Years of extremely low interest rates have created a series of problems for investors seeking income. Gone are the days that investors could rely on a steady stream of coupon income from fairly safe bond investments over the course of their retirement. Since the time of worry free fixed income is behind us, it may be necessary to dig deeper for opportunities to generate income. But we have to be careful not to fall into the trap of yield-chasing strategies.
Despite our first Fed rate increase in years, interest rates are likely to remain historically low for a long time to come according to most analyst estimates and even the Fed themselves. That means investors will have to diversify their portfolios beyond traditional bonds (if they haven’t already) in the search for more income. This need has driven investors to consider asset classes not traditionally considered income sources in a portfolio.
We all know that the key to successful diversification is to invest in asset classes that do not move in the same direction at the same time. The lower the correlation between two asset classes the better, and fortunately for investors there are several of these non-traditional strategies that offer potentially higher levels of income than traditional bonds with varying levels of correlation.
So why wouldn’t investors simply stock up on all the highest yielding strategies? There are plenty bond funds that still seem to offer very high yields. The problem is that yield chasing like this often results in very high credit risk. There are, however, some opportunities that may benefit a portfolio without taking on undue credit risk.
Let’s take a look at three strategies that offer potentially higher income levels than core bonds and provide diversification benefits for a portfolio.
1. Real Estate Investment Trusts (REITS):
Real Estate Investment Trusts (REITS) are liquid types of securities that invest in real estate, often with high dividend yields and trade on exchanges like stocks. They provide moderate to high yields and are an inflation hedge, but have high equity-like volatility.
2. Master Limited Partnerships (MLPS):
Master Limited Partnerships (MLPS) are tax-advantaged, publicly-traded securities that must derive 90% of their cash flows from natural resources, commodities and real estate. MLPs provide high yields, potential for distribution growth and have low correlation to core bonds, although as we saw in 2015, they can have extremely high volatility.
3. Insurance Linked Securities:
Insurance Linked Securities are less liquid equity investments that earn income off of reinsurance premiums and must pay out in the event of insured losses. (Reinsurance is insurance that insurers purchase to protect themselves from large losses) These securities provide high yields, high diversification benefits because of an almost complete lack of correlation with equities or bonds and have low volatility. The negative of insurance linked securities is that should a catastrophe happen, like a major hurricane or earthquake, the investment could experience large losses. They are also less liquid compared to bonds or equities.
An actively managed and diversified portfolio can source income from traditional bonds, real assets, and alternatives. It can also help to mitigate low yields, reduce the risk of future rate hikes and the need for income growth over time. For investors seeking increased income in a zero interest rate environment, the answer could lie in adding one or several of these alternative sources of income to their portfolios.
Consider this your training manual to get and stay financially fit for life!