Defensive Income Strategies for Rising Rates & Bond Outflow Rotation
In today’s financial landscape, investors—especially retirees—are facing a challenging environment marked by rising interest rates, bond market volatility, and shrinking income opportunities from traditional fixed-income sources. As capital continues to rotate from bonds into equities, the search for stable and defensive income strategies has become more critical than ever. This article explores practical approaches to generating reliable portfolio income while managing risk, highlighting options such as high-yield bonds, convertibles, REITs, MLPs, preferred stocks, and covered call strategies designed to help investors adapt to shifting market dynamics.
The Challenge of Generating Income in a Changing Market
Most retirees don’t have the risk tolerance for sharp downward volatility in equity markets, nor are many comfortable with the traditional 10-year holding period necessary to recover from another 40% drop in stock indices. Over a hundred million of retirees will be facing a new reality, as another roughly 75 million baby boomers continue to move into the golden years with the expectation of taking less risk and having sufficient portfolio income to sustain their longevity and lifestyle. However, the days of 3-4% CD yields and 6-7% from investment grade corporate bonds are gone and the opportunity frontier for income has sharply narrowed. Also, bonds carry price loss risk in a rising rate environment, particularly if purchased in mutual funds or ETFs.
The Great Rotation: From Bonds to Dividend Stocks
Perhaps this quandary is one factor that has propelled retirees back into dividend stocks for income, of which we don’t contest the benefits for this allocated part of a retiree’s portfolio. Currently, bonds are experiencing a great rotation, where a substantial amount of money moves from one asset class into another, such as fixed income into equities. In early 2009, we had the reverse, where equity outflows were being redirected into bonds and money markets.
A Goldman Sachs report showed over one trillion dollar net inflow into stocks in the four years prior to 2013, which this year is on pace to exceed past years. Although part of the pie is corporate buyback, M&A buyouts and net issuance, the more recent trend has been a focused paradigm shift away from bonds and into equities. Indeed, investors withdrew an estimated $43 billion from taxable bond mutual funds in the month of June alone and when the market sells bonds and buys stocks in large rotational dollar amounts, bonds decline and equities tend to increase. Of course another equity attraction has been the central bank’s balance sheet stimulus and essential zero rate fuel, which has made many investors assume market risk (equity premium) is lower.
Bond Market Adjustments and Duration Risk
Meanwhile, many bonds have already taken it on the chin, as there has been a large adjustment in some bond funds shifting to lower duration after Bernanke rattled the bond market earlier this year. To keep things simple and not considering the different bond grade ratings or convexity, if a mutual fund has an average duration of seven years, if rates were to increase 1%, the bond fund would hypothetically lose 7%.
Even while the Fed has not moved rates up or indicated an increase yet this year, the asset class rotation has arguably already started, as the Barclays Aggregate Bond Index declined -2.3% so far this year. The ten year Treasury bond ended the quarter yielding 2.5% compared to 1.7% at year end, translating for mutual funds that own long government bonds averaging over a -7% loss this year. Treasury Inflation Protected Securities lost ‐3.6% in June and were down over ‐6.5% year-to-date. Although International bonds recovered +2.4% in July, they have also suffered, with the Barclays Global Treasury Bond Index being down ‐4.7% this year.
Institutional Strategies: Rolling Down the Yield Curve
On the professional institutional investor side, there was ample opportunity to sell longer duration bonds trading at a premium over par (higher market price than maturity value) in early 2013. Also, there was an early yield roll down opportunities as a strategy to generate yield and protect principal investment. Rolling down the curve can be accomplished by purchasing of a bond with a maturity in the higher yielding section of the yield curve and selling the bond prior to maturity when it reaches a lower yielding section, assuming a positively and unchanged sloped yield curve.
When prevailing interest rates are expected to increase in the future, this motivates investors to “roll down the yield curve” with bonds that are approaching maturity, with the assumption that bonds potentially are valued at lower yields and higher prices. In short, some institutional players moved early and locked in price appreciation well ahead of any prospective interest rate increase by the Fed.
Long-Term Outlook for Investment Grade Bond Funds
There has been financial articles’ positing that holding investment grade bond mutual funds in a rising rate environment will only lead to short term price fluctuation losses, but in the longer term the mechanisms are in place for stability as these funds simply hold bonds to maturity and buy new higher yielding bonds (assuming rates are increasing).
We believe this could be an ongoing market loss scenario for longer maturity funds. Assuming a bond fund is not short-term duration, then in an ongoing rate increase environment the bond fund will continually be a step behind prevailing higher market rates, subjecting the fund to continual bond price erosion on seasoned lower yielding bonds relative to prevailing higher market yielding issuance.
Exploring Alternative Income Options for Retirees
With investment grade bond yields barely high enough to cover inflationary costs of living, what are the income options for retirees? In light of the fact that we are in substantial better economic environment than a few years ago, along with considerably stronger corporate balance sheets, we would suggest one part of the answer is to assume different risk for the bond section of the portfolio, such as high yield bonds and convertible bonds.
Both are much further down in the capital structure of a company and offer characteristics to better protect losses in a rising rate environment. Another part of the equation for income would be to choose different sources for yield, such as REITS, MLPs, utility preferred stocks and selling covered calls (often already holding high dividend stocks).
High Yield Bonds: Greater Risk, Greater Reward
Although an investor is taking on more credit risk, high yield bonds have delivered returns that exceed other fixed income vehicles and have been shown to have similar returns to equities over the past decade in a half. Also, with the markedly higher coupon to compensate for risk, these bonds are less susceptible to loss from rising rates.
We would suggest funds that held up in 2008, such as Wells Fargo Advantage Short-Term High Yield Bond (SSTHX, load waived), PowerShares Senior Loan Portfolio ETF (BKLN).
Convertible Bonds: Combining Income and Equity Potential
Convertible bonds are considered hybrid fixed-income securities that offer income with equity-like exposure, and at times, offer defensive characteristics during periods of rising rates.
We suggest diversity via funds such as Greenspring Fund (GRSPX) or SPDR Barclays Convertible Securities ETF (CWB).
REITs: Real Estate-Backed Income Opportunities
Though REITs can be as volatile as equities, this asset class has real property characteristics and provides income through dividends.
We also like diversified conservative Realty Income Corp (O), which yields about 5%.
MLPs: Infrastructure-Driven Income Streams
Although MLPs have already experienced a solid run-up this year, they remain attractive for income.
We like Brookfield Infrastructure (BIP) and UBS E-TRACS Alerian MLP Infrastructure ETN (MLPI).
Utility Preferred Stocks: Stability and Strong Dividends
Utility preferred stocks and preferred funds are long maturity preferred shares in utilities that have high dividend yields and lower volatility.
We find Pacific Gas & Electric Co. (PCG-A), Georgia Power Company (GPE-A), and iShares PFF or Cohen & Steers’ CPXIX fund to be attractive options.
Covered Calls: Generating Extra Income from Existing Holdings
Covered calls earn additional income by selling to another investor the right to buy some of its stock holdings at a set price.
Funds like Gateway Fund (GATEX), Bridgeway Managed Volatility (BRBPX), and Horizons S&P 500 Covered Call ETF (HSPX) can be suitable choices.