By Ryan Giannotto, CFA
Let’s face it: Investors need an income intervention—we cannot go on pretending the rules for retirement have not changed in light of current market conditions. The unfortunate reality is a deep chasm stands between investor income requirements and what conventional strategies can now yield—and this characterizes the yield predicament before the COVID-19 pandemic struck.
We all know the story: between the crash dive to zero interest rates and unprecedented cuts to stock dividends, the traditional 1990s income playbook no longer squares with the concept of a secure retirement, or any at all. This is not a calling to save more during working years, as after-tax, after-fee yields cannot keep pace with inflation. Ironically the more investors save, the further behind they fall on a real basis—we need to stop imagining that investors can save their way out of this quandary with sub-inflation income. To think otherwise is only an exercise in denial.
Show Me the (Lack of) Money!
A two-fold realization necessarily awaits investors serious about retirement, the first of which is an acceptance of mathematical realities as they stand. Investors need to reject historical models and frameworks that now almost assuredly lock in failure; traditional assumptions of what constitutes safe investments are another stumbling block. For instance, many of the supposed “defensive” stocks disproportionately suffered in maintaining their price and dividends.
Misleading assumptions of security pervade bond investments as well. Even a cursory examination of treasury yields does not inspire confidence for income stability, as the 10-year Treasury witnessed its payout fall by over 82% over the past two years. If steadiness of distribution rate is the foremost goal, then this supposedly riskless asset is surprisingly risky indeed. It strikes with revelatory power the insight that past income strategies, practiced successfully for decades over, may no longer be applicable to the modern retiree.
The second juncture for savers is a willingness to pursue solutions that materially move investors toward their retirement goals, not away from them. The sobering reality is that conventional income strategies max out at under 5% with junk bonds (only 1% after-tax real yield), even with attendant credit and volatility risks. The inescapable conclusion is that the building blocks of yield are broken, no matter where you look—at least with the blinders of conventional wisdom.
Simply out of habit, investors have ignored differentiated segments of the market that, as a portfolio complement, can substantially increase potential yields. The alternative income ecosystem seeks to generate very high payout levels by exposing investors to a new series of risks not already encountered in traditional bonds. This distinction is important: alternative income does not seek to double down on duration or credit risk to eke out higher distributions. Indeed, these elements alone are insufficient for income stability, as the current market has made patently obvious.
Reinventing the Yield
What constitutes alternative income? This roughly $2 trillion corner of the market covers the pass-through security universe, spanning closed-end funds, business development companies (BDCs), master limited partnerships (MLPs) and real estate investment trusts (REITs). Through their innovative structures, these investments tend to avoid the double-taxation phenomenon, enabling unique yield opportunities for the end investor. This characteristic of pass-through securities entails a two-fold advantage for yield investors: not only are shareholders entitled to nearly all of a company’s earnings as income, but these earnings can be shielded from taxation at the corporate level as well.
Yet with any investment, the perennial question of where the strategy belongs always begs asking. Consider the impacts of blending alternative income into an existing 60/40 portfolio, meaning 60% stocks and 40% bonds, on a proportional basis. This analysis uses the TFMS HIPS Index, which blends 60 pass-through securities across four sectors to represent the alternative income category.
The results from adding pass-through securities were both immediate and resounding, even at an initial allocation of only 10% (structured as a 54/10/36 portfolio). For instance, a one in 10 allocation to alternative income increased the equity sleeve’s yield by 47%, and overall portfolio cash payouts by 43%. Continuing this trajectory, a 22.5% allocation doubled baseline income—an increase as impactful on retirement financing as moving from California to Mississippi on a cost of living basis. For those targeting very high distributions, a 40% allotment to alternative income boosted yield more than two and a half times to 5.61%.
Even while occupying only a minority of the portfolio, pass-through securities enhanced the income of the 60/40 strategy well beyond what conventional “high income” assets could manage, even if they assumed a 100% allocation. In strict dollar terms, the 40% allocation resulted in an additional $3,550 in annual distributions over the baseline 60/40 per $100,000 invested.
While yield should not be the exclusive concern in financial planning as any approach requires a balanced assessment of risk, higher yields may offer more options in the context of long-term wealth management. Many alternative yield categories straddle the divide between conventional equity and fixed income strategies, representing a hybrid stock-bond exposure.
As revealed through regression analysis, the alternative income category is moderately correlated to the S&P 500, explaining 56% of daily movement, and is negatively correlated to aggregate bonds with a coefficient of -0.19. These data indicate alternative income may serve as a valuable diversifier of risk in both asset categories, helping to moderate portfolio volatility without overreliance on any one risk factor.
The Income Intervention
Even before the outbreak of COVID-19, opportunities for meaningful yield had already been receding beyond reach. The last time the Federal Reserve dropped interest rates to zero, it took seven years before the courage could be mustered to raise rates once more. Currently, there are no forecasts for positive rates resurfacing—the outlook for income has been indefinitely postponed. In this context, alternative yield may present a solution to what may be a confounding dilemma of our time.
Savers must confront the new dynamics driving cash flow generation, or rather lack thereof, from traditional strategies. Unless investors can rationally approach where yield opportunities exist in the market, and where they do not, we cannot say we are advancing the interests of American retirees.
About the author: Ryan Giannotto, CFA
Ryan Giannotto, CFA, is the Director of Research at GraniteShares, a New York-based independent exchange-traded fund issuer that seeks to launch innovative and disruptive ETF investments. At GraniteShares, Ryan focuses on portfolio construction, indexing strategies and the use of non-correlating assets. He graduated from the Honors Program at Boston College with a B.A. in economics and philosophy.
Past performance is not a guarantee of future results. One cannot invest directly in an index. For full disclosure, GraniteShares manages the GraniteShares HIPS U.S. High Income ETF (HIPS).