3 Ways To Add Income Strategies Back Into Your Portfolio

After a decade of zero interest rates and a dearth of available income opportunities, investors are finally getting a chance to diversify away from equities and generate income from other sources. With the Federal Reserve expected to raise rates to 2% by the end of the year, bond markets and other securities sensitive to long-term interest rates have repriced to levels that warrant a potential allocation. It is impossible to know when interest rates will peak, but for investors willing to dip their toe back in the market, three areas currently stand out in providing relative value.

Closed-End Municipal Bond Funds

Municipal bond yields have soared along with sovereign and corporate bond yields. The Barclays Municipal Bond Index yield-to-worst is currently 1.94%, the same level as the Bloomberg US Treasury Index. 10-year AAA-rated municipal bonds now yield 1.70%, up from 1.04% at the start of the year.

One of the best and easiest ways to take advantage of the cheapening is through closed-end bond funds (“CEF”), which are now trading at steep discounts to NAV. Given projections for rate hikes by the Fed this year, investors should stick to funds that don’t deploy leverage. Leveraged funds may have to cut their dividend if short-term interest rates rise. The most liquid unleveraged CEF is the Nuveen Municipal Value Fund, NUV.

As of Feb 15, NUV was trading at a discount of 5.29% to NAV, had a distribution rate of 3.48%, an expense ratio of 0.48%, and held investment-grade municipal bonds with an effective duration of 6.8 years. The 5-year average premium/discount to NAV is -1.19%, so the fund has a higher than usual discount. NUV is ideal for taxable investors with a medium-term hold period of 1-2 years who are looking for tax-exempt income. The primary risk is that the current level of high inflation persists, and the Fed is forced to be more aggressive than the market expects.

Preferred Stock in Financials

Preferred stocks, while considered equities, act more like corporate bonds than they do stocks. In the event of corporate default, preferred stock ranks junior to bondholders but senior to shareholders in terms of claims on assets. Most preferred issues pay a fixed rate coupon and have very long maturities, making them sensitive to fluctuations in interest rates. The recent move in rates has caused prices for some preferred stocks to plummet nearly 15%.

Preferred stock issued by financial companies, such as banks, look particularly attractive. The large banks have plenty of capital and their balance sheets are in great shape, so the credit component of their preferred issues is fundamentally strong. In addition, most bank preferred coupons are classified as Qualified Dividend Income, or QDI, and receive income tax treatment at long-term capital gains rates rather than ordinary income rates. One way to take advantage of the cheapening in the preferred market is the Invesco Financial Preferred ETF, PGF.

PGF invests in fixed-rate U.S. dollar preferred securities issued by financial companies and has an expense ratio of 0.61%. As of Feb 15, it had a distribution rate of 5.07%, not far from the 5-year average distribution yield of 5.16%. PGF has fallen by 12.3% since its recent high in September last year, making the steep selloff in 2022 an excellent opportunity to get some exposure to decent tax-efficient, income-producing securities with relatively low credit risk. The primary risk is a deepening in the selloff in the long end of the corporate bond market.

Equity Index Covered Call Strategies

Covered call strategies are option-based income strategies that seek to collect income from selling options against long positions. Investors still have exposure to the underlying stocks, but premium​s​ generated from selling short-dated call options provide some cushion against lower equity prices. This strategy tends to do best in a stable to rising equity market and when implied volatility is high.

Writing covered calls on broad indices like the S&P 500 or the Nasdaq 100 is generally safer than single name stocks. Investors can usually earn a higher premium when selling volatility on an individual stock, but that benefit is offset by much higher idiosyncratic risk to a company or an industry.

There are several ETFs and closed-end funds that pursue covered call strategies. One is the Global X Nasdaq 100 Covered Call ETF, QYLD. QYLD has an expense ratio of 0.60%, a 12-month distribution yield of 14%, and an average annual return of 12.5% over the last five years. Similar products are available on other indices such as the S&P 500, but the higher implied volatility of the Nasdaq 100 provides higher option premiums and larger monthly distributions.

Taxation of covered call strategies can be complicated. They tend to work best in tax-exempt accounts like IRAs given the majority of the distribution from the fund is treated as ordinary for tax purposes. The primary risk to the strategy is continued downward pressure on the Nasdaq.

Time to go back into the water?

To be sure, the near 100 bps rise in 10-year bond yields over the last six months may not be over. After all, headline inflation is above 7% and real interest rates are still negative. The good news is that inflation bonds are pricing in an average inflation rate of under 2.5% for the next ten years, so current expectations are that the steep rise in consumer prices is expected to be a short-lived phenomenon.

Because it is impossible to predict how high rates will go, investors who have been underweight income-producing assets in their portfolio would not be foolish to take advantage of the recent cheapening and begin to add back some exposure to interest rates. Trying to time the bond market is just as hard as trying to time stocks. It’s better to set some targets, dip your toe into the water, and average into a position.

(Disclosure: the author may own some or all of the securities mentioned in this article)