Building a resilient income portfolio requires diversification across economic regimes, not just within a single asset class.
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Income investing is often treated as an exercise in maximizing yield. A better approach is to treat it an asset allocation problem that needs to survive regime shifts in interest rates, inflation and economic growth.
While many advisors favor total-return strategies with flexible withdrawals, many investors still prioritize predictable cash flow, especially those who rely on their investments to generate income. However, the challenge is that the investments producing the income can respond very differently to changing economic conditions, making diversification across income types just as important as diversification across assets.
For example, a portfolio of 25 high-dividend may appear diversified, but it remains vulnerable to broad equity market risk as well as idiosyncratic risk if one holding runs into trouble. Alternatively, a portfolio of fixed-rate government bonds performs well when interest rates fall, but is exposed to reinvestment risk and a loss of purchasing power if inflation accelerates. The ideal income portfolio should include allocations to as many uncorrelated asset classes as possible, prioritizing maximum diversification over maximum yield.
Building Blocks For Income Investing
Equities are the primary source of income growth in a diversified income portfolio. Dividend-paying stocks generate cash flows that can rise over time, helping preserve purchasing power in inflationary environments. Equities offer the adaptability that static income sources lack. However, the equity component is usually the most volatile, making an all-stock income portfolio too risky for most investors.
Liquid funds such as the Schwab U.S. Dividend Equity ETF (ticker: SCHD, current yield: 3.6%) or the iShares Global Infrastructure ETF (ticker: IGF, current yield: 3.18%) offer higher dividends than the S&P 500 and a track record of annual dividend increases. It is the growth component of dividend investing that helps insulate a portfolio from inflation. Also, given their factor tilt toward value stocks rather than growth, they have historically demonstrated less volatility than the broader market.
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Bonds are another core building block. Fixed-rate bonds, such as government bonds and agency mortgages, provide income stability and capital preservation, particularly during periods of slowing growth or financial stress. In exchange for that stability, bonds assume interest-rate and inflation risk. The dramatic jump in long-term interest rates in 2022 should serve as a reminder than bonds are not without risk.
There are many fixed-income choices for investors, some of which are actively managed to try to limit the impact of changing rate regimes. The BlackRock Flexible Income ETF (ticker: BINC) deploys a go-anywhere approach across all areas of the bond market and pays a dividend of 5.85%. The passively managed iShares Core U.S. Aggregate Bond ETF (ticker: AGG, current yield 3.88%) provides exposure to core Treasuries, mortgages and investment-grade corporate credit. The iShares TIPS Bond ETF (ticker: TIP, current yield: 3.73%) targets inflation-protected government bonds that pay a coupon linked to actual inflation rates.
Credit strategies are a third popular building block for investors. By taking credit risk rather than equity risk, high-yield bonds, senior loans, and structured credit offer higher cash flows than core bond portfolios. Many strategies feature floating rates that benefit from higher short-term rates, helping protect or even increase income potential when the Fed raises rates.
Credit avoids much of the duration risk found in long-dated core bonds but is vulnerable to economic downturns when defaults rise. Used selectively, especially when combined with fixed-rate bonds, an allocation to credit can improve income resilience across rate regimes. Some options for investors in ETF format include the VanEck BDC Income ETF (ticker: BIZD, current yield 11.5%), which holds positions in dozens of Business Development Companies that extend loans to small and mid-sized private companies and the Janus Henderson AAA CLO ETF (ticker: JAAA, current yield: 5.28%) that holds a basket of AAA-rated Collateralized Loan Obligations, or CLOs.
A final building block for income portfolios is the growing suite of alternative ETFs. These strategies are typically more complex and less liquid than traditional ETFs, but they compensate investors with materially higher yields. Take the Calamos Autocallable ETF (ticker: CAIE) for example. This ETF pays a 14% annualized dividend by holding a time-diversified portfolio of autocallable derivatives on the S&P 500. The 14% distribution yield is stable as long as the S&P 500 does not fall 40% from its current level.
Alternatives such as CAIE diversify income by incorporating non-traditional cash-flow drivers. Equities do well when economic growth is strong. Bonds do well when growth is weak. Autocallables do well when nothing happens. Other alternatives could include Real Estate Investment Trusts to gain access to commercial real estate markets, or Master Limited Partnerships, which are considered the toll roads of the energy sector.
ETF performance often depends on market conditions.
Garth Friesen; Gemini
Allocating Across Regime Shifts
True diversification is more than owning many securities. It requires spreading risk across distinct asset classes and income sources, not simply increasing the number of holdings.
A portfolio can hold thousands of stocks across global markets and still behave like a single bet. In most environments, equities tend to rise and fall together, driven by shared exposure to economic growth, financial conditions and investor risk appetite.
At its core, income investing is about cash flow generation. Those cash flows vary with macro forces such as inflation, interest rates, economic growth and currency movements. They are also influenced by more localized factors, including industry trends, geopolitical risk and regulatory policy. A well-constructed income portfolio cannot eliminate these risks, but it can reduce the likelihood that any single factor materially impairs income or value.
Portfolios built primarily to maximize yield often fail this diversity test. Concentrating too heavily on one income source may work well in one regime, but it leaves cash flows exposed when conditions change. Durable income comes not from yield optimization, but from diversification across multiple economic environments.