumont Capital Management, Needham, Massachusetts:
As a portfolio manager, I’m not sure I have a favorite income strategy per se. However, I do like the way our BCM Dynamic Global Fixed Income strategy has been dealing with the varying interest rate environments across the globe over the past three years. Our Global Fixed Income process risk-weights various bond subasset classes and invests in what the system considers to be the best risk/reward scenarios it can find within the specified universe of ETFs.
Now, as far as specific assets and ETFs, high-yield bonds and emerging market bonds have done very well so far in 2017. However, they appear to be getting long in the tooth in terms of both the yield and total returns they may be able to offer in the future.
When we’re building bond portfolios, we prefer to keep the duration slightly less than the Barclays Aggregate Bond Index, as intermediate and long-term interest rate trends are likely to be higher. We do like the actively managed SPDR DoubleLine Total Return Tactical ETF (TOTL).
The fund uses mortgages and some other bond subasset classes that may have slightly lower credits but are still mostly investment grade. Since the Agg has most of its holdings in the high end of the investment-grade spectrum, taking advantage of the lower end of the investment-grade spectrum to try to increase yield and total returns makes a lot of sense to us.
For those investors for whom an equity-income-based ETF is appropriate, we also like the O'Shares FTSE US Quality Dividend ETF (OUSA). This ETF focuses on higher-yielding equities with a well-defined overlay of high-quality and high-cash-flowing businesses.
Clayton Fresk, portfolio manager, Stadion Money Management, Watkinsville, Georgia:
Navigating this rate environment can be a tricky proposition. In the short term, the 10-year looks poised to continue to move lower and potentially break though the post-Trump spike from November. If that were to be the case, I’d be inclined to increase duration at least on a short-term basis to capture some price appreciation since there isn’t much resistance until rates reach the 1.8-2% range on the 10-year.
Taking a more holistic view, I’ve favored corporates (both high-yield and investment-grade) over Treasurys for a while, as spreads have continued to tighten since early 2016. However, as spreads continue to hover near their lows, increased spread duration becomes a concern in case that tightening trend reverses.
While I don’t think spread duration can be reduced significantly given the low-yield environment, diversifying this risk may be of value, such as moving high-yield corporate exposure into emerging market debt via ETFs such as the Vanguard Emerging Markets Government Bond ETF (VWOB).
I’m also taking a closer look at the growing number of smart-beta fixed-income ETFs. While many of these are in their infancy, getting a gauge on performance differentials will take some time. However, based on analysis of the index methodology, there are a few names that seem like very interesting substitutes or complements to the traditionally weighted ETFs.
Taking an even larger viewpoint, moving out of the realm of traditional fixed-income investing—and it’s seemingly increased equity correlation from the addition of spread duration and more equitylike exposure—it’s worth looking into adding noncorrelated asset classes into the mix, particularly liquid alternatives.
While there are a handful of alternative names in the ETF space, I feel this may be one area where looking at mutual funds as a complement to a broader ETF portfolio may be of benefit. This may require further analysis of the landscape as alternative exposure can vary widely, but there are solid names in the mutual fund space that can offer a fixed-incomelike return stream with the diversifying benefit of lower correlations to traditional fixed income.
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Contact Cinthia Murphy at [email protected]