Alternative Income Strategies for a Challenging Market Environment

As we consider updating allocation breakdowns of the traditional stock and bond portfolio to cope with today’s market environment, investors could consider alternative investment strategies that could help better diversify risk and maintain returns for the shifting conditions.

In the recent webcast, How to Future-Proof Your Fixed Income Allocation, Matthew Bartolini, head of SPDR® Americas research at State Street Global Advisors, pointed out that while retail investors maintained significant overweight in equities, hedge funds and risk-controlled exposures may have dialed back their allocations to equities.

Meanwhile, on the fixed income side, with inflation proving to be less transitory than originally thought, interest into Treasury Inflation-Protected Securities (TIPS) ETFs continues to accelerate. Bartolini noted that most fixed income segments are in losses year-to-date, creating tax loss harvesting opportunities in a year of strong equity performance. Given expectations of Fed rate hikes and tighter monetary policy in 2022, the two-year yields had their largest one-month increase since February 2020. Despite an uptick in inflation expectations, the 10- and two-year yield spreads tightened as the rise in short-term rates was the main driver.

Additionally, the credit spread of the lowest-rated high yield bonds tightened further in October but is still above its lowest level for the year. Investment-grade bonds outperformed last month, but still lag high-yield bonds by a large margin year-to-date given the headwinds from duration, Bartolini added.

Looking ahead, Bartolini noted that futures are pricing in two rate hikes for next year, as short- and medium-term inflation expectations had their largest monthly increases in over a year.

With rates still well below their historical levels, income generation remains challenging for bond investors. Bartolini argued that credit sectors, while expensive, may be one source. For example, high-yields, preferreds, and senior loans still offer attractive yield opportunities.

Scott Ladner, CIO of Horizon Investments, argued that while exposures to traditional fixed income assets have helped investors generate higher returns through capital appreciation and yields, these good times won’t last forever. Even in recent years, total returns have slowed down.

Consequently, Ladner warned that the traditional 60% stocks and 40% bonds portfolio should adapt with the times, prompting a more aggressive 80/20 split with the inclusion of alternatives to bolster the income portion.

Ladner believes that using hedged equity strategies is one way to produce the look and feel of a traditional 60/40 portfolio without wasting portfolio allocation on potentially “dead” fixed income money. Another possibility is dynamic use of non-traditional FI categories like converts, loans, and preferreds. However, Ladner noted that these alternatives also need to be risk managed due to their riskier nature relative to a portfolio of government debt.

Komson Silapachai, partner of research and portfolio strategy at Sage Advisory, also pointed out that inflation has been a key theme that many fixed income investors have been watching out for, since rising inflation eats away at real yields and erodes the purchasing power of the dollar.

However, rising inflation is not always a bad thing. Silapachai noted that positive inflation expectations results in higher aggregate demand, wages, and growth. Positive inflation gives the Fed the ability to manage downturns. The trouble only occurs when we experience hyperinflation where the private sector is unable to plan spending and spends resources fighting inflation.

Silapachai also highlighted a number of fixed-income strategies off the beaten path to help investors enhance yield generation and generate higher returns in this challenging market, including TIPs, mortgages, corporates, high-yields, emerging market debt, preferreds, leveraged loans, and alternative yield sources.

Financial advisors who are interested in learning more about fixed income strategies can watch the webcast here on demand.