A fundamental shift is taking shape in markets, with big implications for advisors seeking income generation for clients.
For the past several years, advisors have been forced to reach for income by investing in junk bonds, MLPs and other new, less-liquid products. But as short-term rates rise and an increasingly uncertain macro environment unfolds, those income strategies are growing riskier, while old standards are shining brighter. Consider:
• The Federal Reserve, which has raised rates six times since the financial crisis, is steadily normalizing short-term interest rates. Treasury yields on 1- and 2-year maturities have risen from next-to-nothing, to a potentially interesting baseline for investment. Today, the 2-year TSY pays an annualized income of 2.5 percent, 135 basis points higher than this time last year. Expect these rates to continue their ascent. Fed Chairman Jerome Powell has signaled the central bank will gradually raise rates—potentially three more times—through the rest of 2018.
• Investors have also been impacted by a modest shift upwards in volatility. February brought an extremely significant, and by some measures record-setting, event in equity volatility, with the VIX index (known as the market’s fear gauge) spiking from 10 to near 50 in just two trading days. Those levels of volatility had not been felt since August of 2015, and before that the U.S. debt downgrade of 2011.
• These two factors have had a negative impact on long-term bond yields, as volatility has driven investors to safe havens including Treasury bonds. "Although there are many factors that could lead to higher U.S. yields, such as rising inflation due to tariffs and an increasing supply of Treasury bonds, yields may remain depressed in the near term if volatility remains elevated," Kathy Jones, chief fixed-income strategist at The Charles Schwab Corporation noted in a recent report.
Generating Income In Two Ways
One income strategy emerging from these market factors combines a portfolio of shorter-term U.S. treasuries with an out-of-the-money put selling strategy. This approach pays investors in two ways: first, from the newly interesting treasury yields collateralizing the portfolio, and second, from increased premiums available from selling out-of-the-money put options.
With increased volatility, selling put options, particularly domestic equity index options, are a potentially interesting new source of income. The strategy offers the benefits of favorable tax treatment through the Internal Revenue Code Rule 1256 of 60 percent for long-term capital gains and 40 percent for short-term capital gains, targeted equity exposure, high liquidity and a source of structural alpha. Clients can add income to their portfolios in the range of 300-600 basis points annually, while only exposing themselves to an equity beta of 0.2-0.35.
To execute, advisors:
• select strategy, holdings, and respective percentage of their clients’ treasury portfolio to overlay.