On February 8, AltsDb co-founder Jimmy Atkinson hosted Jay Hatfield, founder and CEO at InfraCap, for a comprehensive one-hour webinar aimed at financial advisors. The live session delved into sophisticated income investing strategies, meticulously tailored for the current complex macroeconomic landscape. The discussion, now available as an audio recording with a brief introduction by Andy Hagans, offered a deep dive into navigating volatile markets through strategic income generation.
The webinar, sponsored by Infrastructure Capital Advisors (InfraCap), addressed the growing appeal of income investing among high-net-worth and ultra-high-net-worth investors and their advisors. Jay Hatfield articulated that income generation forms the bedrock of a robust portfolio, particularly for individuals nearing or in retirement. He shared an anecdote about a close friend whose financial advisor had failed to prioritize yield, leading to an underwhelming portfolio. By implementing a diversified strategy with a target portfolio yield of 4% to 5%, split between bonds and equities, the friend was able to achieve financial independence, allowing him to retire comfortably. Hatfield emphasized that a reliable income stream provides a crucial psychological buffer, enabling investors to navigate market downturns with greater confidence, knowing they can reinvest at lower prices or cover expenses without depleting principal.
Hatfield, a prominent figure in the ETF industry, shared InfraCap’s perspective on the economic outlook for the coming year, following a challenging 2022 for both bond and equity markets. He attributed the market’s struggles in 2022 primarily to aggressive monetary tightening by the Federal Reserve. The Fed’s reduction of the money supply, achieved through open market operations and balance sheet reduction, effectively withdrew liquidity from capital markets, exerting downward pressure on both bond and stock prices.
Economic Outlook and Market Projections
InfraCap holds a decidedly bullish outlook for the S&P 500 in the current year, projecting a target of 4,500. This optimism stems from several key factors. Firstly, the most significant portion of the Fed’s monetary tightening is believed to be behind us. The Fed’s utilization of reverse repo operations, which effectively drained trillions from the financial system, is expected to offset future balance sheet reductions. Hatfield highlighted that this mechanism, often misunderstood, plays a critical role in managing liquidity.
While the Fed is anticipated to implement two more rate hikes, Hatfield does not foresee a significant recession. This deviates from typical recessionary patterns that often accompany Fed tightening cycles, characterized by rising long-term rates and cooling housing markets. Instead, he pointed to post-pandemic tailwinds such as housing and auto shortages, coupled with a resilient labor market, as mitigating factors. The combination of these elements suggests a potentially strong market rally as the Fed’s tightening cycle concludes. InfraCap forecasts that long-term rates will settle around 3%, which is viewed as highly favorable for the bond market.
Inflationary Dynamics and the Fed’s Approach
A central theme of the discussion was the differing views on inflation. Hatfield expressed a strong conviction that inflation is not only decelerating but that the economy is, in fact, experiencing deflation. InfraCap maintains a proprietary index, CPI-R, which has shown a consistent decline over the past four months, indicating an annualized deflationary rate exceeding 4%. This index differs from the Bureau of Labor Statistics’ (BLS) Consumer Price Index (CPI) by utilizing housing prices as a predictor for the shelter component, rather than relying on delayed owner’s equivalent rent estimates.
Hatfield criticized the Federal Reserve’s reliance on the Phillips Curve, which links inflation to the labor market. He argued that high inflation is predominantly driven by loose monetary policy, which fuels housing inflation, and energy price shocks. He pointed to the 1970s as an historical parallel, where similar housing inflation and significant energy price surges contributed to sustained high inflation. In contrast, he believes the labor market, outside of pandemic disruptions, is relatively stable and not the primary driver of inflationary pressures.
The current economic environment, according to Hatfield, is characterized by massive deflationary forces, including significant drops in natural gas prices. He contends that the Fed is misinterpreting the dynamics of inflation, failing to account for how falling goods prices, including shelter, lead to moderating nominal wage demands as real wages rise. This disconnect between real-time inflation indicators and the Fed’s reported data poses a risk, potentially leading to sticky CPI prints due to the lagged reporting of shelter costs. However, he anticipates that the Personal Consumption Expenditures (PCE) price index, which the Fed closely monitors and has a lesser weighting for housing, will fall below 3% by mid-year, prompting the Fed to pause its rate hikes.
Strategies for Income Generation
The webinar outlined several asset classes that InfraCap favors for generating income, particularly within a balanced portfolio approach.
Fixed Income Alternatives
Hatfield presented a spectrum of fixed-income alternatives, categorized by their correlation to U.S. Treasuries and the stock market.
- Treasuries: Currently offering decent yields, Treasuries provide a foundational element of stability.
- Municipal Bonds: Offering slightly lower yields than Treasuries but with reduced interest rate risk and tax advantages for certain investors.
- Corporate Bonds: At present, corporate bonds present an attractive opportunity with yields around 5.4%.
- Preferred Stocks: InfraCap sees significant value in preferred stocks, with average yields around 6%. They note that by diversifying beyond the heavily financial-weighted cap-weighted index, yields can reach significantly higher levels, with their own REIT preferred fund yielding over 7% and another fund nearing double-digit returns. Preferred stocks are characterized by modest stock market risk, generally exhibiting about half the risk of common equities.
- High-Yield Bonds: Currently yielding approximately 9%, high-yield bonds offer attractive income potential with lower correlation to the stock market compared to preferreds.
- Senior Loans: While not actively managed by InfraCap, senior loans are recognized for their lower beta to the stock market and reduced interest rate risk, offering decent yields.
InfraCap recommends incorporating exposure to a diverse range of these fixed-income asset classes to build a resilient bond portfolio, especially considering the recent rally in Treasuries and the attractiveness of other income-generating instruments.
Equity Income Strategies
On the equity side, Hatfield highlighted several sectors conducive to income generation:
- High Dividend Yield Stocks: Large-cap stocks with a history of consistent dividend payments are favored for their lower volatility and attractive income streams. InfraCap’s ICAP fund, for instance, offers a yield well above the index, enhanced by modest leverage and preferred stock holdings.
- REITs (Real Estate Investment Trusts): Despite a challenging 2022, InfraCap believes REITs are currently depressed and offer an attractive entry point. They see potential for a rebound as market pessimism around cap rates and long-term real estate values subsides.
- Telecommunications: Stocks like AT&T and Verizon are considered attractive due to their reduced valuations and good dividend yields.
- MLPs (Master Limited Partnerships): InfraCap views MLPs as a significantly improved asset class compared to their past performance. Modern MLPs are better capitalized, have lower leverage, and prioritize dividend coverage and retained earnings, making them a more stable income source. The potential for strong energy prices in the range of $80 to $100 per barrel further supports this sector.
Portfolio Construction and Yield Metrics
Hatfield suggested that even younger investors should consider a fixed-income component for rebalancing purposes. A hypothetical 30/70 portfolio (30% fixed income, 70% equity) could yield approximately 4.67%, with allocations leaning more heavily into fixed income potentially reaching 6% or even 7%. He stressed the importance of equity income to achieve overall portfolio yield targets.
Regarding yield metrics, Hatfield clarified the distinction between SEC yield and distribution yield. The SEC yield, a standardized estimate mandated by the SEC, reflects the income expected from a portfolio based on dividend yields, minus expenses. The distribution yield, conversely, represents the actual payout to investors. He advised advisors to favor funds where the SEC yield is at least on par with the distribution yield to avoid return of capital notices and ensure the sustainability of income distributions without eroding principal.
Preferred Stocks: An Undervalued Opportunity
Preferred stocks were identified as a particularly attractive asset class currently. Many preferred securities are trading at a discount to their call price, offering potential for equity-like capital appreciation as they revert to par value, coupled with attractive dividend yields. InfraCap’s flagship preferred stock fund, PFFA, yields well over 9%, with a significant portion of its holdings being cumulative preferreds, offering enhanced safety relative to common equities.
Public vs. Private Market Valuations
In response to a question about public market valuations compared to private funds, Hatfield acknowledged that publicly traded securities, particularly in the current environment, can exhibit greater volatility and may trade at discounts relative to private market valuations. He noted that preferred stocks, for example, are trading at levels that suggest a discount to their intrinsic value. This inefficiency presents an opportunity for investors to access alternative assets within the public markets through ETFs and closed-end funds, which offer greater liquidity and transparency compared to many private investment vehicles.
Conclusion
The webinar concluded with a discussion on alternative strategies for investors seeking yield, including short-term Treasuries and CDs. While these can provide safety and predictable income, Hatfield emphasized that they may not offer the same level of return potential as other income-generating asset classes like preferred stocks or high-yield bonds, particularly when considering the possibility of declining short-term rates. The overarching message was that a well-diversified income investing strategy, tailored to individual risk tolerance and time horizons, is crucial for navigating the current economic climate and achieving long-term financial goals. For further information, interested parties are directed to infracapfunds.com.
