Finding Investment Income in a Zero Percent World

"A high dividend yield is a sign that a company that used to be great no longer is." - Brian Feroldi, The Motley Fool

It's impossible to generate a meaningful return in safe assets. By "safe," we mean low-risk investments i.e. bank savings accounts, CDs, U.S. Treasury bills. While investment grade bonds, both municipal and corporate, offer some yield, cratering interest rates have challenged those living off of investment income.

Welcome to the world of zero interest rate policy investing. It doesn't look to be changing any time soon.

Source: Longtermtrends.net

The above chart shows various U.S. Treasury yields by maturity (1/1/20 to 9/22/20). Even the 30-year bond (black line) is yielding sub 1.5%, while shorter term Treasury yields are barely above 0%.

There is no secret asset that generates above market yield and zero risk. With outsized yields come underlying risks. We offer not-so-obvious places to look for meaningful investment income, while highlighting what could go wrong.

High Yield Corporate Bonds

An investor is lending money to a lower quality company (also referred to as junk bonds) in return for interest payments and a return of principal. Because the borrowing company poses a higher credit risk, investors are compensated with higher interest payments.

Pros:

• Yield ~5-7%

• Tend to have shorter maturity terms

• Not as sensitive to increases in interest rates

• Liquid, and can be purchased through an ETF

• Can appreciate like an stock, offering total returns above the stated yield

• Higher up on the capital structure

Cons:

• High yield bonds can default (stop paying interest and loss of principal)

• Sometimes depreciate like a stock, providing total returns well below the stated yield

• During periods of extreme stress, credit markets might lock up and make selling difficult

• Low rates can keep a "zombie" company solvent (an increase in borrowing costs would bankrupt the company)

Emerging Market Debt (EM)

An investor would lend money to an emerging or developing sovereign country. Brazil, China, India, Mexico, are examples of emerging market countries. An investor could be exposed to currency risk, corruption, and political risk. Due to the elevated risk, EM debt is associated with higher yields.

Pros:

• Yield ~4-7%

• Exposure to non-U.S. dollar currency can provide diversification benefits

• EM debt can exhibit lower correlations to traditional fixed income

• Liquid and can be purchased through an ETF

Cons:

• Currency and inflation fluctuations can be wild, especially during times of stress or political upheaval

• EM bonds can default (see Argentina)

• EM countries tend to be much more volatile than developed countries (corruption, political risk)

• Can depreciate like a stock

• Can be expensive, difficult or impossible to directly buy individual EM bonds

Preferred Stocks

Typically issued by financial institutions to manage their capital structure, preferred stocks are hybrid securities with characteristics of equity and debt. These securities usually pay fixed interest, much like a bond, but also offers the potential for appreciation like equity. In the event of a default, preferred shareholders' claim on assets comes before common shareholders, but after bondholders.

Pros:

• Yield 5-6%

• Can appreciate like a stock, offering total returns above the stated yield

• Liquid, and can be purchased through an ETF

Cons:

• Tend to be sensitive to interest rate increases

• Can be called and reissued at a lower market rate of interest

• Concentrated in the financial sector

• Do not have corporate voting rights

• Can suffer equity-like drawdowns (2008, Spring 2020)

Closed-End Funds (CEFs)

These pooled investment vehicles are a hybrid between mutual funds and exchange traded funds. They are usually actively managed by a professional portfolio manager (like a mutual fund), but trade on the secondary market in real-time like an ETF. CEFs often use leverage to increase returns and boost investor income streams.

Pros:

• Yield 4-8% (these figures can deviate wildly depending on leverage and the underlying asset)

• Use of leverage can amplify returns

• Many different CEF offerings to choose from

Cons:

• Outsized distributions are usually taxed at ordinary income rates

• Use of leverage can amplify (positive and negative) returns

• CEFs usually carry hefty expense ratios

• Can be illiquid (difficult to sell)

• Net asset value of the fund can deviate from the value of the underlying holdings

Senior Bank Loans

Senior bank loans are a pool of corporate loans packaged up and sold to investors. As the name implies, these loans are senior, meaning if the business were to go bankrupt, the loans would be first in-line to be paid off.

Pros:

• Yield 4-5%

• Senior bank loan investors usually have a high recovery rate in the event of default

• Rates are usually variable, which can protect against rising rates

• Can easily be accessed through an ETF or mutual fund

Cons:

• Bank loan mutual funds and ETFs can carry hefty expense ratios

• Loans are often made to lower quality, non-investment grade companies

• Rates are usually variable, which can punish investors when rates drop

Master Limited Partnerships (MLPs)

An MLP is a company, usually in the energy complex, that is organized as a publicly traded partnership. Investors can buy units of the partnership on public exchanges and receive distributions (investment income) from the business.

Pros:

• Yield 0-12%

• MLPs do not pay tax at the corporate level (avoiding double taxation) leaving more funds for future projects

• Access to several strategies through individual MLP offerings and ETFs

Cons:

• 2020 has been a particularly horrible year for MLPs with impaired oil prices. Many MLPs have lost 50-80% of their value

• Sector concentration with exposure to volatile commodities (oil, natural gas, etc.)

• Produce the dreaded K-1 during tax season, frustrating CPAs all over the country

High Dividend Paying Stocks

The oldest form of returning capital to shareholders. Dividends are paid out of after-tax profits by mature, well established companies. Many companies view their track record and ability to grow dividends over time as a badge of honor.

Pros:

• Yield 1-5%

• Taxed at a lower rate than ordinary income

• Growing dividend can be a sign of corporate strength

• Companies with a track record of paying dividends can offer a consistent income stream

Cons:

• Investor is subject to the risk of the underlying business. It doesn't do much good if an investor clips a 5% yield and the underlying stock is down 35% (total return of -30%)

• Dividends can be suspended or cut

• A large dividend yield could be viewed as a sign of trouble rather than opportunity

A word of caution, salespeople are pushing annuities and whole life insurance for their guarantees or above market rate income. Keep in mind, insurance companies invest in the same bond market as everyone else. Don't fall for the pitch, an insurance company can't pay out a guaranteed 5% in a 0% world. The math simply doesn't add up.

It's easy to get blinded by yield. There is no free lunch. If it sounds too good to be true, it probably is. Outsized yield equals lurking risk embedded in your ETF, mutual fund, closed-end fund. It's a balance to generate a meaningful return and manage risk.

Let us know if you need help optimizing your portfolio income for the new normal of 0% interest rates.