Income investing ahead of the anticipated Federal Reserve rate cuts might feel like it’s full of uncertainty, but at least advisors can see the challenge coming. The same couldn’t be said for the ride up in 2021, when inflation suddenly surged, spiking the personal consumption expenditures (PCE) price index from 1.6% in January 2021 to a high of 7.1% in June 2022.
In March 2022, Fed Chairman Jerome Powell began to raise the federal funds rate in the hope that making it more expensive for consumers to borrow would cool their appetite for goods and services. But inflation remained sticky, and the Fed’s first 25 basis point increase quickly gave way to 75 basis point jumps.
While the lag between Fed hikes and lower inflation dragged out longer than expected, the PCE has now consistently been below 3% since January 2024, and Powell has telegraphed that the first rate cut will come most likely in September if economic indicators remain stable. So what should advisors be doing and talking to their clients about in advance of the first drop?
“Whether the Fed’s rate cut has a big impact on income investing remains to be seen. We think that things are as simple as pulling one lever and then you might see outcomes exactly as you would expect,” says Yusuf Abugideiri, a certified financial planner at Yeske Buie, headquartered in Vienna, Va. “But it’s just not that simple.”
Tonny Navarro, a CFA and private wealth senior investment manager at Merrill Lynch affiliate the Erdmann Group in Greenwich, Conn., agrees it’s a mistake to put too much emphasis on what the Fed is going to do. “How we think about income is not just dependent upon what happens with the Fed. We’re looking for multiple income levers to pull, so that not one area of the portfolio is doing the heavy lifting,” he says. “And that allows us to be more proactive and not reactive to the market.”
For example, had Navarro reacted to the market, he says that in 2023 he would have positioned his clients’ portfolios to survive a recession. Coming into 2024, he would have prepared for six Fed rate cuts.
“Both of those were wrong. And if we had built a portfolio that was dependent upon macroeconomics and what the economists thought was going to happen, our portfolios would look very different,” he says. “We would be doing a lot of shifting around in order to grab and capture yield.”
Go With The (Cash) Flow
Retirees depending on income streams might not feel better hearing an advisor say, “Don’t worry about the Fed,” since they’re looking at their portfolio through a broader lens, says Kara Duckworth, a Newport Beach, Calif., managing director and CFP at Mercer Advisors, a firm with $60 billion in assets under management.
After all, accumulation is fairly straightforward, while decumulation can be quite complicated, she says. “People think you need to do all this financial planning until you get to retirement, and then everything’s great. Everything’s easy. No. You actually need more financial planning when you’re retired to optimize that distribution strategy so that you get as much cash flow as you can, pay as little in taxes as you can and have that growth in your portfolio, all with as little risk as possible.”
And it all starts with cash flow, advisors agree.
“We don’t do age-based investing whatsoever. Our firm’s overall asset allocation approach starts with defining our clients’ ability to take risk by focusing on what their five-year cash need is from their investments,” says Ryan Johnson, a CFA, CPA and managing director of investments at Buckingham Advisors in Dayton, Ohio. “Whatever they might need in the next five years, we want it to be in cash and fixed income. And then whatever they don’t need in five years can be in equities.”
Jack Gunn, a CFP licensee and wealth advisor at Ullmann Wealth Partners in Jacksonville Beach, Fla., says he takes the same approach, but instead of a five-year window for cash flow, he builds his client plans around a 10-year window.
“We set aside enough money, just like a pension or an insurance company, to prefund those cash flows. We take a look at the current interest rate environment, and we put enough in bonds or some kind of fixed-income investment today to cover the next 10 years of cash flows,” he says. “So regardless of what happens with interest rates today or next year, our clients know that there’s enough money set aside to cover all their outflows.”
The Stability Of Fixed Income
For that fixed-income piece, advisors interviewed by Financial Advisor were unusually consistent in their recommendations. While asking six financial advisors for tips often can yield six different strategies, these advisors all say that they recently extended fixed-income investment durations to lock in higher rates.
“I think it’s really important that investors match their cash needs with the maturities out there. Before, investors could have gotten away with just putting all their cash for the next couple of years in a money market fund. It was absolutely good enough,” Johnson says.
While he does continue to use money market funds for a client’s six-month cash needs, the rest of the five-year cash/fixed-income blend goes to bonds where durations are a little shorter than the bond market average of six years. “We’re closer to four at the moment, but we’re evaluating pushing it out further.” And currently his greatest exposure is to investment-grade corporate bonds, primarily through ETFs, though a year ago he did add in some Treasurys as their rates became attractive, he says.
Abugideiri agrees that if rates in the near term come down, that would make longer-term Treasurys more attractive, with “longer-term” in the current context meaning intermediate duration. He says he’s putting retired clients in two bond mutual funds—one is a one-year fixed income fund, and the other is a five-year dynamic bond fund. And clients who are taking income but still accumulating also have access to a 10- to 20-year bond fund.
Jonathan Finkler, head of fixed income at Bartlett Wealth Management in Cincinnati, says his fixed-income approach is very agnostic. It includes both Treasurys and corporate bonds as long as they’re in the one to 10-year duration and of high quality so the firm can derisk portfolios.
Jeff Fishman, founder of JSF Financial in Los Angeles, has also been beating the intermediate duration drum with his clients to get them ahead of the rate cuts. “We’ve been coaching a lot of clients through this, and it’s hard because most people sit there and say, ‘We’re getting 5% state-income-tax-free in a T-bill that’s riskless, why would we go anywhere else?’” he says. “But that’s been the message we’ve been trying to send clients over the last several months.”
In Pursuit Of Dividends
While fixed-income investing will reflect rate cuts, that may not be true on the dividend side of income investing. According to Duckworth, the time for a company to adjust its dividend was when interest rates were rising, not falling, and even then dividends remained fairly stable. “We didn’t see a dramatic reduction in dividends related to interest rates,” she says.
In fact, when it comes to income investing, many advisors don’t focus on dividends at all. Abugideiri, for example, says his firm doesn’t pursue dividends intentionally. “We appreciate that our clients are going to own stocks that produce dividends, but we don’t particularly chase them,” he says. “Dividends in and of themselves just represent taxable income in the portfolio.”
Instead, Abugideiri says rather than reinvest dividends, he has them issued in cash in order to minimize the trading volume for the client. Most of that dividend income in mutual funds is generated in December, and by disbursing it to the client in January to cover the new year’s spending needs, less additional cash has to be raised.
“It keeps our trading costs low and keeps the amount of taxable income that we’re generating as low as possible,” he says. “So we use them in that way tactically, but they’re not part of the strategy in terms of finding excess return.”
Fishman, however, says he does see value in dividends for an income-producing portfolio, as long as they’re tax efficient. Qualified dividends are taxed at a lower rate than interest on bonds for clients in a high tax bracket, which can enhance their appeal to high-income individuals.
“Overall, given our outlook and our view, we think dividends-generating stocks, and dividends-generating portfolios are still really helpful,” he says. “And clearly you want to make sure that the dividends receive qualified dividends status so they’re subject to capital gains tax, not income tax.”
Women And The Ultra-Wealthy
Certain clients, particularly women who tend to have greater longevity concerns than men, benefit from a strong equity component in their portfolio, notes Duckworth, and generating some income off the equity side can be useful.
“Let’s really focus on that core piece, that nest egg that we know that the client’s going to need, and include in that some equity with a dividend focus and some just pure growth, because they need that growth in their portfolio to get them to that longevity,” she says. “They can have that growth, but also have income on top of it.”
Ultra-high-net-worth clients—those with an average net worth of about $50 million—can benefit from portfolio construction based on cash-flow needs, where the current generation lives on generated income but longer duration investments and the private markets are used to continue to generate wealth. “Those will go into trusts for the benefits of children and grandchildren that haven’t even been born yet,” Navarro says. “We don’t do a lot of decumulation. The wealth we’re managing is intended to be generational.”
It remains to be seen whether the rate cut will come in September, but on some level the exact timing is irrelevant, sources say. What’s important is positioning income-centric portfolios to address client cash-flow needs while controlling for risk.
And that may be harder than it sounds. “It takes a lot of work with clients right now to help them make good decisions. That includes selling holdings that might be up significantly and taking profits,” Fishman says.
“Overall, things have been obviously very strong this year, and you want to go ahead and use that to your advantage, as opposed to one thing you don’t want to do, which is just sit and pray. We can look at what’s underperformed—and one of them is going to be intermediate-term fixed income—and think maybe it’s a good time to allocate some more money in that direction.”