Income Investing in a Low-Yield World
February 29, 2012
Key Points
- In a low-yield environment, investors may wish to consider a multi-front approach to an income-oriented portfolio.
- Such an approach may consist of low-yielding cash investments for preservation of capital, and then a mix of stocks and bonds to help diversify income sources.
- Consider each investment as part of a whole, not in isolation, to help maximize your income potential.
How do you invest for income in a world in which interest rates on the safest short-term investments are essentially zero? How do you do it without adding too much risk? Millions of savers and retirees currently face this challenge. What sort of risks to take, in what sort of investments, for decent income now?
In our view, there's no silver bullet. The current low-interest-rate climate is unquestionably difficult for savers and income-oriented investors. To tackle the problem, we suggest a multi-front approach. Diversify by income sources, and clearly identify the role of each investment in your income portfolio.
Here are thoughts on how:
A low-yield foundation in cash and short-term bonds
For more than three years, yields on traditional safe-havens like certificates of deposit (CDs) and savings accounts have been close to zero. Regardless of the return, we think the classic quote, "I'm not as concerned with the return on my money, just the return of it," should apply for a portion of your portfolio. When interest rates were higher, you’d see some return on your safest investments—that’s not true today.
For money you may need soon, we suggest you focus on return of capital first. Stretching too much to try to boost returns on those safer investments, in our view, should be secondary. With this money set aside, you can then consider investing other assets for higher income potential.
Expanding your fixed income portfolio
After allocating cash for safety, fixed income investments are the investment to consider next. For higher income on fixed income investments, however, you’ll likely need to take some risk—the question is how much and how you manage it. There are two basic ways to try to increase income from your bond allocation: take on some more risk in bonds with longer maturities or in bonds with higher credit risk.
We've written about this previously. For income-oriented investors, taking some of these risks is probably necessary in a low-yield world. You can do it in ways that balance out risks with potential rewards by starting with a "core" foundational fixed income portfolio and expanding from there.
An expanded bond portfolio
To start, consider allocating the bulk of your fixed income allocation to a mix of high-quality bonds rated "investment grade" or higher, with maturities of 10 years or less. Bonds with "non investment grade" ratings or maturities much longer then 10 years carry more risk—of default or of change in value if interest rates increase.
You can do this using one or more high-quality intermediate-term bond funds that invest for you. Or consider a portfolio of high-quality bonds diversified by maturity using a bond ladder or other diversification strategies. For higher yields compared to Treasuries or CDs in an individual bond portfolio, consider a well-diversified portfolio of investment-grade corporate and/or municipal bonds. For adequate diversification, we recommend that no more than 10% of your fixed income portfolio be exposed to any single corporate or muni bond issuer.
After you have the high-quality "core" portfolio, consider expanding your horizons into other more-aggressive sectors of the global bond market. This may be necessary to increase income potential in the current rate environment. These investments might include:
- International bonds. Investing overseas primarily adds diversification, and in moderation, exposure to bonds outside the United States may boost income potential as well. However, given global macroeconomic threats, along with currency risks, invest carefully.
- High-yield bonds. These can of course provide higher income, but it doesn’t come without higher risk. They also generally have greater correlations with stocks than other types of bonds—meaning that when stocks fall, high-yield bonds also often will.
- Preferred securities. These securities combine attributes of stocks with those of bonds. Many investors choose them for higher income potential, but they also come with different risks.
Get started
You can add exposure to these investments with a multi-sector bond fund. The fund manager opportunistically selects higher-yielding investments, diversifying against issuer-specific risks in a way that would be more difficult if you tried to choose these investments on your own.
If you prefer more targeted allocations to specific sectors, consider targeted exchange-traded funds (ETFs) or mutual funds. For ideas, clients can see Schwab’s Mutual Fund or ETF Select List.
How much?
Overall, we think it’s reasonable for more-aggressive income-oriented investors to consider as much as 35% of a fixed income portfolio in these higher-risk investments. More than this would be significantly increasing risk, and potential volatility, in the portfolio.
Example of an expanded fixed income portfolio
Source: Schwab Center for Financial Research. The stock, bond and cash mix show above represents Schwab’s moderate strategic asset allocation. Up to 35% of the fixed income portfolio with a 50% allocation to bonds would equal 17.5% for more aggressive income-oriented investors.
Tilting toward income in stock investments
One of the top questions we hear from investors seeking income is, “Shouldn’t I buy high-yielding stocks to replace bonds, if bond yields are so low?” We don’t think so—at least not if you worry about volatility and potential loss of principal along with income and growth potential. This is especially true if you plan to move a significant amount of money that was earmarked to cash or bond investments to stocks.
Stocks are still stocks: volatility is generally higher; dividends can be cut, and value may fall, as it ultimately depends on what the market will pay—not a promise from the issuer to repay principal in full. On the other hand, dividends can grow, as can the value of the stock itself, to help income keep pace with inflation. The growth potential and possible dividend yield is an attractive feature in a balanced portfolio.
So, by all means, income-oriented investors who value dividends and generally defensive investments may consider blue-chip stocks. We see each investment as part of a whole portfolio, and dividends can support income needs while adding growth potential.
Income-oriented stocks
You can add income oriented stocks by using one or more dividend-oriented stock funds, such as large-cap value funds that focus on blue-chip dividend-paying stocks with potential to grow. There are many ways to do this, highlighted in get started below.
Some investors also consider niche income-oriented stocks to round out their portfolio. These sectors can become more complex, with specialized knowledge required to invest.
- International dividend-paying stocks. Foreign companies, particularly in Europe, often pay out a higher percentage of their profits in dividends than US companies. The dividend yield on the S&P 500 recently crept up to 2%, while it tops 2% for the average stock in Germany, the United Kingdom and Japan, and is nearly 4% in France. International stocks, of course, involve other risks as well.
- Real estate investment trusts (REITs). The first place many look for stock income beyond blue-chips is real estate, often in the form of REITs. Of course, they involve considerable sector concentration and exposure to the ups and downs of real estate, but they’re one area to consider for income potential. Generally, we suggest that you treat REITs as part of your targeted allocation to small-cap stocks as part of a strategic asset allocation plan.
- Master-limited partnerships (MLPs). Master-limited partnerships are a niche sector in the income world, composed primarily of oil and gas partnerships that pay a regular dividend stream. Those who invest in this sector generally have specialized expertise, and the resources available to analyze MLPs closely are unfortunately limited. We suggest caution (unless you follow these securities closely) or diversification using one of a handful of dedicated mutual funds or ETFs, for a small part of your small-cap stock allocation—in the same way that we suggest for REITs—for more-experienced income-oriented investors.
Get started
Fund investors can choose from income-oriented stock funds by viewing Schwab's Mutual Fund Select List or Schwab's Income Select List. Schwab clients can use stock-selection tools and dividend-screeners by logging on and going to Research, then Stocks, then Predefined Screens. You can also find exchange-traded funds that specialize in REITs as well as MLPs and other income-oriented stocks.
How much?
You probably won’t want to tilt too far toward dividend-paying stocks if you’re also looking for growth potential. Stocks that focus on consistent dividends are often large-cap blue-chips. They may not have the same long-term growth potential, or provide diversification in different markets, compared to a portfolio that contains a mix of both growth and dividend-oriented stocks. Decide on your objectives, and then invest accordingly.
Putting it together
As we said at the outset, in a low-rate climate, we think you may need a multi-front approach. This includes the combination of stocks, bonds and cash. Each plays a roll. And each provides opportunities, and risks, to navigate through the low-yield world today.
Adding income-oriented stocks
Source: Source: Schwab Center for Financial Research. Schwab’s Moderate allocation used for illustration. For investors with a preference for income, consider income-oriented stocks as part of the strategic asset allocation that makes sense for you.
For illustration only: The estimated yield for this portfolio as of today, using broad indices to approximate yields, was just greater than 3%. This may not seem like much, but it’s higher than the 2% yield currently on a 10-year Treasury bond or on a balanced portfolio of investment-grade bonds. Stretching to increase yields further inevitably involves some form of higher risk.
This portfolio includes cash investments for short-term liquidity needs, fixed income for income and stability, and stocks for growth and dividend potential. All in all, it helps manage risks and takes a multi-front approach to the need for income now. And when yields on fixed income investments ultimately rise, you can reinvest principal or rely on fund managers to reinvest for you for higher income potential.
Final tip: Start with a portfolio based on risk tolerance and time horizon
At the Schwab Center for Financial Research, we suggest that investors start first with a strategic allocation between stocks, bonds and cash that meets their risk tolerance and time horizon. This includes an appropriate balance between stocks and bonds, no matter the interest-rate climate.
After determining a targeted strategic asset allocation, income-oriented investors can then start to think about maximizing income potential. Clients can determine their targeted strategic allocation by following the asset-allocation tools and questionnaires elsewhere on our website.
For complete portfolios and income-oriented funds selected by Schwab, see Schwab’s Income Select List, at schwab.com/incomelist. For help, talk with your financial consultant or a Schwab Fixed Income Specialist at 800-626-4600.
Important Disclosures
For mutual funds and exchange traded funds investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing. Investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.
Diversification strategies do not assure a profit and do not protect against losses in declining markets.
Investing in dividend stocks carries some risk—the same as with any other type of stock investment. With dividend stocks, you can lose money; for example, share prices can drop (regardless of whether the company pays dividends), companies can reduce or eliminate dividend payments at any time and inflation can reduce savings.
Stocks or stock funds generally have a higher degree of risk to capital than bonds or bond funds.
Certificates of deposit offer a fixed rate of return and are Federal Deposit Insurance Corporation–insured. Penalty for early withdrawal may apply.
International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, political instability, foreign taxes and regulations, and the potential for illiquid markets.
High-yield bond funds invest in lower rated securities and are subject to greater credit risk, default risk, and liquidity risk.
Investing in REITS may pose additional risks such as real estate industry risk, interest rate risk and liquidity risk.
Sector funds are typically not diversified and focuses its investments on companies involved in a specific sector, the funds may involve a greater degree of risk than an investment in other funds with greater diversification.
Charles Schwab & Co., Inc., member SIPC, receives remuneration from fund companies participating in the Mutual Fund OneSource™ service for record keeping and shareholder services and other administrative services. Schwab also may receive remuneration from transaction fee fund companies for certain administrative services.
The information here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
Examples provided are for illustrative purposes only and are not intended to be reflective of results you can expect to achieve.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.