As we consider the obstacles in today’s fixed income markets, investors can look toward exchange traded fund strategies that could help augment their income portfolios.
In the recent webcast, Three Ideas For Investors Who Are Looking For Income Today, Sean O’Hara, president of Pacer ETFs, warns that with yields still at the lower end of the range and duration near all-time highs, investors are challenged to find income solutions. What should have been a traditionally safe investment play in a time of increased uncertainty has suffered steep declines, with the 7-10 Year Treasury Index declining 10% over the past year. Dragging down the fixed-income market segment, the Federal Reserve’s aggressive monetary policy tightening outlook with multiple expected interest rate hikes ahead has weighed on bonds.
Nevertheless, investors can turn to alternative solutions to maintain their income needs. For example, the actively managed Pacer Pacific Asset Enhanced Floating Rate Note ETF (NYSEArca: FLRT) seeks to provide a high level of current income through selective investments within a portfolio comprised primarily of income-producing floating rate loans and floating rate debt securities of non-investment grade companies, which are commonly referred to as bank loans. It can serve as both an income driver and a hedge against rising interest rates.
Bob Boyd, managing director, Pacific Asset Management, explains that Pacific Asset Management’s experience is focused on corporate debt and their primary disciplines are bank loans, high yield, investment grade, and structured products. The bank loan strategy is the longest tenured and largest discipline. Additionally, the strategy actively seeks to minimize defaults and downside risk by focusing on large companies with a margin of safety. Since its inception in 2007, the bank loan strategy has had three defaults and outperformance in periods of negative market returns.
Investors who are in search of income can also turn to a unique, dividend-focused ETF: the Pacer Metaurus US Large Cap Dividend Multiplier 400 ETF (QDPL), which seeks to provide cash distributions equal to 400% of the S&P 500 dividend yield in exchange for modestly lower exposure to the price return performance of the S&P 500.
O’Hara notes that equities are now providing over half of a standard portfolio’s income, and even then, income overall has been declining. QDPL offers investors looking to add more income to their portfolios through an alternative allocation strategy.
QDPL separates the S&P 500 into its two return components: dividend cash flow and price appreciation/depreciation. The fund then reduces equity exposure to the S&P 500 Index at approximately 88% and uses the remaining percentage to purchase dividend futures for 4x greater participation in dividends. Lastly, the strategy recombines the components into new ratios to produce an S&P 500 exposure with 4x dividend yield and approximately 88% S&P 500 Index exposure.
Furthermore, investors can consider the potentially attractive income opportunities in the midstream energy infrastructure segment. Specifically, the Pacer American Energy Independence ETF (USAI), which comprises both corporations and master limited partnerships or MLPs, and offers exposure to the growth potential of infrastructure development supporting domestic energy supplies.
O’Hara pointed out that U.S. oil production started to rise in 2008, and the next seven years marked the fastest oil and gas production increase in U.S. history. The U.S. began exporting finished products and even crude oil into the market. Looking ahead, the growing production of crude oil, natural gas, and natural gas liquids is increasing the need for new infrastructure to move, process, and store this output. This in turn reduces the need for the U.S. to rely on imports to meet its energy needs.
The midstream energy segment is enjoying some supportive fundamentals. O’Hara notes that due to the mature nature of the current pipeline system, capital expenditures are expected to slow which is expected to increase free cash flow for the next three years. Midstream energy infrastructure companies may also generate significant cash flows from long-term contracts supporting high dividend payouts.
Instead of focusing on MLPs exclusively, USAI tilts towards the largest energy infrastructure companies. The ETF follows the American Energy Independence Index, which includes U.S.- and Canada-based energy infrastructure companies, along with high-yielding master limited partnerships and general partners. Since it does not focus exclusively on MLPs, USAI can sidestep some of the tax inefficiencies we may see in the MLP market.
Financial advisors who are interested in learning more about income strategies can watch the webcast here on demand.