The obsession with income is unwittingly steering individuals towards assets that are divorced from economic reality and could be painful in the long run. Advisors and investors looking to generate attractive returns in today’s market need to consider being more diligent.
We all know that yields on the highest-quality bonds, especially Treasuries, no longer suit the needs of retirees and those nearing retirement. The solution has been to invest in equities with dividends above what bonds pay.
Talk to advisors or read the articles about these stocks, however, and a disturbing theme emerges: often, there is no mention of a company’s financial prospects or an understanding of how attractive the security’s pricing is.
Chasing income can have unexpected, disastrous results. Investors avoid Treasuries at the precipice of an interest rate rise because, of course, they know that these securities can quickly lose value. Yet what they may not realize is that these so called “bond replacement” securities can also show dramatic declines once rates start to move.
For example, from July 30th to September 17th this year, when a rate rise seemed on the cards, income proxies like the XLU Utilities ETF (with a 3.2% yield), the XLP Consumer Staples ETF (2.4% yield) and the IYR Real Estate ETF (3.9% yield) declined by 5.5%, 3.4% and 7.18%, respectively. In each of these cases, the declines were much more dramatic than the income they produced.
Thus, we see the risk that comes with chasing yield. Investing in companies because they pay a good dividend while overlooking their growth prospects or their valuations can expose investors to losses that negate the income. It’s absurd.
A fresh approach to asset selection is in order. There are assets out there which provide income and have strong growth prospects. Finding them in this market simply means that advisors and investors have to roll up their sleeves and look beyond just dividends or yields.
One area we often like to highlight is the high-yield corporate bond market. High-yield corporate bonds aren’t necessarily anyone’s favored asset class, but a deeper look at some of the dynamics happening in this market brings up some intriguing prospects.
In spite of explosive growth over the last decade, the high-yield corporate bond market has been affected by liquidity issues as banks and broker-dealers exit in the aftermath of regulation. At the same time, the market has many companies with steady or improving growth prospects – whether it be debt reduction or a vivacious management team.
The result is that there are bonds attached to these improving companies that trade below par – in spite of stronger than expected financial conditions – and have attractive coupons which can provide desirable income. The task at hand for advisors and investors then is to be more flexible and thorough in their approach. To help balance risk and return, one could build a diversified portfolio with varying maturities and pay dates.
Another way to generate income and possible growth, though a bit more advanced, is to sell insurance – i.e., puts – for stocks that you, the investor or advisor, would like to own. This approach has been a favorite of some pension and endowment funds for quite some time, primarily with stock indexes.
Selling puts commits the investors to buy shares at a future date at a pre-determined price. Again, this only makes sense with companies that the advisor or investor has researched and wants to hold. If the shares of a target company, say Company X, are currently trading at $50 and, after analysis, the opinion is that the stock could reach $70 over time, selling puts at $50 makes sense. If the price drops below $50 at expiration, the adviser/investor is buying the stock at what is likely a lower cost ($50 minus the premium received) than if they bought the stock outright at $50.
Advisors and investors should be mindful of whether the premiums received properly compensate them for committing to a future purchase. With the VIX at 13 (at time of writing), this may be a prime strategy if/when market discord persists and volatility takes the VIX higher.
This idea isn’t an outright advocacy for puts; rather, this is simply a fresh way to reduce the costs of buying shares you want to own and possibly attaining some income. Once more, this is the type of fresh thinking that diligent investors can uncover as markets favors stocks that are somewhat divorced from reality.
The race for income has turned into a stampede. Unfortunately, stampedes have the tendency to turn into crushes. Buying companies simply for their dividends, while not desperate, certainly resembles the delirium that underlies panic.
When markets become dislocated like they have, the impetus is there for investors to be even more diligent about the assets they select. More importantly, there is value in finding space to take a breath, tune out the noise and look at new ways to deliver the income and growth they seek.