ETF Income Strategies for Defensive Investors

We feel that because of the way the strategy is structured, it's able to potentially thrive regardless of the direction of interest rates because of the two screens that it implements. I'm Britney Mason with ETF Guide, and it's great to have you with us. If you're new to ETFU TV, be sure to hit the subscribe button to join our community. Also, post your likes and comments in the section below this video. We enjoy interacting with our viewers.

Today we are pleased to have with us Chandler Nichols, vice president of ETF product at Advisor Asset Management. Chandler, it's great to see you again. Great to be back. The Fed seems unsure where interest rates will go. How is the AM SLC low duration income ETF, ticker LOI, managing the current uncertainty about inflation and rates?

That's a great question, and just to set the stage and give a quick primer on the strategy, LOI is an actively managed ETF. It's sub-advised by SLC fixed income, who's an affiliate company of ours here at AAM. They have a vast amount of experience in managing different types of fixed income portfolios with well over 140 billion in assets under management. The value that this particular strategy of theirs and what it's providing in this what we call a stagflation light environment is its fundamental bond picking strategy.

Regarding interest rates, just to answer that part of the question, LOI actually seeks to stay duration neutral to its benchmark. So typically its duration tends to hover anywhere from one and a half to two years, so definitely on the lower end of the duration spectrum. The primary value add from that strategy typically comes from that security selection process and the ability for the portfolio managers to stay unconstrained from a sector standpoint where they can invest in other security types outside of just your typical corporate credit sectors. So think asset-backed securities, commercial mortgage-backed securities, collateralized loan obligations, also known as CLOs.

Right now, these sectors are a bulk of the portfolio and where the managers have been taking profits where necessary and then redeploying that capital into higher quality securities within those particular sectors. So that's how we feel that the strategy is really able to navigate both of those sides of the current environment. What specific sectors or credit qualities is the fund currently rotating between and why?

Yeah, definitely it's a good question to get a little deeper into. The set the stage LOI's portfolio is largely an investment grade portfolio. So for example, right now most of its exposure can be found anywhere from single A rated to triple B rated debt, so on the lower end of the investment grade spectrum. From a sector standpoint in particular, its largest overweights are found within primarily that CMBS and ABS sector. Now most of the positive spread opportunities are where the PMs feel that where they can potentially find more value add opportunities in order to outperform other corporate credit counterparts in the marketplace.

Of these two subsectors, ABS has typically encompassed the bulk of the strategy sector exposure for the vast majority of its inception. CMBS is a newer overweight where they're seeking to find loans backed by higher quality properties that are demonstrating a level of positive relative valuations to other securitized segments. Going into this year, credit spreads were already pretty tight across multiple types of fixed income sectors to begin with. Now that spreads have widened a bit post pre-liberation day, as they called it, there's a lot more opportunity in some of these more deep value sectors in the marketplace.

What investors does the AAM SLC low duration income ETF, ticker LOI, especially appeal to? So we feel there's two types of investors this appeals to. One is that cash plus investor who's willing to take on a level of credit risk and an uptick in duration risk in order to potentially increase both their income potential but to also increase the inflation beating characteristics of their fixed income portfolio as well. So it's important to remember while cash and money markets and money market alternatives, they are safer instruments and they feel safer, but their ability to drive inflation beating returns in the long run is definitely on the lower end of the spectrum.

So we feel LOI could potentially be a good complement for those types of investors looking to increase their income potential. The second type of investor is the core fixed income investor. That value add from that bottoms up fundamental bond picking strategy could potentially be a nice fit here for an investor who's one seeking to lower duration to be a little more defensive on that front, but also looking for sector diversification as well. I mean, for example, the Bloomberg aggregate bond index, it's basically one of the most well-known bond indexes out in the marketplace typically has minimal exposure to securitized sectors as do other broad benchmarks out there. So overall we feel LOI can be a good complement to those types of strategies to increase sector diversification.

To investors overall, we feel LOI can be a nice potential choice. For the AAM low duration preferred and income securities ETF, PLD, is also a low duration fixed income fund. How does the current interest rate environment affect it? I mean, to set the stage on what PFLD is to begin with, we just went through LOI. LOI is an actively managed ETF, but PLD is actually an index based strategy.

So we feel that because the way the strategy is structured, it's able to potentially thrive regardless of the direction of interest rates because of the two screens that it implements. It starts off with a broader universe of the US preferred stock landscape and incorporates a duration screen where upon its monthly rebalance, PLD will seek to remove any preferred stocks with a duration above that of five years or more. But on the flip side, it'll also remove preferreds that are trading greater than 5% to the face value of the preferred as well. So basically in that higher interest rate environment or rising interest rate environment, preferred duration stream could potentially help navigate a time of higher interest rate volatility and potentially lower the volatility of the strategy in comparison to other like longer duration counterparts.

That call screen, as I mentioned earlier, is what I like to call it, is potentially could thrive in a lowering interest rate environment. So to take a step back, preferred stocks overall are typically issued with embedded call options to give the issuer the right to call that back. So PLD, if it had a by being able to navigate through those types of risks, PLD could potentially mitigate its exposure to those types of securities in order to lower the level of reinvestment risk that could occur in the portfolio. So two twopronged approach while low durations in the name, it's a we view PFLD as a pretty evergreen strategy regardless of the direction of rates.

How do LOI and PFLD complement each other in a fixed income allocation and what are the key tradeoffs between corporate bonds and securities versus preferred securities for income generation? To start with the latter question first, when comparing the overall capital stack, you know, very high level, you have your corporate bonds on the higher end, then preferred shareholders will get paid after bond holders, and then common equity holder dividends are paid thereafter. So because preferred sit in the middle of that, they're typically known as hybrid securities and they tend to have characteristics of each both bonds and equities. So when complementing them together, the investor should be aware of that PFLD is viewed as the quote unquote higher volatile investment relative to LOI because it's investing in a basket of preferred stocks.

Now the trade-off there is that PFD would also be expected to have a higher level of income potential and also a potential a higher level of inflation beating return potential as well. So that's the trade-off in terms of preferred and how we view those strategies in a portfolio. Just to also answer the question in full in terms of the PFLD benefits versus LOI is the potential tax efficiencies of preferred stocks. So preferred stocks in general tend to have the ability to have their dividends treated as qualified dividends.

So an investor is not just looking for higher income but higher after tax income could be another way to see these two together in a potential portfolio mix. What investors does the AAM low duration preferred and income securities ETF, PFLD, specifically target? Typically two types here again. So one is the fixed if the fixed income investors seeking to really increase their after tax income potential. Let's say the most common swap story we hear about in the preferred space typically happens within the near below investment grade or the below investment grade market that high yield bond space.

We've seen investors either complement the two together or fully replace their high yield bond exposure with preferred in order to potentially keep risk in a similar range to what they've been accustomed to on the high yield bond side, but while increasing the income potential and increasing the tax efficiencies as well. So being able to achieve a higher level of tax efficient income is a general story with preferred stocks and how they could potentially be a benefit relative to bonds who are typically taxed at higher ordinary income tax rates. For the second investor type that we feel PFLD could be a fit for is actually the defensive equity investor too.

Taking a step back, preferreds are typically issued the largest issuers of preferred tend to be large financial institutions. So think like your largest banks. So an investor that either currently has exposure to this segment of the market or is seeking to increase their banking sector exposure, maybe they want to play that in a more defensive manner. Instead of going to the common equity side of the space, they can look to the preferred side of the space. So that's where we also feel PLD could be an enticing option as well. So yeah, again, two different types of investors, but we feel PLD can be a good fit for both of those.

Thank you, Chandler, for your timely insights. Thanks for having me. Please visit aamlive.com. I'm Britney Mason with ETF Guide. Thanks for watching. We'll see you next time.