Income Investing in a Rising Rate Environment


For most of the last 30 years, bond investors have been spoiled. While some of those relying on collateralized mortgage obligations and other bad real estate loans originating in the 2000s certainly got clobbered, for the most part, bond investors have benefited from a massive, long-term decline in interest rates since 1980. The mirror image of falling rates, of course, is an increase in bond prices. Throw in a marked decline in inflation – a cancer to long-term lenders of all stripes – and real returns to bondholders have been strong for a generation.

Well, all good things must come to an end, and it looks like that’s the case now for bondholders. Interest rates have been picking up across the board, pushing bond prices down. The Barclays U.S. Aggregate Bond Index is down 2.68 percent year-to-date, as of the market close on August 15, 2013. The Global Aggregate index is down 3.67 percent. Bond investors are quickly getting reacquainted with the concept of risk.

What Does This Mean for Income Investors?

If you need income from a portfolio, you have got to get it from somewhere. So what should the income-oriented investor keep in mind as we enter a potentially long headwind of rising interest rates?

Well, the short answer would be to choke up on the bat. Pull in your average maturities or durations in your portfolio to shorter periods. This way, small interest rate increases should produce more modest losses.

But Bill Gross, the manager of the PIMCO Total Return Fund, the largest bond mutual fund in the world, thinks that’s not the optimal strategy. Indeed, he compares it to the British using outdated tactics at the Battle of the Somme, and getting mowed down by modern German machine gun fire.

“I write to alert you to evolving thinking that might win this new war without causing you – the investor – to desert an historical and futurely valid asset class that we believe can still provide reliable income and hopefully steady returns even in the face of higher interest rates,” Gross writes.

Bill Gross’ Strategy

What’s Gross’ thinking? In a nutshell, Gross is trying to make the case for bond investing by thinking beyond pure semi-annual interest payments, and into other factors that can fuel total return, over and above periodic interest payments. To unlock these factors, Gross tips his hand: Rather than rely entirely on a rush to safety and the short end of the yield curve, Gross hints at forays into assets denominated in other currencies, for example. As the dollar loses value against other currencies, much of the risk of a risking interest rate in the US can by diversified away.

We see this already in Europe and Asia: Despite the fall in both the US and Global aggregate bond indexes since the beginning of the year, both the Barclays Asian Pacific Aggregate Index and the Barclays Euro Aggregate index are up year to date, by 1.62 percent and 0.86 percent, respectively.

Gross also writes that the skilled bond investor can also generate alpha, or excess risk-adjusted return, by exploiting things like the volatility premium, mispriced credit risk, and taking advantage of underprice points in the yield curve – emphasizing a “bullet” strategy of focused investment on an underpriced duration point rather than a barbell or diversified strategy.

Gross is, of course, advocating a ‘risk on’ strategy to navigate the rising rate environment – he’s just adding risk from different directions to make up for pulling in on the yield curve, much like a boat captain might navigate a strong head current by revving up his engines or adding more sail and tacking back and forth as he sails into the wind.

Strategies for Retail Investors

But you’re not Bill Gross. So short of investing in Gross’ funds – about which we have no opinion, one way or another – where else can you turn to generate income? Here are some promising ideas:

Real estate. A long-term, proven income generator over time, real estate has the additional advantage of leverage. There are still bargains to be had out there, too, though a year long broad recovery in house prices, plus the infusion of billions from hedge funds into the rental property market has made bargains somewhat harder to find than they were a year or two ago.

REITs and REIT Funds. These investment vehicles invest in real estate, but are taxed to incentivize them to pass on income to the investor in the form of dividends. You can buy REIT funds, or buy individual REITs that concentrate in specific industries like large residential developments, apartments, condos, malls, hotels, specific regions and states, and divide the risk any way you can imagine. You can dial risk up or down, generally, by investing in more or less diversified REITs or combining them. You can even buy untraded REITs to boost yield on your investment, but this is for experienced hands only.

Lifetime Income Annuities. These are insurance products that convert a lump sum to a guaranteed lifetime income. However, depending on your age, the actual yield you get each month or each year can get a significant boost over and above market rates because of a phenomenon known as mortality credits. The older you are when you buy an LIA, the greater the effect. This is most beneficial for those in good health.

Medically-Underwritten Annuities. Are you in poor health? Still need income? The medically underwritten annuity is a little-understood product designed to serve this market. While conventional LIAs benefit the healthy, these annuities provide a payout based on the mortality rates of people who share your less-than perfect medical condition and overall health. This is one way to boost income on a lump sum.

Utility Stocks. Long favored by your grandparents, utility stocks are still generating income based on subscriptions or power usage. A number of them have a long history of generating reasonable dividend income. In some cases, we’re seeing cell phone companies and broadband companies take on utility-like characteristics, at least as far as investors are concerned.

Municipal Bonds.  Yes, some municipal bonds will have difficulties, and there will be more municipal bankruptcies. But the vast majority of them will pay income and principal as scheduled. For those in higher tax brackets, the fact that these bonds are generally tax-free (with the exception of private activity bonds for those subject to the alternative income tax) provides a nice little yield-boost – with no corresponding increase in risk, in many cases.

Covered Calls. When you sell a ‘call’ option, you are selling other investors the right to buy a stock from you – at a higher price than it’s at now, usually. The call is “covered” if you actually own the stock. That means there’s no risk you’ll have to go out and buy it yourself to sell it to them when it comes time to deliver. Other investors are willing to pay for the right to buy a stock at a certain price. Your portfolio can potentially generate a few points of income this way. Often the option will expire, and you just keep the money. Sometimes you’ll have to sell the stock. No problem – take that money and put it in some other bargain!

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