Financial advisers explore exotic options

Plain vanilla is simply not on the menu any more, as advisers scan the markets in search of ways to generate yield in their clients’ portfolios. Advisers have set aside the standard Treasury bond in favour of a wider range of fixed income and equity options that can produce income, often swirling several flavours together.

The scramble for yield has led advisers into areas previously considered exotic, turning foreign bonds and master limited partnerships (MLPs) into more mainstream instruments, and boosting the use of dividend stocks to levels once found only in the portfolios of one-dimensional investors.

With persistently low interest rates as the one certainty in the post-2008 crash marketplace, generating yield is now “foremost on people’s minds”, says David Van Acker, an adviser for UBS Wealth Management Americas in Westlake Village, California. While baby boomers entering retirement amid low interest rates have driven much of the yield-seeking phenomenon, longer-term factors are also at work.

“The world has changed, with people more aware that retirement might last longer than we expected,” Mr Van Acker adds.

While not all very wealthy investors clamour for yield, low rates certainly have driven “mom and pop” investors to chase it, with some pulling out of traditional equity markets at the wrong time, says Brad DeHond, a Morgan Stanley Wealth Management adviser in Chicago.

“You have to really take what the market gives you,” says Mr DeHond. “History is littered with stories of people who stretched for yield and got burnt trying to get 100 or 200 basis points more and instead taking a 5 or 10 per cent capital loss.”

Many investors also fail to evaluate the “give-up” for yield, with common trade-offs – longer duration or higher-risk bonds – not worth the cost today, Mr DeHond adds.

US investors have nonetheless been bulking up on some income investments. For instance, bank loan funds leapt from $72.9bn in assets in 2012 to $138.8bn in 2013, while non-traditional bonds jumped from $67.6bn to $123.1bn, according to data from Morningstar and Cerulli Associates, the research companies.

MLPs – publicly traded securities of specially chartered companies intended to boost US energy sector investment – have also been surging, with assets tracked by Informa PSN, the financial research company, jumping from less than $18bn in 2012 to more than $30bn in 2013.

“Last year saw a tidal wave of activity,” says Steve Chun, director of marketing and product development at Miller/Howard Investments, an MLP manager that nearly doubled assets to $2bn last year. “The search for income is a key reason.”

Advisers say many clients are still adjusting to the wider yield menu.

Margaret Starner of the Starner Group of Raymond James in Coral Gables, Florida, says: “The most important change for a lot of clients [is looking] for yield beyond just fixed income.”

The breadth of options on the table is helpful, says David Harris, chief investment officer of Rockefeller & Co, the wealth manager, citing real estate investment trusts (Reits), MLPs, municipals and emerging market debt.

Emerging market bonds are becoming more popular but may not be for the “faint of heart” because of currency and country-specific risks, Mr Harris warns. There are big rewards for investors who make the right choice, such as those who bought Indonesian bonds in the first quarter of 2014.

“We are not making a strong endorsement for all emerging markets fixed income, but there are markets where there is a premium for currency risk,” says Mr Harris. Another steady yield generator is municipal bonds, especially for investors managing significant tax burdens, he adds.

Ms Starner says her yield strategy taps model portfolios of bond-focused closed-end funds, one targeting municipal bonds and the other a basket of credit opportunity, long-short, duration-managed and other bond strategies.

She is also increasing her use of “strategic income funds” that “can go anywhere for income”, including high-yield debt and dividend stocks.

Another fixed income outlet is limited partnership-style funds focused on senior bank loans and mezzanine debt. These are suitable for high-end “qualified” investors who can handle illiquidity in their portfolios, says Mr DeHond. Some of those funds provide steady income by paying out on coupons.

On the equity side, MLPs are popular, especially in separate account format, but come with considerable tax administration complications that put off some clients, Mr Harris says.

For high-end clients, some private equity funds, particularly in the energy sector, have gained traction as income options, according to Mr Van Acker.

Investors in high income stocks, Reits, MLPs and other equity-like investments should nevertheless be wary that these holdings may be expensive in today’s market and subject to capital loss in a rising interest rate environment, says Mr DeHond.

Ms Starner says she also looks beyond the public markets for yield in structured certificates of deposit and indexed annuities, which generally are structured with guaranteed payouts or principal protection and appeal to clients seeking safety above all.

Even then, however, investors should diversify their options. “You can’t just use one strategy,” she says. “It has to be a combination.”