The path to consistent income is undergoing a transformation
by Chris HuemmerMr. Huemmer is Senior Client Portfolio Manager at FlexShares ETFs. Visit www.flexshares.com.
As the financial world settles into a higher rate environment, investors are presented with both opportunities and challenges in the realm of income-generating investments.
For years advisors have guided their yield seeking clients through a challenging landscape, grappling with the effects of accommodative monetary policies that held interest rates at historic lows. In their quest for yield, many investors found refuge in dividend-paying stocks, real estate investment trusts and fixed income instruments bearing higher risks. Now as global central banks steer policy toward more traditional interest rate levels, a fresh perspective is required to maintain and optimize income streams.
As investors embark on a comprehensive exploration of income-generating investments in the wake of the normalized rate environment, adjustments will be necessary to safeguard and enhance income in this new economic and rate regime. From reconsidering the role that dividends play in an income-seeking portfolio to reevaluating bond strategies, the path to consistent income is undergoing a transformation. Advisors understanding of these shifts and adoption of informed approaches is crucial, in order to position their clients to thrive amidst the new equilibrium.
There Are Alternatives To Equities, But Overlook Dividend Stocks At Your Own Peril
One of the early narratives bandied about as Treasury yields rocketed higher over the last eighteen months was that the stretch for yield was over. The phrase “There is no alternative to equities” could be retired from the common lexicon. Investors could now return to safer assets that offered comparable, or even superior, yields than dividend paying equities with lower risk profiles. It is logical to use a full array of income generating assets to meet your client’s income needs, but moving completely away from equities hazards overlooking the direct reason why yields have pushed higher in the first place: inflation.
Advisors know that inflation is a silent killer in a client’s portfolio. Inflation hollows out the purchasing power of the nest egg retirees have worked so hard to accumulate and can impact how well, and how long, one’s decumulation phase may be. Even low levels of inflation can have a profound impact on an investor’s purchasing power over the course of retirement, and protecting a client’s portfolio becomes of even greater emphasis given the inflation we have experienced over the last couple years. And with peak levels of inflation in the past, it may be some time before we see inflation approach the Federal Reserve’s target of 2%.
Equities offer a level of inflation protection through potential capital appreciation that conventional fixed income securities cannot. This combination of capital appreciation in addition to the dividend payments is what makes dividend yielding equities a compelling piece of an income generation allocation. In fact, there is evidence that dividend stocks have historically done well in periods when Treasury yields are competitive with stock earnings yields, as we are experiencing today.
In the current environment, advisors should look to implement some best practices when evaluating dividend focused strategies for their clients. With input, labor and financing costs all increasing, it is important to evaluate the financial sustainability of a dividend income stream. Too often, people cut corners and believe that dividend growth is analogous to the dividend being well protected. A more effective way of gaining confidence in the dividend is by evaluating the financial strength, or quality, of the company paying that dividend. By simply avoiding the poorest quality dividend payers, advisors can put their client’s in a better position to succeed.
Another best practice advisors can put into place with dividend paying stocks is to source yield from all sectors. Too often legacy dividend approaches overemphasize sectors such as utilities and financials, and overlook sectors such as technology, as potential sources of yield. The first issue in dividends having an over reliance on a few sectors is the potential for missed opportunities when other sections of the equity market do well. The early part of 2023 exemplifies this idea, where dividend strategies that ignored or were drastically underweighted technology, underperformed those with more sector balance. A strategy concentrated in only a few sectors may also open up the entire asset allocation to risks typically diversified by a more sector neutral approach, such as an increased sensitivity to interest rate changes. This type of exposure when combined with fixed income holdings, that are also sensitive to rates, may increase the term exposure of the client’s entire portfolio more than the advisor had intended.
Protecting Against Inflation With TIPS
Similar to how advisors may look to dividend yielding equities as a way to mitigate long-term inflation while generating income, there are securities in the fixed income market that offer advisors tools to mitigate short-term inflation expectation changes. These also have the potential to deliver interest coupon payments. Treasury Inflation Protected Securities, or TIPS, are inflation-linked bonds issued by the U.S. Treasury that are helpful for managing short-term inflation.
First issued in 1997, TIPS are similar to other U.S. Treasuries as they are issued with a fixed coupon rate and a defined maturity. However unlike other Treasuries, the principal of the TIPS is adjusted monthly based on changes to the Consumer Price Index, or CPI. Though the interest rate remains fixed through the life of the debt obligation, if the principal of the bond increases due to rising inflation, the dollar amount of the coupon payment received by the bond holder will also see it increase due to the higher principal amount. These changes in the coupon payment amount received can help mitigate inflation over the short-term.
When implementing a TIPS allocation into a client’s portfolio, advisors should be aware of two things. First, advisors should be aware that while credit exposure within TIPS is no different than any other U.S. Treasury, TIPS do carry term risk and are sensitive to changes in interest rates. As such it is important to be aware of, and optimally control, the duration exposure in your TIPS allocation. Duration, a way to measure term risk, can vary widely within market weighted TIPS indices over time. It is therefore crucial to understand that risk within a client’s portfolio. Be warned that limiting the maturities of TIPS to only a small portion of the available TIPS market – such as only those TIPS with less than five years of maturity – is not the same as controlling for duration. Even short maturity market weighted TIPS indices can see their exposure to term risk swing widely over time. A better practice would be to target a specific duration and aim for that within a client’s allocation.
Second, advisors should make sure their clients understand that the TIPS market moves with changes in inflation expectations, rather than realized inflation changes. That means the current inflation expectations are already priced in when TIPS are added to a portfolio. That is why a strategic allocation to TIPS is best used as a way to mitigate changes in inflation before they happen, similar to buying insurance on a house before an unexpected issue arises.
High Yield Continues To Be An Attractive Tool
Another asset class that has drawn a lot of attention both during the low rate environment as well as during the rate hiking cycle has been high yield bonds. Though often grouped with risk control fixed income instruments, advisors looking to build income generating portfolios may want to examine the
asset class as an alternative to dividend paying equities. Historically, macroeconomic environments similar to what we are experiencing today, where muted real economic growth is paired with positive nominal growth, have shown periods of high yield outperforming equity markets.
One investment approach gaining attention in the high yield space uses quantitative techniques to tease out factor exposures, similar to how factors can be incorporated into equity portfolios. For yield-seeking investors, a value focused high yield approach may be able to generate greater yield than traditional high yield strategies, allowing investors to be compensated for the risk they are taking.
Though the path ahead may contain uncertainty around inflation, monetary policy and real economic growth, there is a greater set of opportunities for advisors to tap into when working with their clients. With adaptability, astute decision making and a strong eye for the possibilities, investors can benefit from the current environment by leveraging the increased toolkit at their disposal.