Investors are desperate for income. But how can advisors satisfy them when traditional fixed-income portfolios—usually relied upon for safety—have become so risky?
With yields still low and interest rates on the rise, advisors say it’s critical to start thinking differently about how to balance immediate income needs with long-term portfolio preservation.
“This is a hard time to generate investment income in the usual ways,” says Randy Carver, president of Carver Financial Services in Mentor, Ohio. “If interest rates continue to rise—which we believe they will— that hurts the value of your longer-term fixed-income investment, but if you choose short-term fixed income, your yields will still be very low.”
As rates rise, bond prices fall, and it doesn’t take much to cause serious damage to a retirement portfolio: A one percentage-point interest-rate increase would cause about a 17% decline in the value of a 30-year Treasury bond. Volatility is less severe in shorter-duration fixed income, but income investors can’t be sustained by short-term yields alone. The three-year Treasury yield has been rising steadily this year but is still only 2.7%.
What’s an income investor to do?
We consulted savvy advisors who have been investing long enough to have experienced the jarring effects of rising rates. Here are their best ideas for income investors in today’s tough conditions:
Emphasize total return
Traditionally, income investors scoured for best yields, and stocks had no place in a discussion about how to sensibly live off of an investment portfolio, unless they paid a dividend. But times have changed. “Portfolios dominated by bonds either aren’t going to pay enough or will be incredibly risky—disastrous, even,” says Steve Cassaday, chairman of Cassaday & Company in McLean, Va. “Investors need to be harvesting the total returns of their portfolios, which include not just dividend and income, but portfolio gains, too.”
This may mean holding more in stocks to help drive growth, and paring back traditional fixed income, whose total returns are already suffering. Just look at corporate bonds. Average yields on high quality are 3.9%, but total returns are in negative territory this year. Over time, paired with inflation, this could quickly erode the value of a portfolio that has to last a lifetime.
“We expect three- to seven-year equity returns to be much higher than fixed-income returns,” says Wally Obermeyer, co-chairman and president of Obermeyer Wood Investment Counsel, in Aspen, Colo. “People will be paid more handsomely for their equity.”
How do stock returns convert to cash? Through regular rebalancing. Each quarter, bring targeted asset allocation back into line by selling off investments in outperforming asset classes, Cassaday says. The cash generated can be pocketed or, if it’s not needed, reinvested.
Dividend-paying stocks should be a staple, with a strong caveat: Don’t reach for the highest yields, which may be a sign of a company’s distress.
“We’re focused not on high-dividend payers, but dividend growers,” says Jordan Waxman, a managing partner at HSW Advisors in New York. “Dividend growth is a marker for the health of a company.”
The average dividend yield on S&P 500 (.SPX) companies is just under 2%, but yields are heading higher. So far this year, dividends have increased by an average 14%, up from 11.4% last year according to Standard & Poor’s. S&P compiles a list of Dividend Aristocrats, which are companies in the S&P 500—such as Exxon Mobiland Johnson & Johnson—that have consistently raised dividends for at least 25 years. Their average yield: 4.1%.
10 income investments favored by the pros
To help protect your portfolio from rising rates, consider these income alternatives.
|Fund or Security/Ticker||Description||Yield||Expense Ratio|
|WisdomTree U.S. SmallCap Dividend ETF / DES||Basket of low-risk, stable small-cap value stocks.||2.87%||0.38%|
|WisdomTree U.S. Quality Dividend Growth ETF / DGRW||Fund of large profitable companies with potential to raise dividends; emphasizes total return.||1.88%||0.38%|
|Vanguard Dividend Appreciation ETF / VIG||Aims to mirror the Nasdaq U.S. Dividend Achievers Select Index; comprised of large-cap consistent dividend growers.||1.82%||0.08%|
|Nuveen Short Duration High Yield Municipal Bond / NVHIX||This fund bested the Bloomberg Barclays Municipal Bond Index over one, three and five years through July; pays a tax-free yield.||3.86%||0.61%|
|iShares U.S. Real Estate ETF / IYR||ETF invests in U.S. real estate companies and REITs and tracks the Dow Jones U.S. Real Estate Index.||3.63%||0.43%|
|DFA Global Real Estate Securities Portfolio / DFGEX||This fund invests in large and medium global real estate comapanies, with a higher tilt toward the Americas than its category average.||3.01%||0.24%|
|Lord Abbot Short Duration Income / LDLFX||Active management across credit sectors, including high-yield corporates and emerging market bonds. More volatile than a typical short-term bond fund; potentially higher total returns.||3.86%||0.49%|
|Transamerica Short-Term Bond / ITAAX||Dipping into lower end of the high-quality corporate bond spectrum has led to returns ahead of the short-term bond category average.||2.08%||0.84%|
|Enterprise Product Partners / EPD||MLP transports oil, gas and petrochemicals. Poised to benefit if natural-gas exports increase, as expected. Morninstar calls EPP a “chess master” while others play checkers.||5.80%||N/A|
|Magellan Midstream Partners / MMP||Owner of U.S.-based pipelines and storage, this MLP collects fees for transporting petroleum, crude oil and other products. Management has reacted nimbly to changing market conditions.||5.22%||N/A|
Sources: Morningstar; company information
Be sure to emphasize a stock’s total return and not just its yield, says Carver, who likes the WisdomTree U.S. SmallCap Dividend (DES) and Vanguard Dividend Appreciationexchange-traded funds (VIG).
Tap traditional bonds for stability
If you hold a Treasury bond to maturity, there’s no risk of losing principal, even if rates rise. But not so for fixed-income mutual funds and ETFs. “One of the biggest mistakes is thinking bond funds are safe and stretching for yield,” Carver says, adding that the primary purpose of fixed income in a rising-rate environment should be to provide safety, not yield.
To accomplish this, advisors recommend reducing bond durations to about five years or less and laddering maturities. “Starting last year, we invested in one- to five-year evenly laddered investment-grade ETFs,” says Robert Fragasso, CEO of Fragasso Financial Advisors in Pittsburgh, who weathered rising rates unscathed in the 1970s with laddering like that. Every year, as 20% of the portfolio comes due, it’s rotated into the longer end of the ladder. “Meanwhile, our portfolio’s total return will give us what we need to live off of,” Fragasso says.
Carver recommends using mutual funds with active managers who can be nimble in responding to changing market conditions. He likes Lord Abbott Short Duration Income (LDLFX) and Transamerica Short-Term Bond (ITAAX).
Dipping into the lower end of high quality can add extra yield without much more risk. Obermeyer says he likes bonds one notch up from high yield. “It’s not real junk. We like a short duration and want to be confident in their shorter-term cash flows— that they’ll be good for paying out two years from now.” BB-rated bonds are yielding about 4.3%, compared with an average 3.9% for high-quality corporates.
When it comes to high-yield bonds, there are few opportunities, says Malcolm Makin, president of Professional Planning Group in Westerley, R.I. But he maintains exposure to Pimco Income fund (PONPX), citing its savvy active management and flexibility to hold bonds across sectors—including high yield.
Consider higher-yielding alternatives
Once a low-risk ladder is established, consider investments that can spice up yield and total returns, without heaping on risk.
Dividend ETFs with a focus
The high-yield municipal bond landscape still offers some opportunity, especially for residents of high tax states like New York, New Jersey, Illinois, and California who lost the ability to deduct much of their state taxes under the new tax law, Waxman says. “Instead of seeing a tax break, some of these people will see a tax hike.”
This effectively increases the value of municipal bonds, whose income is tax-free. On a short-duration municipal bond fund, investors in the highest tax bracket can expect to earn about two to three percentage points more (on an after-tax basis) than on an investment-grade fund, says Waxman, who likes the Nuveen Short Duration High Yield Municipal Bond fund (NVHIX), which has a 3.86% tax-free yield and a 0.61% expense ratio. This is about typical for a short-term high-yield muni fund. “And the credit metrics are strong— municipalities are in good shape,” Waxman says.
He also likes master limited partnerships, which investors dumped en masse in 2015 as oil prices tanked and brought share prices down with them. MLPs are publicly traded partnerships that often own energy infrastructure such as oil pipelines.
MLP fundamentals are attractive, and valuations—measured as price to distributable cash flow, among several other metrics—are close to early-2016 levels, when oil prices had fallen to $26 per barrel and volumes of oil and natural gas were on the decline, Waxman says. “Now, oil is at $69 a barrel, volumes of oil and natural-gas production are at record levels, and balance sheets and distribution coverage have been greatly improved—yet valuations are still stuck toward historical low levels,” he says. To boot, MLPs are yielding 5% to 6% or more, “and we couldn’t be in a more favorable regulatory environment for energy.”
Like MLPs, REITs may seem hard to cozy up to, based on recent performance. They’re barely in positive territory this year, but they’re a great diversifier. They also yield between one and two percentage points more than bonds and have strong total return prospects. Advisors recommend 5% exposure, using strong fund managers who can avoid trouble spots such as department stores, and look for growth areas such as warehouses and suburban office space.
REITs and MLPs got a boost by the Tax Cuts and Jobs Act, effective this year. The new law allows a 20% tax deduction on REIT and MLP income, effectively lowering the top tax rate on the income from the top income-tax rate—now 37% under the new law—to 29.6%.
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