How to Invest for Income in a Rising Rate Market

When the interest rate landscape begins to shift, as might be the case following the upbeat employment data released last Friday, investors that have income as a top priority to pursue with their investing acumen need to consider which sectors and asset classes will not only maintain stability of principal, but also benefit in a rising-interest-rate market. We don’t want to fight the Fed when they are easing, and we definitely don’t want to fight the Fed when they are tightening.

As the economy displays evidence of improvement, industries and businesses leveraged towards growth are the go-to places where speculators can hunt for good investing opportunities. Generally speaking, inflation in its many forms is correlated with rising gross domestic product (GDP) growth, and the possibilities for generating income that is sensitive to inflation are many.

When scouring the investing landscape for places to allocate that are dedicated for income, investors should consider the energy master limited partnerships (MLPs), bank stocks, asset management/private equity MLPs, adjustable rate real estate investment trusts (REITs), floating rate business development companies (BDCs), commodity MLPs and infrastructure MLPs. Staying invested in utilities, bond funds, fixed-rate REITs and consumer staples will show underperformance in one’s income portfolio as capital rotation out of those sectors will pressure share prices.

Another very useful way of garnering a robust income stream is to buy those market-leading equities that are front and center to the broader market upside appreciation, then utilizing an active covered call, or buy/write, strategy to sell option premium into the market’s bid. This creates immediate income while allowing you to own the very best names in the technology, finance, retail, energy, leisure, materials, manufacturing, transportation and services sectors.

Think about it. When the economy is starting to hum, being long in any of Apple, Microsoft, Facebook, Home Depot, Ulta Salon, Macy’s, Nike, FedEx, Disney, Starbucks, Visa, JPMorgan, Citigroup and Wells Fargo is like owning some of the current market’s Dream Team in terms of growth versus valuation. By selling out-of-the-money covered calls against these high-performance stocks, investors can generate well in excess of double-digit percentage income returns within a year.

With a concentrated portfolio of institutional darlings where ownership of the underlying stocks is in “strong hands,” one can structure a very robust income program while being invested right into the teeth of where the strongest fund manager interest lies. It’s a strategy that several closed-end funds are engaged in, one in which track records vary about as widely as the variety of colors in the rainbow.

When examining the many buy/write funds that trade mainly on the NYSE, the one common theme I see that holds back total return is portfolio turnover. Too many times, managers of these funds sell call premium that is too close to the price of the underlying stocks, thereby running the risk of having them called away on an all-too-often basis. This forces them to re-buy their favorite names, typically at a higher price than where the stocks were called out.

Some of these funds incur more than 200% annual turnover of their portfolios, and this explains why investors ask, “If they own all the right stocks, why does the fund underperform?” It’s because they don’t time their entry points into new positions properly, they don’t time the sale of call premium properly and, thus, they are always chasing the market. A well crafted buy/write strategy is not science; it’s an art form of technical prowess.

Properly instituted, a successful covered-call, or buy/write, program can produce yields in excess of 20% per year while being fully invested in the market’s big-cap gazelle stocks that aren’t rich on valuation. Higher-beta stocks will bring in more call premium because of high expectations for future revenue and earnings growth, but it’s important not to be overexposed to stocks with high price/earnings ratios. What the market giveth, it can and will take away much more quickly.

I call this concentrated buy/write strategy a real recipe for having your cake and eating it too. It takes diligence and close attention to maintain this kind of portfolio, and isn’t for everyone, but it does provide for a straightforward approach to crafting a hefty source of income while owning the best of breed equities.

In case you missed it, I encourage you to read my e-letter column from last week about why the Fed should just take the summer off. I also invite you to comment in the space provided below my commentary.