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A Bigger Toolkit for Generating Income Potential 

Doug Forsyth 

 

3/11/2014 

Income can solve a lot of problems, but it’s not easy to find with core bonds today. Investors need broader opportunity sets if they want to find the higher income, lower volatility and lower rate sensitivity they seek, says Doug Forsyth.
Income generation is a top priority for many investors for good reason: Almost any portfolio can benefit from the many advantages that income can provide, from lowering volatility to contributing to total return.
 
Yet today’s environment of financial repression and ultra-loose monetary policy has created historically low yields on investment-grade bonds, which have traditionally been a key income-generating asset class.
 
Moreover, as the historic flow of easy money recedes, long-term interest rates will start to rise.
 
In times like these, owning too many low-yielding, rate-sensitive securities may threaten scarce income streams and put long-term goals in jeopardy.
 
At the same time, while most investors understand the need to maintain an allocation to equities, historical stock-market volatility has left many investors uncomfortable with equity-only strategies, which may present more downside risk than they are willing to accept.
 
The result is a paradox: Many investors have sought safety by overallocating to core fixed income, but those securities offer low yields that may not even outpace inflation. Clearly, while this flight to safety is understandable, it may ultimately be self-defeating, as these investments are unlikely to meet either current income needs or longer-term goals.
 
Our experience has shown that many investors would be wise to “re-risk” their portfolios and consider implementing a range of income-generating strategies that have historically offered stock-like return potential and lower volatility.
 
We have determined that a blended approach incorporating multiple asset classes— high-yield bonds, convertible bonds and large-cap equities with a covered-call options strategy—can address many of these issues and offer a range of benefits: High-yield bonds, which have low correlation to traditional bonds, provide high income potential and a compelling risk/reward profile.

Convertibles have historically provided attractive yields and stable coupons, in addition to capital appreciation and dampened downside volatility.
Stock positions in growth-oriented, dividend-paying equities offer the potential for capital appreciation and income.
Opportunistically writing covered-call options on the long equity positions can provide a supplemental source of income.
 
Collectively, these asset classes can provide a steady source of income, a compelling asymmetric return profile and outperformance relative to core fixed income – key benefits in today’s environment of financial repression. In times like these, when investing too conservatively could put income goals at risk and erode wealth over time, we believe investors should consider using a broader income toolkit.


  
The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.

 

A Word About Risk: Equities have tended to be volatile, and do not offer a fixed rate of return. Convertible securities involve the added risk that securities must be converted before it is optimal. Dividend-paying stocks are not guaranteed to continue to pay dividends. Dividend-paying stocks are not guaranteed to continue to pay dividends. High-yield or “junk” bonds have lower credit ratings and involve a greater risk to principal.

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