No sure thing, but these strategies offer healthy yields
By Jeff Benjamin
March 25, 2012 6:01 am ET
Finding income at a time when all the usual suspects are offering next to nothing in the way of yield requires both creativity and a stomach for a bit more risk. That said, it turns out there are some interesting and relatively simple income strategies that can produce yields well beyond what retirees might get from Treasury bonds or certificates of deposit. Of course, it is worth noting that the following examples of ways to generate income all come with one significant disclaimer: Neither the income nor the principal is guaranteed.
Selling call options on equity-based exchange-traded funds represents a relatively easy way to generate income with stock market exposure.
The sale of intermediate-term call options on a broad market index ETF such as the SPDR S&P 500 ETF (SPY) can generate steady and predictable income for retirees while also acting as a hedge on the downside.
Technically, the strategy doesn’t provide any real downside protection, but the income from the rolling sale of call options that expire every one to three years can be viewed as lowering an investor’s cost basis, according to Ken Himmler, president of Integrated Asset Management LLC, a $100 million advisory firm.
He likes the covered-call strategy because of the way it keeps the category of normally risk-averse retirees exposed to the growth potential of the equity markets, though the upside is muted.
In a simplified example, the owner of an index ETF trading at $100 might sell a one-year call option with a strike price of $105 to another investor for $1.
The owner of the call has the option to purchase the ETF at any point during that one-year period for $105, even if the ETF spikes to $110.
If that happened, the owner of the ETF would net $105, plus the $1 earned for the sale of the call option.
If the option expired before being called, the owner of the ETF would keep the $1 and sell another call option for more income.
“For a retiree, this is a beautiful strategy because it increases income through the option premium, and it limits downside by theoretically lowering the cost basis,” Mr. Himmler said.
Most fans of bond-laddering strategies are first and foremost attracted to the predictability of the income stream.
Whether it is established while an investor is still working or during retirement, there is nothing quite like the expected income that can come from a portfolio of bonds that are maturing in a staggered fashion over a multiyear period.
In a perfect world, where an investor would have managed to save enough to have a fully funded retirement portfolio, a bond ladder strategy might be all you needed.
Bonds of various maturities could be purchased and cashed out at expiration in one-year intervals throughout 30 or more years of a relaxing retirement.
“For most people, however, who are not so rich or not so frugal, they can’t just buy an all-bond portfolio,” said J. Brent Burns, president of Asset Dedication LLC, which builds fixed-income separate accounts.
Thus, like an annuity or most other income strategies, the bond ladder route can act as a handy supplement to a more aggressive equity strategy.
“If you’ve got a 65-year-old who needs 30 years’ worth of retirement income, we’ll use a bond ladder to create eight to 10 years of income certainty,” Mr. Burns said.
By taking a portion of the overall retirement portfolio and building a bond ladder with bonds that mature during the first several years of retirement, investors are able to take on more risk in the equity markets without affecting current income.
When the equity markets are strong, the financial adviser can sell stocks for income and/or add another rung to the long end of the bond ladder.
When the equity markets aren’t so strong, the income comes directly from the maturing bond at the front end of the ladder.
Closed-end funds represent one of the few places where investors still can find attractive yields in the fixed-income area, as long as investors are ready to embrace some credit risk.
The universe of 175 taxable-fixed-income closed-end funds is generating an average yield of 6.9%, which compares with 2% for the 10-year Treasury.
The reason for the higher yield is also part of the risk, according to Stephen O’Neill, a portfolio manager and trader at RiverNorth Capital Management LLC, which has $1.7 billion under management.
“These kinds of funds will typically borrow at short-term rates and buy longer-term assets, and that means the average fund is about 30% leveraged,” he said.
The leverage represents risk because the current low cost of borrowing is a significant contributor to the yields that these closed-end funds are generating.
However, as Mr. O’Neill said, the latest announced policy by the Federal Reserve that short-term rates will be kept at near zero until at least late 2014 represents a green light for this kind of strategy.
“Rising rates represents the enemy because if there is a nonparallel shift where short-term rates start to rise faster than longer-term rates, the cost of borrowing goes up and the distributions will go down,” he said. “But right now is the ideal backdrop for this strategy.”
Advisers looking at closed-end funds for income should consider yield along with a fund’s value in relation to its net asset value.
For example, in the taxable-fixed-income area, the average fund is trading at a 1.5% premium to NAV, but that doesn’t mean there aren’t funds trading at attractive discounts.
The Nuveen Multi-Strategy Income Fund (JQC) is trading at a 7.7% discount to NAV, with 20% leverage and an 8.7% yield.
The BlackRock Credit Allocation Income Fund (BPP) is trading at a 9.6% discount, with 30% leverage and a 6.7% yield.
Master Limited Partnerships
In an environment with such limited sources of income, it is sometimes necessary to step outside one’s comfort zone, and that leads us to master limited partnerships.
The biggest appeal of these infrastructure partnerships is an average annual yield of nearly 7%.
“The yield on these products has grown by about 3% or 4% annually over the past few years, and it’s expected to grow by more than 5% this year,” said Tyler Vernon, chief investment officer at Biltmore Capital Advisors LLC, which manages $700 million.
If invested as a partner, an MLP can trigger significant tax consequences and headaches that might involve tax filings in multiple states where an MLP is operating.
For direct investors, part of the appeal is that the taxes on the quarterly distributions are deferred until the investment is sold, and can even be avoided entirely if held until the investor’s death.
In fact, because of the way that the distributions lower the cost basis, investors have a strong incentive to hold an MLP investment for as long as possible.
A growing alternative to direct ownership is coming courtesy of the mutual fund industry, which has started packaging MLPs inside registered products.
SteelPath Fund Advisors LLC, which launched the industry’s first MLP mutual fund in March 2010, now has a small suite of products, including the $800 million SteelPath MLP Select 40 Fund (MLPTX), which is yielding 6.2%.
Mr. Vernon is a fan of an ETF version, the Alerian MLP ETF (AMLP), from Alps Advisors Inc., which is yielding 6%.