This year, interest rates rose from near-record lows as the market began to anticipate changes in monetary policy by the Federal Reserve. But despite the rise, rates are still historically low, and many investors have struggled to produce income from their portfolio.
Do you stick with historically “safe” Treasuries and their low yields? Or reach out for higher yields and the risks that come with them? Or do you consider non-bond income-generating investments like dividend-yielding stocks or real estate investment trusts? And are you better off with individual securities, funds, annuities, managed accounts, or some combination?
There is no one right answer—you need to examine complex trade-offs between growth, guarantees, access, and inflation protection and make sure your strategy works for your unique goals, time horizon, and risk tolerance. A key part of your strategy should be how to manage guaranteed income sources, which include Social Security, pensions, and annuities. But you may also want or need to generate income from your investment portfolio. And regardless of your stage in life, there may be times you want to generate income for a specific goal—to pay college bills, for example.
Also, your tax situation will come into play. After all, it's not what you make but what you keep after tax that counts. So, although this Viewpoints article doesn’t delve into the nitty-gritty of the tax treatment of investment income, which can vary greatly depending on what you own and your overall financial situation, you’ll want to discuss that with a tax professional.
To help you get started in your analysis, we lay out some of the options—and the trade-offs—along a risk-reward spectrum. Then we show a few examples, based on strategies used in Fidelity funds, of how different types of investors with differing goals and investing styles might piece together a portfolio with the potential to generate income.
Let’s start with the basics, beginning with higher-risk, non-bond options and ending with government bonds.
Qualified dividend-paying equities. These stocks offer a combination of income and growth potential—attractive attributes for investors who need to fund a retirement that may last two decades or more. Owning stocks has historically meant more volatile returns than bond investments. But recently, resilient corporate profits and low interest rates have led more income-oriented investors to brave those risks for higher yields. The yield on the S&P 500® was 1.97% as of October 1. And don’t ignore the growth potential of companies based overseas, some of which may provide stronger dividend payments than their domestic counterparts.
"Unlike bonds with fixed coupons, dividend-paying stocks can offer a rising income stream over time as dividends grow with earnings," says Scott Offen, a Fidelity portfolio manager who invests in dividend-paying stocks. "Rising income and the potential for capital gains may offset inflation more easily than fixed income alternatives," he adds. In addition, according to Offen, there are several reasons dividends may have become particularly attractive recently. "Corporations have been healthy and have high cash reserves and resilient earnings, giving companies the ability to maintain and potentially increase future dividend payouts. The current payout ratios (that is, the proportion of earnings required to sustain current dividends) are near historic lows—suggesting ample room to grow and sustain dividends. Finally, dividend yields are attractive on a historical basis versus the 10-year Treasury."
| Income investment options
Performance, risk, and yield
(August 31, 2008–August 30, 2013)
|Investment option||Five-year annualized
|10-year Treasury bonds||5.01%||8.93%||2.59%|
|This table is for illustrative purposes only. Data according to Bank of America (BofA) Merrill Lynch, Standard & Poor's, and FactSet, FMRCo, as of August 30, 2013. Return and standard volatility measures represent the annualized return for the five years through July 31, 2013. Past performance does not guarantee future results. Standard deviation shows how much variation there is from the “average” (mean, or expected value). Each asset class was represented by an index. Equities—the S&P 500 Index; Convertible securities—BofA Merrill Lynch All U.S. Convertibles Index; preferred stocks—BofA Merrill Lynch Fixed Rate Preferred Securities Index; REITs—FTSE NAREIT All REITs; high-yield bonds—BofA Merrill Lynch US High Yield Master II Constrained Index; leveraged loans—Standard & Poor’s/LSTA Leveraged Performing Loan Index; Treasury—Barclays 10-Year U.S. Treasury Bellwether Index; TIPS—Barclays U.S. Treasury Inflation Protected Securities (TIPS) Index; municipals—Barclays Municipal Bond Index; investment-grade bonds—Barclays U.S. Corporate Investment-Grade Bond Index|
International fixed income options
Just like in the U.S., investment-grade and high-yield debt markets operate in countries around the world. In fact, international debt markets have the potential to give you exposure to many of the fastest-growing and most powerful economies in the world.
Investors can choose from:
- Developed market debt. While the United States and some European nations have struggled with significant debt issues, that doesn’t mean you should abandon the asset class.
- Emerging market bonds. The risk profile of emerging market debt has changed dramatically over the last 15 years. Joanna Bewick, lead manager of the Fidelity Strategic Funds, notes that more than 60% of emerging market countries are now considered to be investment grade.
Investing in international debt can help diversify your income portfolio. “Investing in non-U.S. debt lets you diversify your interest rate regimes, and gives you coupon payments that may be higher than what’s available in U.S. Treasury markets,” says Bewick. “They also add currency diversification by moving a portion of your portfolio away from the dollar.”
However, these added benefits also introduce new elements of risk, including a range of policy decisions and currency conversions.
Convertibles. These instruments—bonds that give you the option of converting to stock at a set price—provide another way to diversify. They offer some of the upside of equities, but because of that flexibility, they tend to offer lower interest rates than bonds issued by the same company. Convertibles have some risks, including the possibility that the issuer will “call” the security, meaning the issuer can force a conversion. For those willing to accept the risks, convertibles may offer more upside than some types of bonds.
Preferred stocks. These have characteristics of both stocks and bonds. While they are equity securities—that is, they represent an ownership stake in the issuing company—they tend to offer bond-like dividend yields and more limited growth potential than shares of common stock. As of August 30, the current yield on the BofA Merrill Lynch Preferred Securities Index was 6.65%, while investment-grade corporate bonds offered 3.24%, and the S&P 500 paid 1.9%.
Preferred stocks also can have call provisions, which tend to favor the issuer. When interest rates decline, the issuer can call the shares back and reissue them with a lower dividend yield. To avoid this scenario, look for a call protection feature, which limits the stock’s issuer from exercising this option for a designated period of time, usually five years.
“About one-third of the preferred stocks we follow are beyond their call date,” says Joanna Bewick, a Fidelity portfolio manager who specializes in income strategies. “If you pay $102 per share, and they’re called at $100, you lose money,” she explains. “Without call protection, you can eat into the yield and turn your investment negative.”
Real estate. For a long time, residential real estate was considered a safe investment, thanks to its ability to produce regular rental income, as well as the tax deductions. And in recent months the housing market has been recovering. But the sharp downturn in housing during the last recession underscored the risks of relying heavily on rental income.
In the most recent cycle, the fundamentals of the commercial real estate market were more stable than those of the residential real estate market. As a result, real estate investment trusts (REITs), while potentially volatile, can still make sense in a diversified equity portfolio. “The downturn in REITs in recent years has had more to do with the financing crisis than with the fundamentals of supply and demand,” says Joanna Bewick, lead manager of Fidelity's Strategic Funds. “Demand may have been weak, but there wasn’t a gross oversupply, so the fundamentals are rather healthy, and I still think you can earn incremental return there. It’s not a market for the uninitiated, though.”
Bewick notes that sectors like senior housing and health care facilities may offer long-term value, given the demographics of an aging population. However, she warns that more economically sensitive industries like retail and hospitality may elevate volatility and overall portfolio risk.
With REITs, there are a number of ways to invest—from investment-grade bonds to the equities of the REITs themselves. Generally, bond interest and REIT distributions are taxed at rates up to 35%.
“Folks who are lower-risk investors are likely going to find themselves more attracted to real estate fixed income, and perhaps as your risk tolerance increases, you consider things like preferreds or the common equity of REITs themselves,” says Bewick. “So it’s a question of deciding what your risk tolerance is, and where you feel comfortable in the capital structure when it comes to real estate entities.”
High-yield bonds. Notable for their low credit ratings, high-yield bonds, issued by companies and governments worldwide, reward investors with higher rates of interest than do investment-grade corporate bonds, to compensate for their significantly higher risk of default. Recently, high-yield bonds have offered a current yield of 6.65%, considerably more than investment-grade corporate bonds, at 2.76%. However, the volatility of high-yield bonds has been on display as well. The five-year annualized standard deviation shows how much returns have varied over time—high-yield investors had a bumpier ride, with a standard deviation of 13.79%, compared with corporate bonds, with a standard deviation of 7.72%.
Leveraged loans. These bank loans have coupons that reset periodically and are viewed as an asset that could provide some protection against rising rates. These securities invest in the leveraged loans of high-yield companies and have interest rates that are set at a spread above a base rate—typically LIBOR (London Interbank Offered Rate). And these loans are “senior” to high-yield bonds, meaning leveraged loan investors are paid first if the company goes bankrupt.
These two characteristics can potentially make a leveraged loan fund less subject to credit risk and interest rate risk than might be the case with a longer-duration high-yield bond fund, while still providing more income potential than some more conservative asset classes. The ability to adjust to rising interest rates may make these bonds attractive, but keep in mind that it also means these investments inherently have higher refinancing/repricing risk. Unlike other credit investments, which may have non-call periods when the bonds cannot be redeemed, leveraged loans are callable at par at any time.
Investment-grade corporate bonds. These securities are issued by corporations that earn credit ratings of BBB or higher from Standard & Poor’s, and Baa or higher from Moody’s. These bonds carry a higher risk of default than Treasuries of comparable maturities. But as a result, corporate bonds tend to offer higher rates of interest than government bonds do.
“Investors who are looking for income and preservation of capital from their investments may also want to include investment-grade bonds in their portfolio,” says David Prothro, a Fidelity portfolio manager who manages corporate bond funds. “Corporate bonds provide an opportunity to choose from a variety of sectors, structures, and credit-quality characteristics to meet investment objectives.”
Treasury bonds. Ten-year Treasuries offered around 2.59% interest on July 31, 2013. While that’s not a tremendous yield, Treasury securities remain an important, high-quality component of a long-term investment strategy. Because they are issued by the government, they are considered a very conservative investment, even after the August 2011 credit downgrade by Standard & Poor’s. The reliable income they provide may give you the flexibility to take on somewhat more risk in other parts of your portfolio.
Treasury Inflation-Protected Securities (TIPS). A TIPS bond functions like any other Treasury, and with the government backing the bond it may be considered lower risk. But unlike a normal Treasury, the principal is adjusted for inflation, so if inflation drives the value of the bond up, the interest payment and principal due at maturity will increase. TIPS may start off paying less than a comparable Treasury bond, but if inflation takes off, they may pay more in the long run.
“Conventional bonds offer a fixed income stream, the purchasing power of which is eroded by inflation,” says Bill Irving, a Fidelity portfolio manager who specializes in government bonds. “TIPS counter that erosion: The cash flows of TIPS are increased by the amount of inflation. TIPS could play an important role in an overall diversified portfolio.”
One thing to keep in mind, however: TIPS can generate "phantom income," which means you could have to pay taxes as the value of the bond rises with inflation, even though you may not receive a payment until the bond reaches maturity. So you’ll want to consider the tax implications before investing.
Municipal bonds. The interest income earned from most municipal bonds is generally exempt from federal income taxes. What’s more, if you live in the state that issues the bonds, the income may also be exempt from state and local income taxes. “The tax advantages of municipal bonds contribute to their appeal for many investors,” says Jamie Pagliocco, director of municipal bond portfolio managers at Fidelity. "Generally speaking, the higher one’s tax bracket, the greater the likelihood that an investor will find municipal bonds an attractive addition to his or her fixed income allocation.” Municipal bonds on the whole tend to offer high credit quality. That said, some issuers currently face a challenging fiscal environment that may negatively impact their credit profile. So it’s critical to do your credit research. If you don’t have the time or ability to do so, a mutual fund or managed account may be a better option.
Combining income assets
Your strategy for building a portfolio of various income-producing assets will depend on your situation—in particular, your goals and your tolerance for investment risk. While each individual needs to decide what mix is right for him or her based on his or her own research and situation, below we show the makeup of three different Fidelity funds to illustrate how these different products might come together in a portfolio.
Developing the right strategy for you requires understanding your particular needs, goals, and temperament. There are a number of different ways you can try to achieve your income goals. You may want to build your own portfolio, either as an individual or in partnership with a financial adviser. Or you may choose a fund that combines different asset classes for you with an eye on growth, capital preservation, or outpacing inflation. Another option is a managed payout fund, which allocates your investments among many options while attempting to provide a disciplined approach to spending down your capital.
If you want to avoid the uncertainty of a traditional investment portfolio and lock in a guaranteed income stream that you can’t outlive, you may want to consider a fixed or variable annuity. Although it may limit your flexibility and growth potential, an annuity can provide peace of mind—and make it easier to stick with the rest of your investment portfolio through market ups and downs. Finally, a managed account can deliver professional portfolio construction and management.
- Joanna Bewick is a manager of Fidelity® Strategic Income Fund, Fidelity® Strategic Real Return, and Fidelity® Strategic Dividend and Income.®
- Learn more about managed payout income replacement funds.
- Explore retirement income strategies with the Fidelity Income Strategy Evaluator.
- Research fixed income securities and funds.
- Looking for someone to build and manage your portfolio? Consider a managed account.
Before investing, consider the investment objectives, risks, charges, and expenses of the fund or annuity and its investment options. Call or write for a free prospectus or, if available, a summary prospectus containing this information. Read it carefully.
Fidelity Income Strategy Evaluator is an educational tool.
Any fixed income security sold or redeemed prior to maturity may be subject to loss.
Increases in real interest rates can cause the price of inflation-protected debt securities to decrease.
Changes in real estate values or economic conditions can have a positive or negative effect on issuers in the real estate industry, which may affect the fund.
Interest income generated by Treasury bonds and certain securities issued by U.S. territories, possessions, agencies, and instrumentalities is generally exempt from state income tax but is generally subject to federal income and alternative minimum taxes and may be subject to state alternative minimum taxes.