High on the list of questions posed to financial advisors these days is this: What do you do with clients’ bond funds in light of rapidly rising interest rates?
As the traditional 60/40 portfolio model unfolds and bond funds continue to bleed, investors are crying out for alternative sources of return.
Two weeks ago, at the Exchange ETF conference in Miami, DoubleLine Capital’s CEO and so-called bond king Jeff Gundlach told CNBC that he recommends a mix of equal parts stocks, commodities, cash and long-term government bonds.
“The bond market is grossly incorrectly priced,” Gundlach said. “If you actually have a 60/40 portfolio, 2022 is your worst year to date ever. But if you had it 25/25/25/25, you would be far better off.”
But Jon Maier, CIO of Global X, said that instead of turning to bonds, investors can look at alternatives to stock income. He presented a wide range of options this week on “ETF Edge.”
When it comes to equities, the popular trend is to lean towards low volatility and high yields – such as the Invesco S&P 500 High Dividend Low Volatility ETF (SPHD), which has risen 5% over the past year.
Quality returns are traditionally more value-oriented, and right now investors are desperately looking for returns.
“The market rewards it at least on a relative basis,” Maier said. “And I think it’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), highlighting their ability to both steadily expand dividends and maintain a strong cash flow.
Master limited partnerships
Master limited partnerships, or MLPs, are listed partnerships that offer tax benefits of a private partnership with the liquidity of a listed company.
Most of these are in the energy industry, where the vast majority have 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 recent rise in commodity prices.
Todd Rosenbluth, research director at ETF Trends, points to the Alerian MLP Index (AMLP) – the largest MLP ETF out there – as a solid source of returns and relative stability.
MLP ETFs are taxed at the corporate level, providing fewer tax benefits than pure MLPs, but also eliminating the headache of filing complicated K-1 tax forms.
“That’s one of the reasons investors like the ETF structure with MLPs,” Maier said. “MLPs and LPs (limited partnerships) are highly correlated with the movement in interest rates. So as interest rates rise and rise, [they] could also potentially increase. “
Improved returns on REITs
REITs may not be an obvious bid in an environment of rising prices, but they have been one of the better performing sectors in the last many months offering improved returns.
The Vanguard Real Estate ETF (VNQ) has risen 6% over the past year, surpassing the S&P 500 by 7%.
Rosenbluth said the fund has seen strong growth and REITs have become more attractive because they offer investors equity exposure, consistent dividends (they are required to pay 90% of their income in the form of dividends) and diversification.
REITs have also become more and more growth-oriented with exposure to sectors such as data centers and mobile phone towers, which are still benefiting from a strong economy.
Demand has grown for the popular two-way option strategy, which allows investors to sell stock options on a stock-to-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 about $ 7 billion in assets. The fund’s annual return is around 12%; it is very high, although much of it stems from market volatility.
Covered call funds are generally best used in an area-bound market, Maier said. “You are somewhat subdued on the downside depending on the volatility of the market.”
The currents tell the story, and Rosenbluth said the demand is clearly there for ETFs with covered calls. He cited QYLD, JPMorgan’s Equity Premium Income ETF (JEPI) and the Amplify CWP Enhanced Dividend Income ETF (DIVO) as good examples.
“Extremely complicated, extremely complicated,” Rosenbluth said. “But we also find great interest in our customer base.”
They come at a higher price, but Maier said it’s worth it for the higher income and the convenient structuring. He also advised investors to look at it from an overall return perspective, warning that lower volatility could potentially lead to a bit more downward.
Favorite stocks are also getting more attention. These are essentially bond-like stocks that pay both coupons and preferred dividends: a hybrid of stocks and bonds.
However, the preferred market is dominated by banks and related financial institutions, which tend to be more economically sensitive.
Rosenbluth said iShares Preferred and Income Securities ETF (PFF) has gained ground as a popular preferred ETF game. “Unlike getting some of the stock upward that you would get, you also get a higher return than you would get from the bonds,” he said.
That said, preferences have underperformed so far in 2022. PFF and Global X US Preferred ETF (PFFD) have fallen by 12.5% and 16% respectively this year.
“They are instruments of long duration, so if prices rise, the long end of the curve rises,” Maier said. “Inevitably, these will fall in price, but the underlying credits are strong.”
Adds it all
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 concerned with, essentially a bond-proxy-type portfolio that is not tied to interest rate movements.
Global X Equity Income Portfolio, which consists of quality dividends, MLPs, preferences and other high-yielding instruments. distributes a yield of about 4.5% and in some cases mitigates the blow from rising rates.
“One could argue that this is a complete solution,” he said. “In the current environment, it can replace your entire portfolio, not just 40% bond allocation.”
But in the end, Rosenbluth warns the average investor against throwing bonds out with the bathwater.
“It’s confusing, but I do not think people should swap as much as 40% of their fixed income portfolio for something that is equity income oriented, because then you take on so much more risk,” he said. “So you get some of that interest rate sensitivity, some of that credit risk. But there are typically more disadvantages to investing in stocks than investing in a bond portfolio.”
Of course, if a severe dot-com boom-style downturn started, everything would go down and investors would be left with very few places to hide.
In that case, Rosenbluth recommended looking at ultra-short-term fixed-rate ETFs, which he called “cash-like with a little bit of income.”
“You can have short-term corporate bond products,” he said. “Equity exposure is a risk and investors need to make sure they understand what risk they are taking.