Alternative income: Swimming Upstream
SCOTT KEFER, CFA 21-Oct-2021
Income investors must feel like they are swimming against the current. Over the past 10 years, bond yields have been slashed and anyone reliant on investment income has struggled to generate enough cash flow. Consider the yield on seasoned Aaa corporate bonds—a proxy for high-quality corporate bonds as rated by Moody’s. As of October 2021, the yield on such a portfolio was hovering over 2.6%, which is about half of what investors would have received 10 years prior. Doing the math on any bond portfolio is both straightforward and rather alarming, and the resulting loss of income has not been insignificant.
So what are the choices for investors facing this upstream struggle to generate adequate income? Some investors may choose to take on greater credit risk, moving money into lower-quality bonds in the hope capturing incremental yields. Others have shifted assets into equity strategies that offer attractive dividend income, even though the volatility carried by equities has historically been higher than bonds. Both of these moves can be prudent in the right circumstances (if done judiciously), but investors need to be mindful of the added risks.
Given the current backdrop now facing investors—very low Treasury yields; equities at lofty valuations by historical measures; and an economy fueled by unprecedented amounts of fiscal and monetary accommodation that may ultimately usher in a new era of inflation—investors might benefit from a strategic approach to supplement their income by seeking dividends while also managing equity risk. Is this too good to be true? Perhaps not.
A three-step approach
Despite the fact that equities typically carry a higher risk profile than most fixed income asset classes, dividends can still be a viable (i.e. relatively safe) source of income when properly managing for volatility risk. One way to do this is by structuring a hedge designed to neutralize equity volatility through the use of liquid market equity futures, which are a type of derivative.* And even though “derivatives” can make some investors nervous, it’s important to remember that many fixed income portfolio managers commonly employ various types of derivatives to control duration, credit risk, and other exposures.
So how, exactly, could one improve an income portfolio’s efficiency by seeking dividends while working to reduce risk? Here are three steps:
1. The first step is to build a portfolio of potentially high-dividend paying stocks. However, this should be done in a way that doesn’t just chase highest yielding stocks, but rather allocates across various sectors, regions, and market caps for balance.
2. The second step is to neutralize the volatility and risk that typically comes with investing in these dividend-paying stocks. This can be done through various derivatives, which are contracts that are based on the value of underlying securities and often used to hedge risk. But the manner in which one hedges risk matters because exogenous events can sometimes impact the availability or pricing of a put option* on an individual stock. A better alternative may be to use very liquid broad market equity index futures that correspond to the asset classes of the high-dividend equity portfolio.
3. The third step is to address the potential for sector, style or region bias. For instance, a portfolio of high-dividend-paying stocks typically has a value tilt, so generating complementary growth exposure would be a possible solution.
Admittedly, building and executing this type of sophisticated income strategy can be challenging—mostly likely beyond the capabilities of the typical individual investor. However, there are alternative income vehicles available that may be able to capture attractive equity dividends and offset the equity risk in a prudent manner. But remember, how this hedge is implemented matters, and evaluating these strategies is critical.
As we mentioned above, investors might wish to avoid any alternative income strategy that attempt to manage equity risk by shorting* individual stocks, which in turn may open the fund up to the vagaries of the option market and/or the risk of a short squeeze,* as we saw with a few notable meme stocks early in 2021. Another important variable is cost, which can eat into the potential income gain offered by any such funds. And finally, investors may wish to look at how these funds perform in times of higher volatility and market disruption.
Nevertheless, in the proper circumstances, it just might make sense for investors to carve out a place in a diversified income-oriented portfolio for market-neutral income strategies. This could be a strategic tool to supplement income in many market environments
*Glossary of Terms:
• Derivatives: A financial contract whose value is dependent on an underlying security. Derivatives are commonly used hedge risk, or in some cases to speculate on the future prices of the underlying. Options contracts, futures contracts and swaps are all examples of derivatives.
• Put options: A type of derivative in which the buyer assumes (or will profit when) the future value of the underlying security will decrease. Investors often buy put options on individual stocks they already own to provide downside protection in the event that the underlying security falls.
• Shorting stocks: A practice in which an investor is speculating and expects the future value of a stock will decline.
• Short squeeze: A scenario where many investors are speculating that a security will move lower (i.e shorting the security), but the price action of the underlying actually moves higher, often abruptly. This prompts investors who are shorting to close their positions (by buying the underlying stock) to avoid further loses. However, this added demand to buy the stock tends to send the stock even higher, thus “squeezing” the shorts.