Climate Change of a Different Sort

Advisors often tell us that they invest with an income focus, reflecting the desires of their clients. But focusing on income as opposed to total return has always been a head scratcher for us, because a desired income stream can easily be manufactured with a mixture of income, dividends and sale of principal. And in the current, painfully low interest rate climate, focusing on dividends and income could end badly, as it requires investors to take on additional risks.

Over the 60 year period ending in 2015, the 10-Year Treasury sported an average yield of 6.1% and the dividend yield on the S&P 500 averaged 3.0%. Therefore, a 60/40 portfolio would have generated a combined yield of 4.24%, or close to what many believe to be a sustainable rate of withdrawal during retirement. But today, the 10-Year yields a paltry 1.85% and the S&P has a dividend yield of 2.2%, so that same 60/40 portfolio is yielding 2.06%, or less than half of the long term average. In order to match the long term combined yield of 4.3%, investors with an income focus would be forced to increase their valuation, credit and duration risk. Taking those in order:

  • Valuation risk: As of April 30th, 3 of the 4 highest dividend yielding sectors within the S&P 1500 – Energy (3.7%), Utilities (3.3%) and Consumer Staples (2.7%) – were the three most expensive sectors on both a P/E and P/S basis when measured against their own averages over the last 5 years.
  • Credit risk: In order to match the long term average yield on the 10-Year Treasury, an investor today would have to construct a portfolio consisting of about 87% high yield debt and 13% 10-Year Treasuries, and in doing so, move from an average credit rating of AAA to single B.
  • Duration risk: While it is impossible to match the long term average yield on the 10-Year Treasury simply by extending duration, it’s worth noting that an investment grade bond portfolio, proxied by the iShares Core US Aggregate Bond ETF, carries an average effective duration of 5.2 years and a yield to maturity of 2.1% as of May 19th, while a portfolio of long term Treasuries, proxied by the iShares 20+ Year Treasury Bond ETF, carries a duration of 17.7 years with a yield to maturity of 2.6%. In order to eke out an additional 50 bps, an investor must be willing to more than triple the duration risk.

The bottom line is that while some investors view tapping into principal as taboo, that is unfortunate, because:

  • Dividends reduce share price by an equal amount; this is a reduction in principal, just one determined by the company rather than the investor.
  • Total return investing is likely more tax efficient, given the tax rate differential on income and capital gains.
  • Total return investing allows for greater diversification across traditional and alternative assets and strategies, and thus more consistent outcomes.