On February 8, AltsDb co-founder Jimmy Atkinson hosted Jay Hatfield, founder and CEO at InfraCap, for a comprehensive one-hour webinar designed to equip financial advisors with robust income investing strategies tailored for the current complex macroeconomic landscape. The session, which also featured an introductory segment by Andy Hagans, delved into the rationale behind income-focused portfolios, explored the prevailing economic outlook, and identified specific asset classes poised to deliver consistent returns amidst market volatility. An audio version of the webinar is available, along with a YouTube recording for visual reference.
The Enduring Appeal of Income Investing
Hatfield articulated the fundamental appeal of income investing, particularly for individuals nearing or in retirement. He shared an anecdote about a close friend who, after experiencing high fees and meager yields from a previous advisor, sought to rebalance his portfolio. By constructing a diversified portfolio with a target yield of 4% to 5%, encompassing both bonds and equities, the friend gained the financial confidence to retire, knowing his expenses were adequately covered. Hatfield emphasized that a consistent income stream provides a crucial sense of security, enabling investors to navigate market downturns by reinvesting at lower prices and higher yields, even when drawing from their portfolios for living expenses. He asserted that this strategy is not exclusively for older investors but offers a degree of stability for all investors.
Economic Outlook: Navigating Post-2022 Uncertainty
Reflecting on the challenging investment year of 2022, which saw significant declines in both bond and public equity markets, Hatfield provided his perspective on the year ahead. He attributed the market’s pain in 2022 to aggressive monetary tightening by the Federal Reserve, which he noted reduced the money supply by nearly 20% through open market operations. This liquidity withdrawal, he explained, directly impacted both bond and stock prices.
Looking ahead to 2023, InfraCap projected a more optimistic outlook for the S&P 500, targeting a level of 4,500. This bullish stance is underpinned by the expectation that the bulk of the Fed’s monetary tightening is behind us. Hatfield highlighted the Fed’s use of reverse repos as a key mechanism for liquidity reduction, a detail he noted is often overlooked. He anticipates the Fed will implement two more rate hikes but will refrain from further significant increases thereafter.
Crucially, Hatfield posited that the economy is unlikely to experience a major recession, a deviation from typical cycles where Fed tightening leads to economic contraction. He cited post-pandemic tailwinds, including persistent shortages in housing and automobiles, alongside a remarkably resilient labor market, as mitigating factors. These conditions, he argued, are atypical for a period of monetary tightening and suggest a potentially strong market rally as the Fed’s influence wanes.
Inflationary Dynamics and the Fed’s Role
A central theme of the discussion was Hatfield’s critical assessment of the Federal Reserve’s approach to inflation. He contended that the Fed is "completely out to lunch on inflation," asserting they are not utilizing the correct indicators. InfraCap’s proprietary index, CPI-R (Consumer Price Index – Real-time), which calculates CPI using housing prices instead of the Bureau of Labor Statistics’ owner’s equivalent rent estimate, has indicated a negative inflation rate over the preceding four months, exceeding a 4% annual decline.
Hatfield explained that high inflation, historically, has been driven by loose monetary policy, leading to housing inflation, and energy or commodity price shocks. He contrasted this with the Fed’s reliance on the Phillips Curve, which emphasizes the labor market. While acknowledging the labor market’s role in moderating inflation, he argued that it is not the primary driver of high inflation. The current deflationary forces, stemming from declining energy prices (natural gas down 75% from its highs) and moderating housing costs, suggest that nominal wage growth will naturally slacken as real wages rise.
He further elaborated on the lag effect of housing data in official CPI reports. Even as real-time indicators suggest deflation, the delayed reporting of shelter costs can create the appearance of sticky inflation. This disconnect, he believes, can lead to market misinterpretations, particularly in the first half of the year, as reported CPI prints may seem elevated due to these lagged components. However, he projected that the Personal Consumption Expenditures (PCE) core inflation, which the Fed closely monitors, will fall below 3% by June, supporting the Fed’s eventual pause in rate hikes.
Strategic Asset Allocation for Income Generation
The webinar detailed strategies for constructing a balanced portfolio that prioritizes income generation. Hatfield outlined several asset classes suitable for this objective:
Fixed Income Alternatives
- Treasuries: Currently offering decent yields, providing a foundational element of stability.
- Municipal Bonds: Offer tax advantages and slightly lower correlation to Treasuries, with half the interest rate risk of government bonds.
- Corporate Bonds: Becoming increasingly attractive with yields around 5.4%.
- Preferred Stocks: A key focus, with average yields around 6%. Hatfield noted that by diversifying beyond the financials-heavy cap-weighted index, yields can significantly exceed 7%, with some funds reaching nearly double digits. These offer moderate stock market risk.
- High-Yield Bonds: Attractive at current yields of approximately 9%, exhibiting lower correlation to the stock market than preferreds.
- Senior Loans: While not directly offered by InfraCap’s funds, these are identified as an asset class with lower beta to the stock market and decent yields, though less attractive than other options.
Hatfield recommended a diversified approach to fixed income, incorporating exposure to all these asset classes to optimize yield and risk management.
Equity Income
- Utilities: While historically a stable income source, Hatfield noted they are currently overvalued based on their yields.
- REITs (Real Estate Investment Trusts): Considered undervalued and depressed following 2022, presenting an opportunity as cap rates normalize.
- Telecom: Attractive yields are available from companies like AT&T and Verizon, whose stock prices have recently declined.
- MLPs (Master Limited Partnerships): InfraCap sees these as significantly improved asset classes, better capitalized and with more stable dividend coverage than in the past.
- High Dividend Yield Stocks: Large-cap dividend stocks, particularly dividend aristocrats, have historically delivered comparable returns to the NASDAQ with significantly lower volatility and superior income. InfraCap’s ICAP fund, for instance, aims for yields well above 7% by employing modest leverage and investing in preferred stocks. The S&P 500’s current yield of 1.7% is deemed insufficient for meeting significant income needs.
A hypothetical 30/70 portfolio (30% fixed income, 70% equity) could yield approximately 4.67%, with higher allocations to fixed income potentially reaching 6% or even 7% for more conservative investors.
Preferred Stocks: A Deep Dive
Preferred stocks were highlighted as a particularly compelling investment, especially for clients seeking income and potential capital appreciation. Hatfield emphasized their attractive yields, often exceeding 9% for funds like InfraCap’s flagship PFFA. He pointed out that many preferred stocks are trading at a discount to their par value, offering the potential for equity-like returns as they revert to par. Furthermore, preferred dividends are generally cumulative, providing a layer of safety relative to common stock dividends, as companies often prioritize maintaining preferred dividend payments to protect their credit ratings. The default rate for listed preferreds is comparable to investment-grade bonds, suggesting a moderate risk profile when actively managed.
Master Limited Partnerships (MLPs) Reimagined
Hatfield addressed past concerns surrounding MLPs, noting that their prior structure as growth stocks with high leverage and low dividend coverage led to significant volatility. However, he stated that large-cap MLP companies have since restructured, improving dividend coverage, retaining earnings for asset acquisition, and reducing leverage. This transformation, coupled with the potential for strong energy prices ($80-$100 per barrel), makes them a more attractive income-generating asset class. InfraCap’s corporate structure for its MLP fund (AMZA) eliminates the K-1 tax complexities associated with direct MLP investments, offering capital gains treatment instead.
Yield Metrics Explained
Clarifying different yield metrics, Hatfield explained that SEC Yield is a standardized calculation mandated by the SEC, which estimates income based on current portfolio holdings and dividends, net of expenses. It aims to be an objective measure. In contrast, Distribution Yield represents the actual cash payout to investors. Advisors often prefer an SEC yield that is at or above the distribution yield to ensure that distributions are not classified as a return of capital, which could erode the principal investment.
Public vs. Private Market Valuations
Regarding the valuation of publicly traded funds compared to private funds, Hatfield acknowledged that private markets often exhibit higher valuations due to less frequent marking and potentially less stringent valuation criteria. He pointed to preferred stocks trading at a discount in the public market as an example of market inefficiency offering an opportunity for investors. While private funds may appear to have higher marks, the liquidity and transparency of public markets, particularly through ETFs that trade close to net asset value, offer a more straightforward investment path.
Addressing Concerns about Short-Term Yields
In response to a question about opting for short-term Treasuries or CDs for yield, Hatfield acknowledged their safety but underscored the missed opportunity for higher returns and capital appreciation available in other asset classes. He cautioned that short-term rates are likely to decline, potentially diminishing future yields, whereas investments in preferred stocks or well-covered dividend stocks could offer sustained higher income streams and mitigate principal erosion.
The webinar concluded with a Q&A session that further explored the yield curve, the financial sector, asset class selection for blended portfolios, and the nuances of yield metrics. Attendees were directed to infracapfunds.com for more information and resources.