Income Opportunity in Bonds and Beyond

There’s a lot to be concerned about within fixed income, given bond volatility this year. The potential for more interest rate hikes continues to play a large role in prolonged volatility. However, a possible end in sight for rate hikes has many investors looking to long-duration exposure once more.

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Increasingly more investor and advisor conversations recently revolve around rate concerns and timing. Investors are asking “if these are really attractive interest rate levels that they should be trying to lock in for the longer term”. That’s according to Garrett Paolella, co-founder and managing partner of NEOS.

“I think it’s a dilemma for advisors over the last year or so on what to do,” said Christian Magoon, founder and CEO of Amplify ETFs. “This elevator keeps going up on interest rates,” Magoon explained, without any strong indicators from the economy that the Fed should ease off or lower rates.

It’s the kind of environment that lends itself to the need for alternative income strategies.

In the volatility and uncertainty of the last year and beyond, investors increasingly chose exposures to hedge against risk. Ultra-short exposures have been enormously popular this year, given enhanced risk from multiple fronts. Of those ultra-short allocations, Treasuries remain a big winner in 2023 for investors for the tax efficiency and yields.

“A lot of people have put a tremendous amount of money into ultra-short,” said Paolella.  “You can really leverage the short duration and the inverted yield curve that we’ve been in for the last twelve months.”

It’s been a great year for money markets as well, given yields and the relative safety compared to much of the market. Magoon views all of the cash currently in money markets as a “powder keg of money on the sidelines for when there is a change in regime.”

Options-based income strategies also took off this year as investors flocked to income opportunities beyond bonds. Options strategies offer investors four key benefits: income generation, diversification, tax efficiency, and hedging against downside risk.

The NEOS suite of ETFs focuses heavily on income generation and tax efficiency. The funds include the NEOS S&P 500 High Income ETF (SPYI A-), the NEOS Enhanced Income Aggregate Bond ETF (BNDI A-), and the NEOS Enhanced Income Cash Alternative ETF (CSHI ).

All three funds utilize index options which receive favorable tax treatment with the IRS. The index options are taxed at a 60% long-term capital gains rate and a 40% short-term rate. They’re options that offer more potential tax efficiency than equity, synthetic, or ETF-linked options, according to Paolella.

NEOS also engages in tax-loss harvesting throughout the year, as appropriate.

“A lot of options-based strategies create you a long/short,” Paolella explained. “You might be long in an underlying equity exposure and then you’re selling an option against to generate that income.” Various market environments will not always favor both positions, so NEOS harvests losses when applicable. The managers also use tax-loss harvesting as an opportunity to redistribute allocations in a more tax-favorable position.

All three funds offer tax-efficient alternatives or compliments for core allocations. SPYI provides exposure to the S&P 500 and employs a covered call, S&P 500 index options strategy to enhance monthly income. The fund currently generates between a 10-12% annualized yield.

CSHI offers exposure to ultra-short, 1-3 month T-bills alongside a put spread overlay on the S&P 500. The fund seeks to generate 100-150 basis points of additional yield above T-bill yields. Meanwhile, BNDI offers exposure to the broad bond market alongside a put spread overlay on the S&P 500. The options generate 2-2.5% additional yield for the fund.

Amplify offers two dividend-focused ETFs, the Amplify CWP Enhanced Dividend Income ETF (DIVO B+) and the Amplify International Enhanced Dividend Income ETF (IDVO ). Both funds focus on high-quality companies that exhibit both earnings and dividend growth. The two funds also employ a tactical covered-call strategy that allows for both dividend and premium capture.

“Many advisors are using IDVO or DIVO to upgrade the quality of their dividend ETF while at the same time doubling their dividend yield,” Magoon said.

Meanwhile, the Amplify High Income ETF (YYY B+) is index-based and provides exposure to closed-end funds that trade on the secondary market. The closed-end funds are 80% bonds, and 20% equities, and the strategy seeks those funds trading at a discount to their NAV.

For more news, information, and analysis, visit the Tax Efficient Income Channel.