Each generation faces its own unique investment challenges. During the inflationary 1970s, maintaining the purchasing power of income and assets was a preoccupation for both wage-earners and investors. In the first decade of this century, protecting the downside in any portfolio exposed to two of the most dramatic stock sell-offs in history (2002 and 2009) would have been a priority. Today, one of the toughest challenges facing investors in a low-yield environment is the problem of converting a lifetime of savings back into a livable income stream.
At this writing, the 10-year Treasury yield falls in the neighborhood of 2.4%, having touched 3.0% during the last six months. At such yields, half a million dollars in savings produces less than $15,000 in pure yield.
The first step to solving this problem is to think more globally about the problem of income. Many conservative investors slot themselves as bond investors or as muni bond investors and never revisit the problem of income production. In a low-rate environment, such thinking can impose significant opportunity costs. The average return for the S&P 500® over the last 10 years is just over 8%, and that period includes one historic bear market. So the inclusion of some stocks in an income-oriented portfolio can boost total return.
The inclusion of some high-quality dividend-paying stocks can also contribute a dividend yield of 4% or better to a portfolio’s cash flow, together with some potential appreciation. Companies that have a tradition of sharing profits with investors through dividends like to increase their dividends over time, whereas the coupon yield on a bond never changes.
Some selective exposure to high-yield bonds can also boost total income, especially at a time when default rates are low. There have been many times when high-yield bonds have earned the name “junk,” but in 2013 when high-quality bonds sold off sharply, a small exposure to high-yield would have actually helped to reduce risk in a diversified portfolio. We prefer to obtain this exposure through a modest allocation to a well-managed high-yield fund large enough to absorb one or two isolated defaults.
Managed limited partnerships (MLPs) are tax-advantaged investments in pipelines that pay attractive income streams (4-7%). A widely cited index of MLPs has more than doubled in price appreciation alone over the last five years. Their tax treatment is complex and they are not risk-free, but they do not move in lock-step with either stocks or bonds and can play a part in solving the income puzzle for many patient investors.
Bank loan funds have the advantage of paying attractive, variable rates of interest. Because bank loans reset frequently, they are not as vulnerable as bonds to a loss of market value in a rising-rate environment. In fact, bank loans will closely track rising rates in such an environment. These qualities do not come without some offset — bank loans are less liquid than bonds and their credit quality is typically lower.
None of these solutions is a silver bullet for the income problem. Stocks can be volatile and dividend-paying stocks will react to both a selloff in the stock market as well as an increase in interest rates. High yield bonds will sell off in a credit crunch or in any flight to quality. MLPs suffered a sharp downturn in 2008 when hedge funds dumped them in order to fill redemption orders and bank loans could prove very illiquid in any widespread sell-off. But as complements to a solid core of high-quality bonds, all of these peripheral strategies can help an investor solve the problem of income in a low-yield environment. Successful implementation leads us back to the time-honored practice of diversification.*
Philip Rich, Chief Market Strategist
* Diversification cannot guarantee a profit or protect against loss in a declining market.
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