High up on the list of questions being posed to financial advisors these days is this one: What do you do with clients’ bond funds in the face of rapidly rising rates?
As the traditional 60/40 portfolio model unravels and bond funds continue to bleed, investors are clamoring for alternative sources of yield.
Two weeks ago, at the Exchange ETF Conference in Miami, DoubleLine Capital CEO and so-called bond king Jeff Gundlach told CNBC that he’s recommending a mix of equal parts stocks, commodities, cash and long-term Treasury bonds.
“The bond market is grossly mispriced,” said Gundlach. “If you actually have a 60/40 portfolio, 2022 is your worst year to date ever. But if you had the 25/25/25/25, you’d be far better off.”
But Jon Maier, CIO of Global X, said instead of turning to bonds, investors can look to equity income alternatives. He laid out a whole host of options this week on “ETF Edge.”
Quality dividends
When it comes to equities, the popular trend is to lean toward low volatility and high dividends — such as the Invesco S&P 500 High Dividend Low Volatility ETF (SPHD), which is up 5% over the past year.
Quality dividends are traditionally more value-oriented, and right now, investors are desperately searching for yield.
“The market is rewarding that at least on a relative basis,” Maier said. “And I think that’s a safer place to be than some other sectors and abroad.”
He recommended the Vanguard High Dividend Yield ETF (VYM) and the iShares Core Dividend Growth ETF (DGRO), touting their ability to both steadily expand dividends and maintain strong cash flow.
Master limited partnerships
Master limited partnerships, or MLPs, are publicly traded partnerships that offer the tax benefits of a private partnership with the liquidity of a publicly traded company.
Most of these are in the energy industry, with the vast majority holding midstream infrastructure, such as oil pipelines and storage facilities.
MLPs provide a high income and are closely correlated with crude oil prices, which have benefited from the commodity’s recent surge.
Todd Rosenbluth, director of research at ETF Trends, points to the Alerian MLP Index (AMLP) — the largest MLP ETF out there — as a solid source of dividends and relative stability.
MLP ETFs are taxed on the corporate level, which provide fewer tax benefits than pure-play MLPs, but also remove the headache of filing complicated K-1 tax forms.
“That’s one of the reasons that investors like the ETF structure with MLPs,” Maier said. “MLPs and LPs (limited partnerships) are highly correlated to the movement in interest rates. So as interest rates go up and up, [they] also potentially could go up.”
Enhanced yields of REITs
REITs might not be an obvious bet in a rising rate environment, but they have been one of the better-performing sectors for the last several months, offering enhanced yields.
The Vanguard Real Estate ETF (VNQ) has risen 6% over the last year, outpacing the S&P 500 by 7%.
Rosenbluth said the fund has seen strong inflows, and REITs have become more attractive, because they offer investors equity exposure, consistent dividends (they’re required to pay out 90% of their income in the form of dividends) and diversification.
REITs have also become increasingly growth-oriented, with exposure to sectors like data centers and cellphone towers, which still benefit from a strong economy.
Covered calls
Demand has grown for the popular two-part options strategy, which allows investors to sell call options against stock on a share-for-share basis while owning or buying the same amount of the underlying security.
Global X has several covered call ETFs, the largest of which is the Nasdaq 100 Covered Call ETF (QYLD) with roughly $7 billion in assets. The fund’s annual yield stands at about 12%; that’s very high, though much of that stems from market volatility.
Covered call funds are generally best used in a range-bound market, Maier said. “You’re somewhat cushioned on the downside depending on the volatility in the market.”
The flows tell the story, and Rosenbluth said the demand is clearly there for covered call ETFs. He pointed to the QYLD, JPMorgan’s Equity Premium Income ETF (JEPI) and the Amplify CWP Enhanced Dividend Income ETF (DIVO) as prime examples.
“Enormously complicated, extremely complicated,” Rosenbluth said. “But we’re finding a lot of interest with our client base as well.”
They come at a higher price, but Maier said it’s worth it for the higher income and convenient structuring. He also advised investors to look at it from a total return perspective, warning that lower volatility could potentially lead to a bit more downside.
Preferred equities
Preferred stocks also are garnering more attention. These are essentially bond-like equities that pay both coupons and preferred dividends: a hybrid of stocks and bonds.
The preferred market is dominated by banks and related financial institutions, though, which tend to be more economically sensitive.
Rosenbluth said the iShares Preferred and Income Securities ETF (PFF) has gained traction as a popular preferred ETF play. “As opposed to get some of the stock upside that you would get, you get a higher yield than you would from the bonds as well,” he said.
That said, preferreds have underperformed so far in 2022. The PFF and Global X U.S. Preferred ETF (PFFD) are down 12.5% and 16%, respectively, this year.
“They’re long-duration instruments, so if rates go up, the long end of the curve goes up,” Maier said. “Inevitably these are going to go down in price, but the underlying credits are strong.”
Adding it all up
By mixing and matching sectors, Maier said, it is possible to create an income-focused equity portfolio that can replace all the bonds that Gundlach and others are worried about, essentially a bond proxy-type portfolio that is not tied down to interest rates moves.
The Global X Equity Income Portfolio, which consists of quality dividends, MLPs, preferreds and other high-yielding instruments. doles out a roughly 4.5% yield and, in some cases, cushions the blow from rising rates.
“You could argue this is a complete solution,” he said. “In the current environment, it could replace your whole portfolio, not just the 40% bond allocation.”
But at the end of the day, Rosenbluth cautions the average investor against throwing out bonds with the bath water.
“It is confusing, but I don’t think people should swap out the entire 40% of their fixed income portfolio into something that’s equity income-oriented, because then you’re taking on so much more risk,” he said. “So you get some of that interest rate sensitivity, some of that credit risk. But there is more downside investing in stocks, typically, than investing in a bond portfolio.”
Of course, if a serious dot-com boom-style slowdown kicked in, everything would go down, and investors would be left with very few places to hide.
In that case, Rosenbluth recommended looking at ultra-short oriented fixed income ETFs, which he called “cash-like with a little bit of income.”
“You can have short-term corporate bond products,” he said. “The equity exposure is a risk and investors need to make sure they understand what risk they’re taking on.
