Income Seekers: Here's The Best Way To Achieve Attractive Yields At Lower Levels Of Volatility

Written by Michael Fredericks

If you’re investing for income today, or at any time in the past few years, you know it’s an endeavor fraught with uncertainty, perhaps even disappointment, and this may very well have you on an emotional risk-on/risk-off seesaw—trying to achieve a decent amount of income without indecent risk. [Indeed,] BlackRock has observed that a convergence of market and behavioral dynamics has caused many investors to operate at the extremes as they seek income: they are taking undue risk in a reach for yield and at the same time hoarding cash. In our opinion neither the full-throttle risk nor the “no-risk” approach is optimal. [Let me explain why that is the case and what you should do instead.]

Consider that for an equal amount of income, investors needed to take more than double the risk they did 10 years ago. This is shown in the chart below. I’d also argue that there is risk in the seemingly no-risk “run to cash” scenario. There’s opportunity lost by not investing those dollars in higher-potential opportunities as well as the tangible loss of growth and purchasing power after the effects of inflation and taxes.

(Click on image to enlarge)

Fortunately, income seekers do have options between these two extremes. I think a managed, multi-asset approach to income investing that invests specifically for attractive yield at lower levels of volatility makes good sense today. As the portfolio manager of such a strategy, I’d offer the following observations and considerations for fellow income seekers:

1. Favor shorter duration: Duration, or interest rate sensitivity, of bond investments, has steadily risen recently as investors have piled money into fixed income. Longer-duration assets may be particularly at risk as the Federal Reserve prepares to hike interest rates. Floating-rate securities or short-term fixed income might offer a better cushion in episodes of rising rates.
2. Use volatility: Equity market volatility, as measured by the VIX, touched its lowest level in 42 years in August. And it hasn’t taken off as much as we might have expected despite the looming election and other uncertainties. Times of low volatility can be opportune for buying an equity hedge while it’s inexpensive, to target some protection on the downside. At times when volatility spikes, pricing dislocations can occur in otherwise attractive assets. Market corrections, particularly when indiscriminate, can be times to look for buying opportunities.
3. Pick your places in high yield: Some pockets of high yield look better than others from a risk/reward standpoint. For example, the yields on CCC-rated high yield bonds are quite low on a 10-year basis given the historically higher default rates in this low-quality portion of the market. In our opinion, there’s not enough yield to compensate for the risk. On the other hand, in a slow but steadily growing economy, shorter-maturity, higher-quality high yield (BB and B rated) looks like a potentially interesting place—not for price appreciation, but for consistent cash flow. We would apply the same selective thinking to bank loans and other areas of credit fixed income.
4. Focus on dividend growers: Central bank policy has implications not just for interest rates and bond prices, but for pockets of equities. These are typically income-producing equities, such as utilities and consumer staples, which tend to act like bond market proxies. Stock dividends are still an attractive source of income, but we would not target the highest yielders now. We prefer stocks with a history of cash flow generation and dividend growth. There is no guarantee that stocks will continue to pay dividends.

With a number of important events exacerbating uncertainty through year-end, we think it makes sense to keep risk at the low end of the continuum now. This might mean lower exposure to equities and some forms of credit. However, the Holy Grail for income investors today is selectivity and an active, eyes-wide-open approach to managing opportunities and risk.