How To Build An Alternative Income Portfolio In Volatile Markets
When one of the most successful local exchange traded fund providers, BetaShares, is advertising its three bear market ETF on financial news sites, it might be a clue that sentiment has changed for the worse and investors are looking for a way to ride out the downturn in relative comfort.
The funds, BetaShares Australian Equities Bear Hedge (ASX: BEAR), Betashares Australian Equities Strong Bear Hedge Fund (ASX: BBOZ) and BetaShares U.S. Strong Bear Hedge Fund (ASX:BBUS) seek to profit when markets are falling and have all done well in the past one-, three- and six-month performance periods.
A global shakeout in growth stocks and broad market falls triggered by the prospect of an end to decades long easy money policies as central banks combat rising inflation have delivered solid gains for the three funds. But in the years when share markets were rising, the funds’ performances were deeply negative.
Rising rates spark volatility, change in strategy
Many investors had a good time of it last year as easy money policies and COVID-19 stimulus fuelled a 17% return for the S&P ASX 200 index and house price gains averaging 22.1%1 around the country.
But financial planner Louise Lakomy of Crystal Wealth Partners, says she has seen an increase in inquiries this year from clients who fear inflation and rising interest rates will bring those double-digit returns to an end and who want alternative strategies for income and capital preservation.
“People are nervous about what the future holds,” Lakomy says. “They are saying ‘if you can keep up with inflation and interest rates, I will be happy’.”
Classic income strategies centre around bonds - which pay regular interest - and property, where rents provide regular payments as well as the opportunity for capital growth.
But Lakomy says fixed income bonds can have the disadvantage of low yield while direct property investing suffers from a lack of liquidity in that property transactions can take weeks or months to close. Meanwhile, managed funds focused on credit and fixed income often require larger initial investments that are locked up for a few years, denying investors the flexibility that comes with liquidity.
Yield, value stocks come back into focus
But for income-focused investors, the listed market continues to deliver a growing range of options that combine steady, and even growing, income as interest rates rise, with the liquidity of shares.
Investors can also hunt for high-yield shares, which is to say companies with higher dividends relative to their share price. These are typically so-called value shares, such as industrial stocks that lack the high-growth appeal that has dominated investing during the extended period of low interest rates. But it can also include sectors that have been out of favour because of the pandemic, such as office and retail property trusts or travel companies.
Morningstar analyst Justin Walsh says that value stocks have a lower “beta,” meaning share price movements tend to track or even be less than the overall market movements. Thus, in a higher trending market so called value stocks can lag the market but when the market takes a tumble they tend to outperform.
As an example, the ETF Securities S&P/ASX 300 High Yield Plus ETF has largely tracked the market since launch in April 2016, but pays investors quarterly dividends. The $900 million-plus fund’s top holdings include iron ore heavyweights Fortescue Metals Group (ASX:FMG), Mineral Resources (ASX: MIN) and Rio Tinto (ASX:RIO) as well as Telstra (ASX: TLS), JB Hi-Fi (ASX:JBH) and Wesfarmers (ASX:WES).
Investors who prefer bonds could consider the iShares Global High Yield Bond (AUD Hedged) ETF (ASX:IHHY) which invests in high yield corporate bonds across developed markets and pays a distribution three times a year.2
“The issue is that yields (on bonds) have just been so low, so if you want yield you have to play credit, and that is at the higher risk end of the market,” Walsh says.
Another potential risk highlighted by both Lakomy and Walsh is in trying to time the market to coincide with rising rates. “We are certainly going into a cycle where rates should be increasing,” says Walsh. “The debate is how much and how quickly.”
Higher rates a benefit for some stocks
Lakomy says the risk for investors is that they pay up for investments in expectation of rate increases that may not happen.
Stocks that benefit from rising interest rates – such as banks who can expand their interest margins and insurers who have large holdings of bonds that benefit from rising rates – are among the traditional options.
Lakomy says she also looks for infrastructure investments such as toll roads, transmission lines, phone towers and airports that have long-dated concessions providing security of income. However, consolidation and takeovers by local and offshore pension funds have narrowed the local investment options such that investors often need to look offshore for opportunities.
Hybrid securities – which have characteristic of both debt and equity – have also grown in popularity, with investors attracted to their higher, usually floating, yield over fixed income securities – some above 4% or even 6%, according to the ASX.
There was $46.9 billion worth of convertible preference shares, capital notes, convertible bonds and hybrid securities listed on the stock exchange at the end of December.3
Ausiex data shows that in 2021 funds focused on hybrids were among the most popular trades with investors. BetaShares Australian Major Bank Hybrids Index ETF (ASX: BHYB) was the second most popular ETF launched in 2021 and has attracted more than $100 million in investments since launching at the end of April.
Among exchange traded managed funds BetaShares Actively Managed Hybrids Fund (ASX: HBRD) was the second most traded fund and had $1.67 billion of assets and a running yield of 3.38%.4
Private credit offers an alternative
Investors should be cautious, however, that buying single name hybrids can be difficult. There are a large number of smaller issues and the market is not very liquid, meaning trade orders can move the price against buyer or seller, says Lakomy.
An increasingly popular strategy involves private credit, where asset managers have stepped into a gap left by the banks and lend to companies and property developers, funding the loans from investors. Most investment opportunities are in managed funds, which require investors to lock up their funds for a fixed period. But Metrics Credit Partners has two ASX listed Investment trust (LITs) – the Metrics Income Opportunities Trust (ASX: MOT) and the Metrics Master Income Trust (ASX:MXT) – which are closed-end, typically lend at a floating rate above official cash rates and pay monthly distributions.
Managing partner Andrew Lockhart says the funds are designed to protect investor capital and provide attractive, risk-adjusted returns to investors.
“Because the loans we make are typically at floating rates, investor capital is not at risk from rising interest rates and there is an opportunity for increased total returns to our shareholders,” Lockhart says.
MXT was the second most traded LIT on AUSIEX in 2021.
It’s not yet clear when rates will go up or by how much, but there are plenty of options available for investors who want to prepare and have an income strategy in place.