Funds and ETFs that generate Income
With interest rates at their highest levels since 2007, the opportunity for investors to generate substantial income through their ETF and Mutual Fund investments has returned. This quarter, DDW identified nearly 1900 institutional Mutual Funds and ETFs that paid 12-month distribution yields in excess of 5%. Just three years ago, in 2021, the number of institutional Mutual Funds and ETFs offering a 5% yield was only 474. Below is a brief overview of some options investors have in this space:
Fixed Income Funds:
After being abandoned by investors in 2022 due to significant price declines caused by rising interest rates, fixed income products have stabilized in price and now offer much higher yields than before. The average yield on the universe of Fixed Income MF/ETFs is currently 4.16%. Risks vary depending on the underlying strategy of the fund. However, with a full slate of duration and credit options available, clients have plenty of choices to match their desired risk tolerance.
Equity Income Funds:
The average equity income fund has a 12-month yield of 2.52%. While more volatile than fixed income products, these funds allow investors to enjoy income while offering the potential for capital appreciation. Given the wide variety of investment objectives and mandates, proper due diligence on these products is essential.
Alternative/Liquid Alt Funds:
With the continued growth of the ETF market, more advanced income strategies are being offered to clients. These can include covered call strategies, currency overlays, leveraged strategies, and commodity strategies. For Liquid Alternative funds that pay a 12-month distribution, the average yield is 4.05%. Due to the idiosyncratic risks of each strategy, it is especially important to conduct proper due diligence on each product to understand the benefits and risks adequately.
Given the importance investors place on income, product providers are incentivized to offer more income opportunities, sometimes taking on extra risks to do so. Schedule time with DDW today to review your income offerings and ensure they provide a full slate in line with your platform's risk tolerance.
Structured Products that Generate Income
With the bond market's performance over the past 18-24 months, more focus has been placed on income-focused structured products. Structures that allow for income generation may be available through all different product types, i.e., Full Principal Protection (MLCDs & PPNs), Partial Principal Protection (Buffered Notes), and full Principal at Risk (Barrier Notes); given multiple factors, most of the focus has been on Principal at Risk/Barrier Notes.
This attention to income-focused barrier notes can be attributed to a few reasons.
The first is the recent poor performance of the bond market over the 18-24 months. While many technical terms, ratios, and summaries may be provided, this can clearly be shown through an image of recent performance. The table below illustrates the performance of the iShares Core US Aggregate Bond ETF (AGG), which is in blue, and compares it against the S&P 500 Index, which is in yellow:
The upper image does not compare fixed income's performance against equities within the S&P 500 but shows the point at which the AGG dipped below 0% while showing the positive trend line of the S&P 500 index. The beginning of this poor performance marked the general starting point when fixed income became less attractive, and investors began to look for yield elsewhere. For numerical context and comparison, the one-year return on the AGG as of March 31st, 2024, is a whopping 1.7%, compared to the one-year return on the S&P 500 of 29.88%
The second, and a continuation of this poor performing starting point, is that this extended and ongoing 18+ month period of poor performance would also affect ongoing and held positions, as fixed income was no longer acting like fixed income, which has led to using structured products to replace the poorly performing bonds. 
Some advisors who shifted to using structured products for income have had positive experiences and liked the story, which continues to build interest in this space. The advisor's and customers' positive experiences are likely correlated to the buoyant equity markets, which lead to notes being called and call premiums being paid. These call premiums currently range from ~6-9%, and once called, the face value is returned, which allows for redeployment.
The third reason is that these income notes can provide additional diversification, lower the portfolio's standard deviation with limited downside protection, and allow for the preverbal clipping of coupons. This reason applies to more sophisticated advisors who are building and analyzing their clients' portfolio analytics.
Some considerations must be evaluated, such as the client's and firms' willingness to accept the additional complexities associated with barrier notes, as buffered notes are not as attractive given the current market conditions. While Partial Principal Protected Notes, namely buffered notes, offer income-focused crediting structures, the current market conditions are not as conducive given the issuer's offerings, which can be attributed to the current VIX or volatility levels. The table below illustrates the past five years of VIX performance, which shows 2024 as having the lowest levels since 2020. Of course, the VIX is not solely attributed to income-focused buffered notes but is associated with the overall market, and the buffered note offerings thrive more when the VIX is elevated due to the option pricing of the derivatives utilized to build them.
While the income-focused barrier notes are currently more attractive than the buffered note offerings, not all banks or broker-dealers offer these structures, which may make the buffered notes a potentially attractive addition to a portfolio.
Due Diligence Works continually monitors the structured product market through monthly offerings and reviews each offering for our clients. If we see one continuous theme with structured products, it would be markets continuously shifting, which requires a dedicated team to analyze and review these offerings each month.