On February 8th, financial advisors convened for a live, hour-long webinar hosted by AltsDb co-founder Jimmy Atkinson, featuring Jay Hatfield, founder and CEO of InfraCap. The session meticulously dissected income investing strategies, offering practical guidance tailored to the current complex macroeconomic landscape. This in-depth discussion, also made available as an audio podcast with an introduction by Andy Hagans, provided a crucial platform for financial professionals to navigate the evolving investment terrain.
The webinar, titled "Income Investing Strategies for Volatile Markets," underscored the increasing relevance of income-generating assets in an environment characterized by uncertainty and fluctuating market conditions. InfraCap, a prominent player in the Exchange Traded Fund (ETF) industry, brought its expertise to bear on a topic of significant interest to AltsDb’s audience, which predominantly consists of high-net-worth and ultra-high-net-worth investors and their advisors.
The Enduring Appeal of Income Investing
Jay Hatfield opened the discussion by addressing the fundamental question of why income investing has garnered such significant traction. He posited that income generation is not merely an option but the very cornerstone of a robust, high-quality portfolio, particularly for individuals nearing or already in retirement. Hatfield illustrated this point with a personal anecdote: he assisted a high school friend who had recently parted ways with an advisor. Upon reviewing the friend’s portfolio, Hatfield noted a distinct lack of substantial yield, exacerbated by high management fees. By constructing a diversified portfolio with a target yield of 4% to 5%, comprising approximately half bonds and half equities, Hatfield provided his friend with the financial security needed to retire.
"It’s really the core to a high-quality portfolio, and particularly, of course, for people who are either nearing retirement or in retirement," Hatfield stated. He emphasized that a reliable income stream offers a critical psychological buffer, enabling investors to maintain composure even during periods of market turbulence. The ability to reinvest dividends and interest payments at lower prices during downturns, or to draw upon income to cover expenses with confidence, provides a level of stability that capital appreciation alone cannot guarantee. Hatfield further noted that these income streams have demonstrated resilience and growth even amidst broader market declines, a strategy he applies to his own portfolio as well.
Navigating the Economic Landscape of 2023
The conversation then shifted to the broader economic outlook for the year ahead, following a challenging 2022 for both bond and equity markets. Hatfield, who had accurately predicted a negative market sentiment for 2022, particularly concerning tech stocks and speculative assets like cryptocurrencies, explained his rationale. He attributed the market’s struggles directly to the Federal Reserve’s aggressive monetary tightening.
"The Fed was tightening, they were reducing the money supply dramatically," Hatfield explained. He highlighted that the Fed’s reduction in the money supply, primarily through open market operations rather than solely interest rate hikes, effectively drained capital from the financial markets, impacting both bond and stock prices. This liquidity reduction, he argued, was the driving force behind the widespread market pain experienced in 2022.
Looking ahead to 2023, InfraCap projected a more optimistic scenario, setting a "top decile target on the S&P of 4,500." This bullish outlook was predicated on several key factors. Foremost among these was the expectation that the bulk of the Fed’s monetary tightening was nearing its conclusion. Hatfield pointed to the Fed’s use of reverse repo operations, a mechanism to absorb liquidity, as a critical but often misunderstood component of their strategy. He suggested that the significant reduction in the money supply achieved through these operations in 2022 would likely be offset by future Fed actions, easing pressure on capital markets.
While acknowledging that the Fed might implement two additional rate hikes, Hatfield expressed confidence that they would not implement further aggressive tightening. He also highlighted several post-pandemic tailwinds that would mitigate the risk of a severe recession, including persistent shortages in housing and automobiles, and a remarkably resilient labor market. These factors, he argued, are atypical in a tightening cycle, suggesting a potentially stronger economic backdrop than historical precedent might indicate.
The Inflation Conundrum: A Divergent View
A particularly striking point of contention raised by Hatfield was his assessment of the Federal Reserve’s approach to inflation. He boldly stated, "The Fed is completely out to lunch on inflation." Hatfield elaborated that the Fed’s reliance on traditional indicators, such as the Phillips Curve, which links inflation to unemployment, fails to capture the true drivers of current inflationary pressures.
Hatfield introduced his firm’s proprietary index, CPI-R, which he described as a more accurate, real-time measure of inflation. This index, he explained, calculates CPI using housing prices rather than the Bureau of Labor Statistics’ (BLS) owner’s equivalent rent, which has a significant lag. Based on CPI-R, Hatfield asserted that inflation had not only decelerated but had, in fact, entered a deflationary phase, with his index showing a negative annual rate of over 4% in recent months.
He identified two primary drivers of high inflation: loose monetary policy, which inflates the housing sector, and energy price shocks. He contrasted this with the Fed’s focus on the labor market, arguing that while the labor market influences moderate inflation, it is not the primary cause of high inflation. Hatfield pointed to the dramatic increase and subsequent decrease in the monetary base as evidence of the Fed’s role in volatile asset prices. Furthermore, he noted that energy prices, particularly natural gas, had fallen significantly, contributing to deflationary pressures.
This divergence in inflation outlook has critical implications for monetary policy. Hatfield contended that the Fed’s continued rate hikes, while perhaps inevitable given their current policy stance, are misaligned with the underlying deflationary forces at play. He expressed concern that this policy disconnect could lead to an odd situation where reported inflation figures might appear high due to lags in data, while the economy experiences genuine deflation.
Strategic Asset Allocation for Income and Growth
The webinar delved into practical strategies for building portfolios that balance income generation with potential for growth. Hatfield emphasized the importance of a diversified approach, encompassing both fixed income and equity income asset classes.
Fixed Income Alternatives:
Hatfield outlined several fixed-income alternatives, ordered by their correlation to U.S. Treasuries and the stock market:
- Treasuries: Currently offering decent yields, providing a foundational element of safety and income.
- Municipal Bonds: Offering similar interest rate risk to government bonds but with potential tax advantages for certain investors.
- Corporate Bonds: Becoming increasingly attractive with yields around 5.4%, offering a step up in income and moderate stock market risk.
- Preferred Stocks: Highlighted as a particularly compelling asset class, with average preferred stocks yielding around 6%. Hatfield noted that by moving beyond cap-weighted indices heavily weighted towards financials, investors could access significantly higher yields, with some REIT preferred funds yielding over 7% and other strategies approaching double digits. These offer approximately half the risk of common stocks.
- High-Yield Bonds: Attractive at present with yields around 9%, exhibiting lower correlation to the stock market than preferred stocks.
- Senior Loans: Offering lower beta to the stock market and reduced interest rate risk, with decent but not exceptionally high yields.
Hatfield recommended incorporating exposure to all these asset classes within a diversified bond portfolio, especially given the recent run-up in Treasury prices, which made them less attractive at the beginning of the previous year.
Equity Income Strategies:
On the equity side, Hatfield discussed several sectors and asset classes suitable for income-oriented portfolios:
- Utilities: While historically offering steady income, Hatfield noted that this sector currently appears overvalued, reflected in its low yields.
- REITs (Real Estate Investment Trusts): Considered attractive due to depressed valuations following excessive pessimism. Hatfield suggested that the market for REITs, particularly office and retail properties, is poised for a rebound.
- Telecom: Offering good yields as stock prices have moderated.
- MLPs (Master Limited Partnerships): Hatfield expressed a strong liking for MLPs, emphasizing their evolution into a more stable and better-capitalized asset class. He acknowledged past investor apprehension due to the "K-1" tax structure and past growth-stock orientation but highlighted that current large-cap MLPs are well-covered by free cash flow, retaining earnings for growth and share buybacks, and have reduced leverage.
- High Dividend Yield Stocks: These are central to InfraCap’s strategy, with their ICAP fund targeting higher yields. Hatfield noted that large-cap dividend aristocrats have historically delivered comparable returns to the NASDAQ with significantly lower volatility and superior income, which is critical for conservative investors.
Building a Balanced Portfolio for Different Horizons
Hatfield presented a hypothetical portfolio demonstrating how different allocations between fixed income and equity income could achieve varying yield targets. A 30/70 fixed income/equity split was projected to yield approximately 4.67%, while increasing the fixed income component could push yields to 6% or even 7% for more conservative investors. He stressed that achieving substantial income requires robust income generation from the equity portion of the portfolio, moving beyond the low yields of broad market indices like the S&P 500 (currently yielding around 1.7%).
For younger investors with longer time horizons, Hatfield suggested a more aggressive approach. This might involve reducing or eliminating Treasury exposure and increasing allocations to higher-yielding assets like high-yield bonds and preferred stocks, which can offer equity-like returns. A greater allocation to equities, potentially including more volatile sectors like tech, could be balanced with income-generating assets like MLPs and REITs.
Preferred Stocks: A Compelling Opportunity
Hatfield particularly emphasized the current attractiveness of preferred stocks. He explained that many preferred stocks are trading at a discount to their call price (par value), offering the potential for capital appreciation as they revert to par. This, combined with their attractive dividend yields, presents a compelling risk-reward profile.
He highlighted that 90% of the preferred stocks in InfraCap’s flagship fund, PFFA, are cumulative, meaning that missed dividends must be paid back. This structural feature, coupled with the low default rates observed for preferred stocks over the long term (comparable to investment-grade bonds), makes them a relatively safe income-generating asset, especially when actively managed to avoid distressed credits and securities trading significantly above par.
Master Limited Partnerships: A Renewed Outlook
Regarding MLPs, Hatfield addressed the past negative sentiment. He explained that historically, MLPs were structured for growth, often with high leverage and low dividend coverage. However, the industry has undergone significant restructuring. Today’s MLPs, he argued, are characterized by well-covered dividends, lower leverage, and a focus on sustainable free cash flow generation. This transformation, coupled with a supportive energy price environment, makes MLPs a viable income and total return investment, particularly for those who can navigate the partnership tax structure or invest through corporate wrappers like InfraCap’s MLP ETF.
Q&A Highlights and Future Outlook
The Q&A session provided further clarity on several key issues. Regarding the yield curve, Hatfield predicted it would likely remain inverted for the next two years due to the Fed’s cautious approach but expected long-term rates (10-year and 30-year Treasuries) to settle around 3% to 3.25%, driven by global demand for bonds and modest economic growth.
On the financial sector, he expressed a positive view, noting that banks benefit from an inverted yield curve and that fears of widespread loan write-offs are likely overstated, especially given the resilience of the housing and auto markets. He suggested a potential rotation into riskier investment banks later in the year as the market anticipates a Fed pause.
Addressing the distinction between yield metrics, Hatfield clarified that SEC yield is a standardized, calculated estimate of income after expenses, while distribution yield represents the actual payout to investors. He cautioned against funds that pay high distribution yields but have significantly lower SEC yields, as this may indicate a return of capital rather than true income generation.
Finally, when asked about short-term Treasuries and CDs versus other income-generating assets, Hatfield acknowledged their safety but emphasized the missed opportunity for higher returns and potential capital appreciation available in assets like preferred stocks and MLPs, particularly when purchased at discounts. He reiterated that for investors seeking to outpace inflation and grow their principal, a diversified approach that includes these higher-yielding, actively managed alternatives offers a more robust long-term strategy.
The webinar concluded with an offer for attendees to access the presentation deck and recording, directing them to infracapfunds.com for further information and engagement. The discussion underscored the critical role of informed asset allocation and a nuanced understanding of macroeconomic trends in successfully navigating the contemporary investment landscape.
