4 ETF Income Ideas In An Era Of Low Yields

February 03, 2015

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Clayton Fresk, CFA, portfolio management analyst at Georgia-based Stadion Money Management.

It seems to be a never-ending question for advisors and their clients: How can I generate a sufficient amount of income? Moreover, can I do so without taking undue risk and/or subjecting a portfolio to excess volatility?

It seems to me advisors are coming to the realization that traditional income sources just aren’t going to cut it anymore. Although only a few weeks into the new year, market activity has already shined light onto these questions.

In this article, I‘ll analyze a few different scenarios.

To the surprise of no one, traditional fixed income is no longer generating sufficient yield. Below is a look at the year-end yield of the BarCap US Aggregate in the past 10 years:

2005 5.08%

2006 5.34%

2007 4.90%

2008 3.99%

2009 3.68%

2010 2.97%

2011 2.24%

2012 1.74%

2013 2.48%

2014 2.25%

For investors looking to capture a 5 percent yield, this was a sufficient portfolio option back in the day. However, from 2006 to 2014, yields have dropped more than 3 percentage points, and now the Barclays Aggregate doesn’t generate anywhere close to 5 percent.

So what can generate a 5 percent yield? For these examples, I’ll back up a year, starting at the end of 2013, and look at how certain allocations have performed.

Here are the 2013 year-end yields for four standard fixed-income indexes:

  • BarCap US Treasury (Bloomberg: LUATYW): 1.44 percent
  • BarCap US Corporate (Bloomberg: LUACYW): 3.26 percent
  • BarCap US MBS (Bloomberg: LUMSYW): 3.26 percent
  • BarCap US High Yield (Bloomberg: LHVLYW): 5.41 percent

Exploring Options

By simply isolating to these options, the only way to generate 5 percent would have been to allocate nearly 100 percent to high yield. Many would feel this is not a prudent allocation decision, so the next step would have been to add duration. An option for this would be:

  • BarCap US Long Credit (Bloomberg LULCYW): 5.23 percent

Using a 50/50 High Yield/Long Credit allocation would have generated sufficient yield with 8.5-year duration and 2.5 percentage-point spread over Treasurys. Moreover, this approach to exposure can be accessed via two ETFs, the SPDR Barclay’s High Yield Bond ETF (JNK | B-68) and the SPDR Barclays' High Yield Bond ETF (JNK | B-68).

How Did The Portfolio Fare?

An investor starting at the end of 2013 would be happy with the combination of the two ETFs I mentioned above.

However, for an investor trying to enter the same trade at the end of 2014, things may not seem as cheery. The same portfolio would still generate a sufficient yield of about 5.5 percent, but now there would be additional duration risk (from 8.5 to 8.9 years) and spread risk (from 250 basis points over Treasurys to 330 basis points).

Also, while the negative correlation of the two asset classes helped negate some of the overall volatility, if correlations were to pick up, that diversification effect may no longer be present.

There are also concerns regarding the sustainability of artificially low interest rates (due to such factors as QE3). Additionally, while high-yield spreads have crept higher particularly in the latter half of 2014, they remain relatively tight at +478 basis points over Treasurys as of Dec. 31.

So there are definite concerns regarding using an allocation I laid out above. Some of those concerns became amply clear during the sharp September sell-off, as the chart above shows.

Other Yield-Producing Options

So what are some alternative options? One is looking at fixed income outside of the U.S. However, rates abroad are generally lower than abroad than in the U.S. For example, the 30-year German bund was yielding 1.39 percent at the end of 2014). Additionally, the weak currency market—in other words, the strong U.S. dollar—has been a major drag on the primarily unhedged non-U.S. fixed-income ETF market.

As has been widely discussed, another option would be to use equity-based income options. This may come in the form of dividend-paying equities, MLPs, REITs, etc. While there could be diversification benefits of adding these asset classes into the mix, there could also be increased volatility.

Using the long-credit/high-yield-example-allocation I discussed above as a starting point, we can examine an effect of adding a 20 percent allocation to MLPs via the Alerian MLP ETF (AMLP), which yielded 6.3 percent in 2014. To be clear, that creates a 40/40/20 long-credit/high-yield/MLP allocation.

On the positive side, the addition of AMLP would have increased the yield by nearly 25 basis points to 5.45 percent. However, the other side is the price appreciation, which would have come in about 1 percentage point lower (from 3.5 percent to 2.5 percent). At the same time, the standard deviation of the price return climbed to more than 5 percent.

Equities For Income

The addition of more standard equity names would have helped the diversification and price return. For example, the iShares Select Dividend ETFs (DVY | A-50) returned 11.3 percent on a price basis. That said, DVY also created a small drag on the overall yield, as DVY’s yield was 3.6 percent in 2014.

There are concerns 2014 may have been an anomaly in terms of the low-beta names being the top performers. Utilities, for example, was the top-performing sector in 2014, returning an astonishing 29 percent.

Obviously, this sort of price appreciation in dividend payers is unsustainable. Additionally, there are concerns the bull market in equities may be running out of steam, so this equity price action may actually reverse course and be an even further drag on an income-producing portfolio.

Outside of an allocation decision, there are other options in play that can generate income and/or protect a portfolio. One would be to tactically allocate to these different income-producing asset classes.

While there are times where having a duration-heavy portfolio would be the allocation of choice, there are other times where being credit- and/or equity-heavy would be ideal. Being able to migrate among various classes depending on market conditions could help alleviate some concerns.

Another decision would be to use the options market as an income producer and a hedging mechanism. Looking outside the traditional covered-call strategies, another strategy that could be beneficial would be to sell volatility via strategies such as straddles.

For those who worry that the bull market is running out of steam and using equities in an income-producing strategy is a scary proposition, this options play may be an attractive opportunity.

Given the normally inverse relationship between equities and volatility, if equities were to head lower, volatility should rise, and one could take advantage of selling this higher volatility and collecting income off the strategy.

Conclusion

There is a justifiable consensus that a traditional fixed-income portfolio is insufficient to generate income in this market. Investors should be diligent in reviewing the alternative income-producing asset classes, and should look beyond a traditional strategic asset allocation decision.


Founded in 1993, Stadion Money Management is a privately owned money management firm based near Athens, Georgia. Via its unique approach and suite of nontraditional strategies with a defensive bias, Stadion seeks to help investors—through advisors or retirement plans—protect and grow their “serious money.” Contact Stadion at 800-222-7636 or www.stadionmoney.com. References to specific securities or market indexes are not intended as specific investment advice.

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