Income Investing in a World of Low Interest Rates

Although few realized it at the time, 1958 marked a turning point for income investors. Until that point, dividend yields on large capitalization stocks had exceeded long-term U.S. Treasury yields going back to the middle of the 19^th century. This phenomenon reflected the view of many investors that stocks were riskier than bonds and therefore needed to offer higher dividend payouts to compensate investors for their additional risk. But a funny thing happened in 1958: the dividend yield on the S&P 500 Index fell below the yield on the 10-year U.S. Treasury and didn’t revert during the process.

Investors could hardly be blamed for questioning whether the inversion of bond and dividend yields in 1958 represented a long-term trend. After all, while dividend yields had previously approached long-term U.S. Treasury yields in 1898 and 1928, such compression had been temporary and subsequent market movements—either in the form of a bond market rally or stock market decline—had always caused dividend yields to revert to higher levels relative to bond yields.

However, something changed in 1958. The bond market subsequently went on a 20+-year bear market that saw the yield on the 10-year U.S. Treasury peak above 15% in 1981. Meanwhile, while dividend payouts grew in absolute terms over that time, rising stock prices in the 1960s kept dividend yields well below the yields on long-term bonds.

Various explanations have been offered as to why bond yields and dividend yields inverted in 1958. Some have pointed to inflationary pressures that began during World War II and continued into the 1970s; therefore, eating into the returns offered by fixed-income instruments and driving up bond yields. Others have noted that an improved disclosure regime increased transparency in the stock market, making investors more comfortable with a lower equity risk premium, which equates to lower dividend yields relative to bond yields. Still others have advanced more nuanced theories, such as the notion that investor perceptions of risk, and therefore the yields they demand from bonds and equities, are influenced by the relative volatility of bonds and equities in the recent past.

Whatever the explanation for the inversion of bond yields and dividend yields that occurred in 1958, the change influenced how income investors viewed stocks and bonds. Whereas stocks had historically offered higher yields than bonds, albeit with greater risk of losing principal, by the 1980s investors could earn significantly higher yields from U.S. Treasurys with no risk of losing principal (at least in nominal terms). In such an environment, it should not be surprising that bonds became the preferred investment vehicle for income investors.

And investors who purchased long-term Treasurys in 1981 were richly rewarded after the Federal Reserve clamped down on inflation, ushering in a bond bull market that saw the yield on the 10-year U.S. Treasury fall to an all-time low of 1.32% in 2016. From the beginning of 1981 to the end of 2019, a portfolio comprising the then-current 10-year U.S. Treasury earned an annualized total return of 8.0%, according to PortfolioVisualizer.com.

As well as long-term Treasurys performed over that period, large capitalization stocks did even better, earning an annualized total return of 11.1% from the beginning of 1981 to the end of 2019. But the road for stocks had some speed bumps, including a 42% drawdown from 2000 to 2003 and a 51% drawdown from 2007 to 2009.

Investors seeking higher risk-adjusted returns with less chance of catastrophic drawdowns would have been better served by a balanced portfolio of 70% 10-year U.S. Treasurys and 30% large capitalization equities during the period beginning in 1981 and running through 2019. Such a portfolio was less volatile, had a smaller maximum drawdown and generated a higher Sharpe ratio than either bonds or stocks. The table below provides performance data for 10-year U.S. Treasurys, large-cap stocks and a 70%/30% balanced portfolio over the period.

Source: All performance data sourced from www.portfoliovisualizer.com.

These statistics should not be surprising to students of modern portfolio theory, which argues that investors can construct optimal portfolios that maximize risk-adjusted returns by diversifying away idiosyncratic risks associated with particular asset classes or securities. For income investors, the key takeaway should be that even during one of the greatest bond bull markets in history, a balanced portfolio earned higher returns with less volatility than a portfolio of long-term U.S. Treasurys.

All of this brings us to the present day, which based on relative bond and dividend yields, looks like 1958. Even as the great financial crisis and a sluggish economic recovery in its wake pushed long-term U.S. Treasury yields to historically low levels, the stock market enjoyed a decade-long bull market that kept the dividend yield on the S&P 500 index at levels comparable to the current yield on the 10-year U.S. treasury.

For income investors seeking to navigate a world of low interest rates, bonds no longer seem the obvious choice. At the same time, while low interest rates are typically bullish for equities, stocks hardly seem cheap by any traditional metrics. And income investors, many if not most of whom are retirees, may not have the time or inclination to ride out the sort of dramatic drawdowns equities periodically provide.

While nobody can predict what markets will do in the future, some suggestions come to mind for income investors in a world of low interest rates:

• Diversification Works. Harry Markowitz, the father of modern portfolio theory, reportedly called diversification the only free lunch. By investing in well-diversified, multi-asset portfolios, investors can maximize risk-adjusted returns and minimize idiosyncratic risks associated with particular asset classes or securities. To the extent investors wish to take on more risk and earn higher potential rewards than unleveraged diversified portfolios offer, history and theory suggest they are better off levering up such diversified portfolios rather than making concentrated investments in particular asset classes or securities.

• Total Return Determines Income. Income investors too often focus on yield when evaluating potential investments, which explains the popularity of niche asset categories like high-yield bonds, master limited partnerships, real estate investment trusts and covered-call funds. While these asset categories can serve as important components of diversified portfolios, the total return of a portfolio determines how much income it can provide to an investor. It does an investor no good to receive a six percent yield from a holding if it loses 20% of its value. Conversely, a portfolio that generates a total return in excess of its portfolio yield can pay higher distributions without losing principal.

• Taxes Matter. For investors with taxable accounts, taking distributions in the form of non-taxable return of capital can generate higher after-tax returns. In this respect, ETFs that hold a portfolio of ETFs (sometimes called “funds of funds”) offer a unique advantage unavailable to investors who invest directly in ETFs or securities through a brokerage account. By using an in-kind creation and redemption process, ETFs can regularly rebalance their portfolios and generate cash to pay out total return without incurring immediate tax consequences for the portion of a distribution in excess of its taxable yield. This return of capital reduces the investor’s cost basis in the ETF, allowing the investor to defer capital gains until sale of the ETF. If the investor dies before selling the ETF, his heirs will inherit the ETF with a stepped-up cost basis, effectively eliminating taxes on the capital gains the investor monetized during his life.