As income-minded exchange traded fund investors look for ways to generate additional cash in their portfolios, it is equally important to think about managing the risk in doing so.
In the recent webcast, Tactical High Yield Solutions for Today’s Yield-Starved Environment, Matthew Bartolini, Head of SPDR Americas Research, State Street Global Advisors, outlined how the markets performed over the past year, with riskier assets finishing 2020 around record highs as additional fiscal stimulus and progress on vaccine development and distribution further buoyed risk sentiment. He pointed out that most major asset classes regained their losses over the bear market and finished the year near record highs, with U.S. and emerging market equities outperforming in global markets.
Meanwhile, investors ended the year on an optimistic note -the investor confidence index was at its highest level in over two years. Additionally, risk asset implied volatility continues to fade amid the optimism of cyclical recovery for year ahead.
The economy is on the mend with physical goods consumption recovering faster than services consumption, which is still well below its historical trend line. The housing market remains a bright spot in the recovery.
Looking at the fixed-income market, Bartolini pointed out that 10- and-2-year yield spreads widened along with increasing 10-year yields to their widest level in three years as the Federal Reserve pledged to keep rates near zero. However, increasing long-term nominal yields are not able to keep up with rising inflation expectations, which has resulted in negative real yields for investors. Meanwhile, high yield spreads have tightened even further to one third below their long-term averages amid the risk-on sentiment, and credit rating actions have turned more positive after the economic rebound in the second half of 2020.
As fixed-income investors try to find positions in this more challenging yield environment, Jeffrey Thompson, CEO, Donoghue Forlines, argued that income investors are now out of luck. The S&P 500 Index showed a 1.6% yield at the end of 2020 while 10-year Treasury notes had a 0.9% yield. The current yield of a 60/40 global portfolio is now 1.59%, compared to 2.25% this time last year. Looking ahead, income investors face a number of challenges, including disruptions to the economic cycle, market volatility, geopolitical concerns, and low interest rates.
“We feel that the Fed is forcing investors to take on more risk,” Thompson said, “which calls for a different approach to income investing.”
Thompson believed that there appears to be opportunity in credit to help bolster the income potential of a diversified investment portfolio.
“High yield securities have been shown to trade on earnings like stocks. However, they can trend like bonds; and we believe trends are easier to identify in the high yield market,” Thompson said.
“Historically, high yield bond funds pay a higher dividend than stock funds. Since high yields are driven by earnings, we feel they have tremendous capital appreciation potential,” he added.
Additionally, high yield bonds are historically less interest rate sensitive than higher quality fixed income asset classes, and not as volatile as dividend paying stocks.
Thompson, though, warned that high-yield bonds are more highly susceptible to credit risk. Consequently, investors can consider an alternative approach to high-yield investing, such as the recently launched TrimTabs Donoghue Forlines Tactical High Yield ETF (DFHY), which can help participate in the high yield bond market by offering generally high coupon rates.
“The strategy utilizes proprietary defensive ‘Tactical’ indicators to attempt to mitigate downside volatility and preserve capital by shifting primarily towards intermediate term treasury exposure during market declines and by tracking the underlying Index,” Thompson said.
The TrimTabs Donoghue Forlines Tactical High Yield ETF utilizes technical analysis to determine whether High Yield is a positive or negative trend to determine whether it trades in High Yield Bond Funds or Treasuries. When High Yields are in an Uptrend, technical indicators are designed to initiate a buy signal to 100% HY Bonds. Alternatively, when High Yields are in a Downtrend, technical indicators are designed to initiate a sell signal to 20% HY Bonds and 80% Treasuries.
DFHY “aims to capture the majority of the upside and more importantly avoid the majority of the downside of the high yield asset class during a full credit market cycle,” Thompson said.
“We believe that combining High Yield with Tactical Defensive Risk Management is a differentiator in Index and ETF construction,” he added.
Financial advisors who are interested in learning more about a tactical high-yield strategy can register for the Thursday, January 21 webcast here.