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Beyond the Bond: Three Alternative Income Strategies as Price Risk Looms

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Look for alternatives to fixed income -- especially if you agree with the general market hypothesis that interest rates are due to rise.

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My concern about interest rates leaves me pondering alternative income strategies. I want to avoid traditional fixed income because of the price risk when interest rates start to rise again. (Goldman Sachs even put out a research piece in which it predicts a half-point rise in real interest rates by year end.)

So, what are some alternatives that don't carry the same long-term interest rate risks? Here is what my firm is looking at and using:

1. Utilities

The utilities sector, of all of the sectors in the S&P 500 (INDEXSP:.INX), has the lowest correlation to the broader market. It is still a group of stocks, but it doesn't move in lockstep with the index like many of the larger sectors.

The S&P Utilities Sector ETF (NYSEARCA:XLU) is the one my firm likes to use. It offers a 4% dividend and it has options that trade on it if you'd like to purchase long term protection from a significant market event.

Utilities do carry some interest rate risk, but it is not very high and it is not correlated to the broader fixed income market. The only risk in utilities to interest rates is that utilities are often viewed as a substitute product for fixed income. So, as interest rates improve on new bond issuances, some of the utilities money might move naturally back in to fixed income. But that is a sea-change trend – not an overnight one. For now, we like utilities for a nice dividend yield.

2. Selling Covered Calls

We have said for a while that we think the market looks fully valued. If we believe that, then we should be willing to sell covered calls with real conviction.

If you have a significant equity position(s), consider selling calls against it to generate some extra premium. The volatility of the stock should determine the returns you can create relative to the upside you need to give up. For the average stock, we look to generate around 4% in extra annual premium. For higher volatility stocks, we look for north of 6%. For lower volatility stocks, we look for just around 2%.

We like to ladder our covered calls – meaning if we had 900 shares of a stock, we might sell three contracts in the near month, three contracts in the expiration out two months, and the final three contracts in the expiration that is three months away. We would look to give the stock more room to run in the later months. And we would try to blend that rate we get back in premium to create the desired annual returns.

If you have an equity portfolio anyway, we recommend this approach. You might as well look to grab some extra premium.

3. High Probability Credit Spreads

This strategy is not correlated to the fixed income market at all, and it is a one-month strategy. Interest rate moves will tend to have little to no effect.

We sell deep-out-of-the-money options structured as a spread to traders that are speculating that the market will move in a violent swing in a short time frame -- by the near month expiration.

Good luck looking for alternatives to fixed income – especially if you agree with the general market hypothesis that interest rates are due to rise.

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No positions in stocks mentioned.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

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