The majority of ETF income investors focus their portfolios on dividend-paying stocks and bonds to generate yield. However, those traditional asset classes have now risen to the point where their income streams have fallen significantly. One strategy to overcome that deficit is to move down the credit spectrum or select speculative equity plays to supplement your core holdings. While that decision may result in short-term relief, it also introduces a significantly higher level of risk.
That leaves the door open for alternative income assets such as REITs, MLPs and preferred stocks to diversify your portfolio and enhance your yield. These often-overlooked income sources offer significantly higher dividends with the added bonus of uncorrelated price movement. In many instances, a measured dose of each can provide a counterweight to traditional stocks and bonds that lowers the volatility of your income portfolio as well.
The key to layering alternative income themes into your portfolio is getting a grasp on the factors that influence their behavior. Since nearly every asset that generates income can be loosely tied to interest rates, evaluating the intermediate-term direction of Treasury bond yields is an important factor. Observing interest rate movements should also offer insight into the relative value of alternative income assets when compared to owning bonds with low credit risk and high duration.
From there, you can dive into individual asset classes to gather insight on other collateral factors that dominate price fluctuations. For example, the majority of preferred stocks are issued by banks and insurance companies that are seeking alternative sources of capital outside the debt markets. In turn, the overall health of the individual company and the financial system as a whole are going to be the fulcrum of a successful investment outcome.
Preferred stocks are typically issued with call features or maturity dates that equate to long periods of time, such as 20-30 years. As a result, they happen to exhibit price movements that sympathize with long-term Treasury bond prices. The best time to purchase preferred stocks is typically after a swift rise in interest rates which adjusts a preferred stock’s price closer to its issue or call price.
Timing a purchase closer to the issue price reduces call risk and premium risk, and increases your income stream. In addition, rising interest rates can also have the follow-on effect of improving lending fundamentals for large banking institutions that issue preferred stocks, further increasing in investor’s margin of safety.
With yields typically double that of common shares, preferred stocks offer an excellent way to increase portfolio yield without increasing traditional equity market exposure. Our favorite way to gain exposure to the preferred sector is through the iShares Preferred Stock Fund (PFF), which has over $10 billion in assets, and currently yields 5.73%.
On the other side of the risk spectrum, REITs and MLPs offer attractive income streams but also can come with the expense of elevated volatility. The primary reason for erratic gyrations in prices typically relates back to the cyclicality of the economy.
For example, at its core, a REIT is essentially an entity that holds physical real estate. This structure enables it to transfer the earnings from rents back to shareholders as income. However, the price can be moved by changes in the value of the underlying real estate holdings, the loss of revenue from vacancy, or both. Therefore REITs typically perform best in an environment dominated by low interest rates to reduce funding costs, as well as high economic output to create scarcity and demand in the real estate market as a whole.
Arguably one of the best ways to gain exposure to REITs is through the diversified, low-cost Vanguard Real Estate ETF (VNQ). This ETF has over $23 billion in assets under management and a yield of 3.73%.
Oil and gas MLPs have a similar relation to REITS in that they typically own physical energy pipelines and deliver income to shareholders from those assets. Yet, MLPs are formed as partnerships rather than trusts, which can subject a holder of an individual MLP to receiving a K-1 during tax season. Investors can largely avoid this burden by owning MLP exposure through a mutual fund or ETF. However, it’s always best to double check the prospectus to clarify the details and taxation of any investment vehicle.
Carrying an allocation to oil and gas MLPs entitles the investor to a portion of the income derived from infrastructure such as pipelines, terminals, storage or transportation of crude oil, natural gas or other refined products. Therefore fluctuations in MLP prices can coincide with demand for the underlying commodity, supply side disruption or access to funding. Generally speaking, MLPs perform best in a strong economy with relatively low interest rates and a strong demand for energy products.
Depending on the type of MLP index, the yield and level of diversification can vary significantly. Two excellent choices include the actively managed First Trust NA Energy Infrastructure Fund (EMLP) and Alerian MLP ETF (AMLP).
Leveraging new income streams from alternative sources works to further diversify your portfolio away from more exposure to traditional bonds or dividend paying stocks. Furthermore, when it comes to managing risk in a steady income portfolio, seeking assets that exhibit lower overall volatility and have the potential to pay higher income streams can protect your portfolio from inflationary forces. Like any successful strategy, developing a plan and then implementing it decisively, will always yield the best results.
Disclosure: At the time this article was published, principals and clients of FMD Capital Management held positions in PFF and VNQ.