Where to Find Income Outside of Bonds: Strategies from the Pros

Key Takeaways

• Investors can earn income outside of bonds through dividend strategies, individual stock selection, and liquid alternatives.
• The strategies come with risks, but they can also act as powerful diversifiers within a larger portfolio.

Bonds may have top billing when it comes to generating income in a portfolio, but they’re not the only way for investors to capture steady, reliable yields. Speaking at the Morningstar Investment Conference in Chicago on Thursday, three market pros laid out strategies investors can use to bolster their portfolios beyond traditional fixed-income assets. These strategies carry their own unique risks, but they can be powerful diversifiers.

Dividend Growers

Tony DeSpirito, global chief investment officer of fundamental equities at BlackRock, pointed to dividend strategies in the equities market, which have outperformed the broader market so far this year. He’s focused on companies that not only pay a dividend today, but also have the potential to grow those dividends over time.

DeSpirito thinks this is especially important in an environment of elevated inflation. “The income from fixed income is fixed,” he said, “and so the bolus of your money doesn’t appreciate over time … That’s not true in equities.”

DeSpirito also uses a strategy called an options overwriting, which involves selling call options on stocks an investor owns. “The options overlay also provides incremental downside protection,” he explained, though it can also limit upside.

Liquid Alternatives

This encompasses a wide range of complex strategies available to investors through mutual funds or ETFs, like convertible bond arbitrage. Many are designed to enhance diversification beyond traditional stock and bond strategies, and they tend to be less exposed to interest rate risk.

Liquid alternatives have two main benefits for investors, explained David O’Donohue, co-head of alternative strategies at Calamos Investments. First, they make investment strategies that were once only accessible to hedge funds or institutional investors available to retail investors. “Putting them in an easy-to-trade liquid wrapper really brings that to the masses,” he said.

These strategies also can be tailored to investors’ goals (including income) and risk profiles. “We’re building uncorrelated, diversified return streams, and that’s what people love about it,” O’Donohue said.

Morningstar’s Jason Kephart, a senior principal with the multi-asset team, took a closer look at the role of liquid alternatives in portfolios this spring.

Stock Selection

There is plenty of diversification in the stock market too, if you know where to look. Scott Mensi, institutional portfolio manager at Fidelity Investments, said his team looks for areas within the equity market where there’s “too much bad news priced in” as part of their broader income strategies. “If we can do that, we’ll have a great risk-adjusted return for a long period.”

Mensi pointed to opportunities in certain oil tanker businesses that have reduced debt and have stable income profiles and can serve as hedges during geopolitical unrest, bucking the easy assumption that those firms are highly cyclical.

Risks for Investors

It’s important for investors to remember that these strategies carry downside risks. Mensi warns investors against products with an advertised yield that seems too good to be true, while DeSpirito cautions against value traps in the equity market.

“There’s no free lunch out there,” said O’Donohue. “If you want higher income, there’s a tradeoff. If you want downside protection, there’s a cost.”