Amid historically low rates, the income solutions of yesterday are not going to cut it. Global X ETFs has recognized and reacted to this paradigm shift by developing alternative, higher-yielding strategies.
Rohan Reddy is a research analyst with Global X ETFs. He joined Global X in 2015. He works within the firm’s research team, providing insights into the financial markets and Global X’s unique range of ETFs, including energy infrastructure, preferreds, covered calls, and dividend strategies. Rohan is also a member of the firm’s portfolio construction committee (PCC), providing model portfolio solutions to investors. He is a frequent contributor to the Global X blog.
I recently recorded a podcast with Rohan here.
Tell me a little bit more about your role at Global X.
I'm a research analyst at Global X and I've been here for a little over five years. We offer 77 ETFs. I specifically cover the firm's income suite of ETFs and I'm a market and product specialist within that area.
We're speaking just a few days after Joe Biden became the president-elect. In the last two weeks, rates have risen quite a bit. The 10-year yield is up about 20 basis points over that two-week period. What do you attribute that move to?
The risk-on sentiment is back in the market and the makeup of Washington is a big part of that. Biden was expected to win the presidency and the Democrats were expected to control the House. But the Democrats had an unexpectedly poor performance in the Senate race, and it will come down to two runoffs in Georgia in January. The reason that's important is because without control of the White House, it becomes harder to get legislation through. Democratic proposals at a broad level are expected to be a net negative for the markets, including Biden's proposal to raise the corporate tax rate from 21% to 28%. The status quo of a gridlocked Congress in some ways is viewed more positively by the markets.
The other reason is the news that we saw yesterday about Pfizer's COVID vaccine and its 90% effectiveness. It's the first real breakthrough we've seen on a potential vaccine and it speeds up the timeline of returning to a normal economic setting. Cyclicals and small caps rallied tremendously the other day in response to that.
That move in the last two weeks is in anticipation of Biden becoming president and the Senate remaining in Republican hands, which would be positive for business, positive for the markets and signifies a positive outlook for the economy. How does that translate to an outlook for interest rates and yields going forward over the longer term?
Yields have gone up recently, but the Fed has made it clear they're not looking to raise rates anytime soon. They've mentioned the end of the 2023 at the earliest. The Fed's balance sheet stands at $7 trillion and they're purchasing $120 billion a month in the credit markets. Fed Chair Jerome Powell just said that we shouldn't expect any major changes to its bond purchasing policy anytime soon. I would expect what we're seeing right now to be the status quo going forward.
The situation in Europe is even more extreme. Certain medium-term sovereign yields in Greece just went negative, something that may have seemed almost unfathomable just a few years ago. The ECB’s QE programs have been quite aggressive in Europe too. We believe finding income today is going to be very challenging, especially if inflation keeps ticking higher going forward. We don't think there's going to be a meaningful rise in yields for the foreseeable future even if there is another rally in the equity markets.
I want to ask about that challenge of finding income. Given that rates are so low and the Fed is going to keep them low, can fixed income still be considered a reliable source of income the way it has been traditionally?
Traditionally, sovereign and muni bonds are a big part of investors' portfolios for income. But they're not what they used to be as bellwether income vehicles. A lot of this has to do with rates being pushed so low at the central bank-level by institutions like the Fed. These rates will naturally come down with those policies.
The other challenge is ultra-tight credit spreads. The Fed moved into the corporate credit markets back in March during the height of the pandemic, which is something they previously had never done.
In the past, the Fed was primarily just in Treasury and mortgage-backed securities. Even if you take slightly more risk in an area like investment-grade bonds, that isn't getting you a whole lot more yield than you need. Outside of muni bonds, most of fixed income is also taxed at ordinary interest rates. Your after-tax income is even lower than the stated yield in most cases.
Where else can investors find sources of reliable income?
They need to look to equity income and higher-yielding pockets of the fixed income market as well as option strategies, which are becoming increasingly popular. Two other areas are MLPs and REITs, which are exempt from taxes at the federal level and they pass along their income to investors. On the fixed income side, we're seeing emerging market bonds and preferred stock getting a lot of interest because of their yield spread to the rest of the market. Selling options contracts and getting premiums is also becoming a popular strategy. That's been a growing area of interest for institutional and retail investors.
I know that options are one of the areas that your firm specializes in. Explain how option strategies like covered calls could be useful in today's environment.
Given that the markets have been quite choppy this year, covered calls are a useful strategy to stay invested in the market and also generate income. You can offset some of the downside risk with the options premiums that you receive. Markets have fluctuated quite a bit this year. But they have stayed on an upward path. In many ways, that is a pretty good environment for covered calls because you're still invested in the markets and you're receiving income at the same time.
Volatility has been high and that translates to a higher premium on the options, which for those who are selling options is more income. How else should advisors think about covered calls in the context of a higher volatility environment?
Options premiums from selling call option contracts is correlated to volatility. During a period of heightened volatility like we're seeing, it's a way to monetize that volatility by getting higher options premiums. When other parts of your portfolio, like equities, are facing adverse effects, covered calls can be a valuable addition to the portfolio. It's one of the reasons why options strategies have become more popular this year. Volatility is up and it is a way to de-correlate your portfolio compared to traditional equities.
You also mentioned preferred stocks. What is the case for preferred stocks? How should advisors think of preferred stocks within the context of their overall portfolio?
Preferreds are an interesting asset class. They're often overlooked because they're a pretty small pocket of the market. But they do have some interesting characteristics. Advisors tend to use them on either a one-off or an ad hoc basis, but they have merit as a longer-term allocation in the portfolio. Specifically, preferred stocks have a mix of both fixed income and equity characteristics, but they tend to act a bit more bond-like than stock-like.
Given their above-market yields, they can be useful in an income portfolio. Many investors use them for the tax benefits, since many preferred coupons are considered qualified-dividend income rather than ordinary interest. Most bonds that are taxed as ordinary interest. Your after-tax income can be a bit better on preferreds than in other pockets of the bond market.
We are also seeing more investors move out of high-yield bonds and into preferreds as a trade. That's been one of the more popular trades we have seen this year. Most preferred issuers are in the financial sector, specifically within banks and insurance companies. Many of those companies, after the 2008 financial crisis, were highly regulated to protect against any systemic risks to the system. Within the advisor pocket of the market, there was some trauma that came out of preferreds after that 2008 period because of the Lehman and Bear Stearns collapses. But preferreds now are quite different from that period because of the regulatory aspect that was not necessarily there before.
One of the main thing about preferreds is that they are interest rate-sensitive. But as we were discussing earlier, interest rates have been low and are expected to stay low. This hasn't had much of an impact on preferreds. Our outlook for preferreds is to expect more coupon-like returns going forward because of this.
The yield on the 10-year Treasury now is about 90 basis points. Give me a sense of what yield advisors can expect on preferreds with similar duration risk.
Preferreds at the market level tend to yield somewhere around 5% to 6%, so the spread to the Treasury is quite high. You also get that positive aspect of the qualified dividend income. It does have some of those stock-like characteristics, so the volatility is going to be a mix of bond- and stock-like characteristics. But it is a useful way to generate yield in the portfolio, especially when you compare it to something as low yielding as say the 10-year Treasury.
What are some of the other non-traditional income sources that investors and advisors should be thinking about?
We're seeing a lot of interest within emerging market (EM) bonds. They're an interesting place to be. Sovereign EM balance sheets were stretched during COVID. But in the wake of Biden's victory and the reduced trade tensions that may come with that, this should be constructive for the emerging markets. Specifically, we prefer dollar-denominated emerging-market debt rather than the local currency debt. This is to mitigate some of the risks that comes with local currency exposure. By nature, dollar-denominated issuers are seen as more creditworthy than local currency issuers.
But EM bonds are also an interesting place to explore because investors who are concerned about tight domestic spreads in the investment grade high-yield markets may also be concerned about the outlook for principal returns. EM bonds have attractive valuations and we are coming off a period when some of the macro headwinds may be abating. We like emerging market bonds as an area to generate yield within the portfolio.
Given the range of possibilities – covered calls, preferreds and emerging markets – where are you and Global X seeing the flows move towards in the fixed income space?
Preferreds is one of our most popular areas, in addition to covered calls, which is the options strategy. This has been happening for many of the reasons that we talked about: Interest rates are very low, which helps preferreds because they're duration-sensitive. Volatility is high, which also helps covered call strategies. Our two strategies within those spaces are fairly straightforward, which has been contributing to a lot of the flows that we've seen.
Our preferred ETF (ticker PFFD) is a beta-access fund and it only charges 23 basis points, so it's very competitive within the preferred ETF market. We run a suite of covered call ETFs that write one-month, at-the-money call options and we roll those over each month. It is a fairly mechanical process. Its ticker is QYLD and it is our most popular fund within that space. It's well over a billion dollars in assets and it writes call options on the NASDAQ 100 Index, which as we know has been a bit more volatile than some of the other indexes this year and over the longer term as well.
Do you have an ETF in the emerging markets space?
Yes, we do and the ticker is EMBD. This is an actively managed fund at a very competitive price point, 39 basis points. It's sub-advised by our parent company, Mirae Asset. They have a lot of expertise within this space and we were excited to partner with them because it's our first actively managed fund. But we also see a lot of opportunities within emerging market bonds and also specifically within the ETF space.
If there's one piece of advice that you would offer to financial advisors who are are looking for a framework to evaluate the range of income-oriented solutions from which they can choose, what would that be?
The key is how much income you need to generate and the corresponding amount of risk you're willing to take. There's always that pendulum aspect for advisors; if you only need to generate the inflation level to keep up with your client's cashflow needs, that's where traditional income starts to play in. If you want to go with muni or investment-grade bonds or something that is more in the traditional realm of fixed income, that's where your risk aspect can stay relatively low.
But the bigger question that we're hearing from advisors is, "Well, not only do I need to keep up with inflation but I also need to meet my client's increased cashflow needs." That could be either because their life expectancy is longer or certain aspects of their circumstances have changed. That is the question we're hearing a lot more today. Do you want to take equity risk? Do you want to go for a higher yield within pockets of the fixed income market? How much risk at a portfolio level do you want to take?
A good way to go about this is to mix different asset classes, which brings me to my next point about diversification. It is also a critical aspect within income-oriented portfolios, because a lot of times income can only be found in a few asset classes or sectors. We have found that portfolios can get concentrated because of that aspect. That's where mixing in other unique solutions, like option strategies or fixed income and equity income, is a useful way that you can spread out risk within the portfolio.
Those are the key pieces of feedback we are hearing from advisors about how things have changed compared to other years. We also run model portfolio strategies (as do other issuers) to help advisors. Our most popular strategies over the last couple of years have been our equity-income portfolios and some of our other income portfolios. This is a top-of-mind issue for advisors, but overall the key is balancing your need for income and the risk you're willing to take and then trying to diversify the portfolio.
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