Traditional Income Strategies Are at Risk — Here’s an Alternative
Traditional income strategies are supposed to be attractive to conservative investors. In particular, sectors with a high concentration of dividend-paying stocks (such as utilities and consumer staples) are often referred to as “widow and orphan” investments because they are safe enough for the most risk-averse investors.
However, in today’s investment environment, traditional dividend stocks have much more embedded risk in them. To understand why the strategy of buying solid dividend-paying stocks could be harmful to your account, we need to take a look at the state of financial policy in the U.S.
It is common knowledge that we live in a period of exceptionally low interest rates. The Federal Reserve has intentionally driven interest rates to historically low levels in an attempt to boost economic activity. The Fed’s expectation is that if interest rates remain very low, income investors (both individuals and institutional investors) will be forced to move further out on the risk curve as they “reach for yield.”
A reach for yield can support an economic recovery because capital naturally moves into more “productive” areas — typically out of Treasuries and into corporate bonds, or out of bonds entirely and into equities. If companies are able to raise capital, which would typically be invested in safer areas, then it can help to boost expansion and support employment.
Considering the low interest rates over the past several years, capital has moved into traditionally safe income stocks, pushing stock prices (and valuation metrics) to higher levels.
Capital Rotation in Reverse
Now that the U.S. economy is beginning to recover, the Fed is considering its options for reducing stimulus measures, which would naturally allow interest rates to float back up to higher levels. In particular, the tapering of the Fed’s $85 billion monthly bond purchase program is being discussed. When this happens, it will lead to lower Treasury prices and corresponding higher yields.
At this point, it looks like the capital rotation out of fixed-income securities and into traditional income stocks has reached its zenith. With the prospects for higher interest rates now upon us, investors need to be ready for the trend to shift, with capital moving out of dividend stocks and back into “safe” income investments with newly appreciated yields.
This reverse capital rotation could be very challenging for traditional dividend stock investors. Since these stocks are trading at premium valuations to historical norms, they could see significant capital outflows once their competitive income edge is lessened.
For this reason, I’m worried that conservative dividend investors may be in danger of suffering significant losses in the coming weeks and months.
An Alternative Income Source
One strategy that dividend investors may want to consider is selling puts, which can generate reliable income and also allow investors to potentially pick up quality stocks at a significant discount.
Here’s how the put selling strategy works: Income investors sell a put option, which obligates them to buy 100 shares of stock at the option’s strike price if the stock is below that level when the option expires. Typically, we choose a put option that is out of the money, that is, with a strike price that is below the current stock price. That means our obligation only kicks in if the stock drops in price.
There are two ways the trade will evolve. Either the stock will remain above the strike price and the put seller will not be required to buy it, or the stock price will decline, in which case the put seller will buy the stock at a discount.
Income is generated from this strategy through the process of selling the put option. The income we receive, which is known as premium, is basically compensation for accepting the obligation that comes with selling the put option.
In a rising interest rate environment, selling puts may help income investors better protect their assets, generate reliable income, and potentially enter stock positions at a significant discount. At the very least, this strategy offers an attractive diversification from traditional income stocks that may be especially vulnerable during a time of rising interest rates.
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