Income Investing in an Uncertain World | Part 1

Author: Nathan Rowader
Date: October 11, 2016
Category: Alternatives, Financial Planning
Tags: , , , ,

As the recession of 2008/2009 wound down, many investors began to survey the wreckage of the financial markets and shift their attention from asset preservation to capital appreciation. Traditional fixed rate bonds, particularly sovereign bonds such as U.S. Treasurys, appeared to be grossly overvalued thanks to aggressive monetary stimulus from nearly every central bank. The idea that sovereign bonds are grossly overvalued stems from a historical understanding of interest rates, which have now either reached their lowest point in decades or reached their lowest point ever. Therefore, it is easy for many investors to look at long-term yield charts and speculate on the likely path of future interest rates.

As the recovery continued, it was probably prudent to think about the normalization of the interest rate environment. However, when the U.S. was looking to stop quantitative easing, the European Central Bank and the Bank of Japan unleashed their own version of quantitative easing aimed at stabilizing banks and periphery economies, while jumpstarting stalled economic growth. As a result, global rates of nearly every government bond issued by developed countries have fallen and, in many cases, are negative, as seen in Figure 1. Despite a generally universal agreement that bonds are currently overvalued, government bonds continue to defy expectation. Given this environment, it is prudent to plan for a much longer period of low rates. And this begs the question, does income really matter?

Figure 1: Government Bond Yields Across Maturities (Years)


Source: Salient Partners, L.P., Bloomberg as of 6/30/2016

Does income really matter?
To put it as plainly as possible: YES…A LOT! If we look at the composition of returns of the S&P 500 over the past 25 years, an investor would have had approximately a 9x return. Yet, as Figure 2 illustrates, 40% of that return can be explained entirely through reinvested dividends. In other words, without the reinvested income from the S&P 500, the investor would have only received a return of 5.6x their invested capital. The story is even more profound when we look at bonds: Approximately 70% of the total return of a treasury investment is due to reinvested income. When we combine these asset classes into a diversified portfolio of 60% stocks (as represented by the S&P 500) and 40% bonds (as represented by the Barclays Treasury Index) we see a very similar impact from income. In this case we see roughly 30% of the total return is explained from reinvested income.

Figure 2: Growth of $100,000
June 1991 to June 2016


Source: Salient Partners L.P., Bloomberg as of 6/30/2016

Over 25 years, a return of 9x versus 5.6x is hugely impactful.  Furthermore, when we break it down into smaller periods that are more easily relatable to the financial plan, we can see the real effect. In the case of the S&P 500, it is the difference between a respectable return of 9.4% per annum and 7.2% per annum, a loss of over 200 basis points in just one year. The problem is that the current low levels of income in bonds are already depressing the returns on our portfolios. We see this in action when we examine a diversified portfolio of 60% stocks and 40% bonds in Figure 3. In this example, it is assumed that an investor continues to get a healthy price appreciation of 4.9% (the 25 year average) but a yield of only 1.1% (the current yield of U.S. Treasurys). If you compare the current yield to the 25 year average of 4.3%, the result is a nearly 28% reduction in the realized return, or an annualized return of 8.0% versus 6.6%. It is probably safe to assume that most financial plans are not prepared for a 1.4% annualized shortfall in returns. So, in short, income does really matter whether or not you are living off the income or planning for asset growth.

Figure 3: Cumulative Gain on $100,000 using a 60/40 Blend
June 1991 to June 2016


Source: Salient Partners L.P., Bloomberg as of 6/30/2016

So What Can an Investor do to get more income?
We believe the simplest thing an investor can do is to increase their exposure to higher income asset classes. For example, at the end of June 2016, high- yield corporate bonds, EM corporate bonds, and high-yield municipal bonds were yielding 7.3%, 8.3%, and 6.0%, respectively. If an investor shifted the portfolio from all treasurys to one that is equally weighted between treasurys and the asset classes listed above, the investor would realize a substantially higher level of income from 1.1% to 5.6%. Figure 5 illustrates that the equal weighted portfolio including higher yielding asset classes would not only make up the shortfall brought on by the lower level of income, but actually increase the total portfolio value by an additional $60,423, a 60% increase from the initial capital.

Figure 4: Comparison of  Cumulative Gains for 60/40 Blends
June 1991-June 2016


Source: Salient Partners L.P., Bloomberg as of 6/30/2016

Of course, this will increase the overall risk of the portfolio from 7.7% to 8.7%, as measured by annualized standard deviation. Another way to measure this risk is to look at the maximum drawdown of -28% of an all treasury bond portfolio to -37% when blending in the various bond asset classes. However, this increased risk is rewarded with a higher return moving the Sharpe ratio from 0.96 to 1.03. However, even this outcome can be improved with a strong risk management process. This will be the subject of Part 2 of this series.


Investing involves risk, including possible loss of principal. The value of any financial instruments or markets mentioned herein can fall as well as rise. Past performance does not guarantee future results.

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Nathan J. Rowader is a registered representative of ALPS Distributors, Inc.

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