Enhanced Fixed Income
It is a challenging time for investors who need regular income. Bonds and CD’s are returning so little that it almost seems like you have to pay the banks to hold your money!
This is a dangerous situation, since it pushes the yield-hungry investor into risky assets. It is easy to calculate the income stream, but much more difficult to evaluate the risk in the underlying assets.
For those who want to get right to the bottom line, I have prepared estimates of what I think is possible in the current market environment. The objective is total return – a good income stream and growing principal. Here is what I am looking for.
The assumptions for the forecast include a modest (5%) market gain for the expected value, lower than most expect and much lower than I do. The upper and lower ranges are consistent with most market estimates. Obviously, the results could go outside of these ranges in extreme circumstances. The plans emphasize downside protection. The stocks we choose have good balance sheets. The covered write program can emphasize protection when we need to.
Investors can and should choose a personal asset allocation. Two questions are crucial:
- Are you preserving wealth, or creating wealth?
- What is your personal risk tolerance? Can you see through the swings with a longer time horizon?
These programs are much safer and more rewarding than simply buying the top dividend stocks or the highest-yielding bonds.
Our approach to fixed income investing emphasizes the concept of total return. We recognize that reaching aggressively for yield carries higher risks, risks that may not always be obvious. Our plan has been published in a series of articles on Seeking Alpha. Each of the articles in the series has been an Editor’s Choice, which is probably a first for something like this. The editors have recommended that I expand the series into a book.
The Enhanced Fixed Income program is relatively new, but the techniques are not. I have been advising bond and options traders for nearly 25 years. This program brings together investor needs, the current market opportunity, and my own skills.
The Bond Ladder
A bond ladder has a special value at a time when interest rates are rising – right now! As a lender, you do not want to lock in low rates for the long term. Instead, you have a portfolio structure that accepts some very low (and very safe) short-term investments and does not make commitments too far in the future. When the near-term “rungs” of your ladder mature, you can roll out to the new and higher yield opportunities. Meanwhile, the overall average duration of the portfolio is under your control.
My most recent bond ladder client had a duration of 3.16 years and a yield of about 3.5%. I used fifteen different corporate bonds, all investment grade. None of the companies are on a negative watch. This is a very safe portfolio. You can ignore the daily swings in the market value and wait to collect on the bonds. It is the lowest volatility part of the program.
The Dividend Stocks
There is one big mistake that most people make in looking for dividends – reaching for the highest yield. If you choose a stock that is valued mostly on the dividend yield, the stock will move lower as rates move higher. There are also companies that cannot really sustain current payouts.
My approach emphasizes good stock picking, where we are proven experts, as well as the search for yield. The result is a yield that might seem a little lower at first glance, but is actually much safer. On a total return basis, considering the prospects for the stocks, it is better than merely reaching for yield.
The Covered Write
Most people are frightened by options, so they miss one of the best opportunities to improve yield. Experienced options professionals know that selling calls against your stock positions is a conservative and successful strategy.
Right now I am selling calls that are slightly out of the money. I do this because the market has a nice upside bias and I want to capture that. The call premiums add about 7.5% to the annual return. Because we have sold the calls, we lose the explosive upside in a roaring bull market, but we may well make another 10% from stock appreciation. Meanwhile, we have downside protection.
Using Past Performance
It would be deceptive to cite past performance from programs like this. Bond programs will not do as well as they have in the past decade, since we cannot expect interest rates to fall further. The covered write program can take a totally different focus in a declining market.
I have executed all of these strategies in client accounts for many, many years, but I cannot honestly segregate the results. If I did cite some specific trades, they would be overstating my expected success in these programs.
I realize that many of my competitors highlight only the winning trades, but I refuse to do that. In this summary this is what an investor should expect from each part of the program in terms of income stream, risk, and total return. These estimates reflect current market conditions, and I will update them frequently.