For a decade or more, we have been in an historically low interest rate environment. The interest on 10-year Treasury bonds has languished below 9% since the late eighties- almost twenty-five years ago. We haven’t seen a 5% yield on the 10-year Treasury since 2000, more than a decade and a half ago. Today’s current yield for the 10-year Treasury is under 2%.
Where to find a better yield on bonds?
Investors are tempted to buy very long maturity bonds or to dive deep into lower credit quality in search of yield. Another term for these high yield bonds are “junk bonds” because they are usually below investment grade in credit quality. Any additional yield realized by this strategy comes at the price of very real increased risk. Unlike stocks, a bond is not an ownership stake in a company. It is a loan you make to the company with a stated interest rate. If the loan is repaid when due, and you receive all of your interest payments on time, then you get your money (principal) back as well as the return (interest income) on your money. However, if the bond goes into default, you will get nothing back. Another problem with junk bonds is that they act like stocks when the stock market falls. When investors get scared, they pour money into the safest bonds, causing the price of junk bonds to drop right along with stock prices.
Since your profit is limited to the interest rate on your bond, a very long bond could suffer in comparison to newer bonds that may be issued at a higher interest rate. This is especially true now as the Federal Reserve has just started what they have signaled to be a gradual rise in interest rates. Both long bonds and junk bonds have a limited upside (the interest rate) and a downside risk almost as great as stocks. If you are going to assume the very real risk of your bond going to zero, you might as well own the stock of the same company-at least you will have a larger potential upside.
While the current 1.5% yield on a 5-year U.S. government bond is not very exciting, the purpose of short to intermediate, high quality bonds in a diversified portfolio is to counterweight the equity positions and provide a stabilizing influence in rocky markets.
What about high dividend stocks?
The average dividend yield on the stocks in the S&P 500 has also fallen from a 60-year historical average of 3.28% to just over 2% today. The actual dividend yield for most of the dividend paying stocks in the S&P 500 is between 1% and 2%. Only 40 stocks have a current dividend yield of 4% or higher. A portfolio of only those 40 stocks would be concentrated in three or four economic sectors and would fail to provide adequate diversification.
Dividends don’t grow on trees – they have to come from somewhere and that “somewhere” is either the company’s profits or its capital reserves. Stockholders have always liked receiving dividends, but academic research has shown the dividends paid today shrink the assets of the company and reduce its future earning power.
Still, investors find owning these more stable, “Blue Chip” stocks comforting because they are well-known companies with a history of regular dividend payments. Many times they don’t realize that the dividend yield on a stock has increased solely because the stock price has fallen (see the equation above). Investors in 2008 found that the high dividends they had been enjoying from their bank and other financial services stocks all but dried up during the great recession.
Just last week Bloomberg News ran this story:
Where to turn?
This is not to say that high dividend stocks and lower credit quality (but still investment grade) bonds have no place in a diversified portfolio, but investors are not likely to meet their total withdrawal needs solely through an income yield strategy.
Resist the urge to view your portfolio income and portfolio principal as two mutually exclusive components. Instead, adopt a portfolio-wide withdrawal strategy that includes the entire portfolio. In addition to the yield on your portfolio, whether from stocks, bonds or real estate, you also hold in your arsenal capital appreciation, fixed income and cash reserves, and expense management. This is a total return strategy.
Optimizing the Total Return Approach
At Focus Wealth Management, we take several measures to optimize your total return strategy. We draw from portfolio income (dividends, interest and distributed capital gains) and also from capital appreciation – which is the profit or gain in your individual securities that can be sold to fund planned withdrawals.
Typically, sales are made when the value of a security or an asset class increases to a level above its target allocation. Selling at these high points is a disciplined way to sell high and buy low. This tactic is at the heart of portfolio rebalancing-maintaining the desired or target asset allocation among a wide variety of asset classes. For a newly constructed portfolio, there may not be gains early on when the first withdrawals are needed. In that case, you could draw on your bonds and cash reserves until the equities have an opportunity to appreciate.
A simplistic income-generation plan is rarely the optimal strategy for funding your retirement income needs. Instead, a total return strategy, with an appropriate amount of risk is the preferred approach. By focusing on factors that you can control, such as tax-management and using low-cost investment vehicles, we can create a portfolio that is broadly diversified, meets your liquidity needs, and suits your risk tolerance.