Thinking Outside the "Income" Box

It’s official (it has been for a long time actually): investors’ tolerance for risk has been shaken. Need evidence? Investors continue to pour billions of dollars into taxable and tax-exempt bond funds, with $74 billion and $14 billion of net inflows respectively in the first quarter of 2010 alone, according to the April 2010 Morningstar Direct Fund Flows Update. Keep in mind that these sums are on the heels of record-breaking net inflows in 2009 of $284 billion and $72 billion respectively. Of course, while this migration is accentuated by late-to-the-party performance chasers, there has been a marked rise in investor demand for income generating portfolios and the relative stability they provide.

For those investors that have turned to fixed income, the question becomes: How to handle interest rate risk? As a due diligence consultant that meets regularly with asset managers, this has been a popular topic of discussion. While the managers we speak with diverge in their opinions of when rates will increase, they are unanimous in their prediction that following a period of lackluster growth and low inflation, rates will, must, have to…rise. Unprecedented economic stimulus, ballooning government spending and ever-expanding federal debt leave few tools to rein in future fiscal situations, with the likely result of inflating our way out of our overwhelming debt burden. Coupling these factors together leads many of us to believe that the 20+ year secular decline in interest rates has come to an end. It is not a question of if, but when, interest rates will rise, and by how much over the yield curves.

Similarly, the fixed-income credit spread picture offers little relief for investors. In 2009, non-Treasury fixed income securities experienced record-setting excess returns, with everything from Agencies (+2.9% outperformance) to U.S. Corporate High Yield Bonds (+59.5% outperformance) vastly outpacing Treasuries, according to BlackRock’s Barclays Indexes. The dramatic risk-trade rally of 2009 and its continuation into 2010 left spread-sector yields at or near historic lows, as of April 30 in Barclays Capital Live Database. This puts investors between a rock and a hard place, since money markets are essentially yielding 0% and there is little room for further spread compression.

For many advisors who are concerned with the potential for rising rates, many are shortening the durations of their clients’ bond portfolios and focusing on analyzing the quality of the underlying credits. Others have turned their attention to equity dividend managers to satisfy their clients’ demands for high current income. However, not all dividend managers are created equal nor do they share the same investment objective. Some emphasize dividend growth rates while others seek high portfolio yields as the first and only priority. The problem with this solution for certain investors is that the all-equity portfolio is still vulnerable to violent swings in the stock market, and to achieve a yield above 4%, portfolio concentration and a limited stock universe can be problematic.

In our view, little attention has been paid to more opportunistic, specialty managers that cross asset class boundaries to meet high income mandates. One such example is the Forward Uniplan Advisors–High Income Total Return SMA strategy. The manager combines dividend paying common stocks, real estate investment trusts (REITs), master limited partnerships (MLPs), convertible bonds and preferred stocks into one portfolio to provide clients with high income (typically 5%+), less-correlated, and potential equity-like upside returns. The strategy’s U.S. equity correlation, benchmarked against the Russell 3000 Index, is typically 0.75, while the U.S. fixed income correlation, benchmarked against the Barclays Aggregate Bond Index is +/- 0.10.