Where to go for income in a low-yield world

Not only did the rate cut fail to spark a recovery in the flagging equity market, at least in the short term, but it also has negative implications for income-seeking investors. Short-term Treasury yields are closely connected to the fed-funds rate; a lower fed-funds rate tends to translate into lower yields. And in addition to the Fed’s actions, investors have been bidding up the price of bonds in an ongoing flight to safety; that buoys bond prices but pushes down yields. Yields on 10-year Treasury bonds dropped to 0.318% on Monday, an all-time low, before settling around 0.50%; the 10-year Treasury yield was 1.5% as recently as February.

Of course, declining yields boost bond prices, so in a sense, bond investors win on that side of the ledger even when they lose out on the income front. Moreover, bonds’ recent strength--and specifically the fact that investors are willing to put up with their miserly yields--is an indication that investors expect stocks’ fortunes to be rocky for the foreseeable future. They’re also expecting inflation to stay low. That means that demand for bond prices could remain robust through equity-market turbulence.

If you’re an income-minded investor surveying the available sources of yield today, here are some of the key trade-offs to consider.

Dividend-paying stocks
The Good: For income-minded investors, the big plus is that yields from dividend-paying stocks look better than high-quality bond yields do today. While the Bloomberg Barclays U.S. Aggregate Bond Index pays out just less than 2% today (based on the SEC yields of funds that track it), the FTSE High Dividend Yield Index, composed of the higher-yielding half of U.S. dividend-paying stocks, yields nearly twice that. Dividend-paying companies also have the opportunity to increase the dividends they pay out to shareholders. With a bond, the yield you see is the yield you get.

Moreover, dividend payers have fundamental attractions relative to the broad equity universe. For example, 42% of firms that pay out dividends have a narrow or wide Morningstar Economic Moat Rating, whereas just 33% of non-dividend-payers do. In addition, yielders look more attractive than nonyielders when their valuations are factored in. Fully 42% of companies that pay dividends earn Morningstar Ratings of 4 or 5 stars currently, whereas just 12% of nonyielders do.

The currently favorable tax treatment of dividend income also belongs on the list of what's right with dividend-payers. Qualified dividend income is currently taxed at just 15% for single filers with incomes of less than $441,450 ($496,600 for married couples filing jointly). Meanwhile, single filers with incomes below $40,000 and married couples filing jointly with incomes below $80,000 pay no taxes on dividends, assuming their incomes stay below those thresholds. Bond income, by contrast, is taxed at your ordinary income tax rate.

The bad: 
The big negative with stocks, even high-quality dividend-paying stocks, is price volatility. Over the past 15 years through the end of February, a period that captures the financial crisis, the S&P High Yield Dividend Aristocrats Index had a standard deviation of 14, versus just over 3 for the Aggregate Index.

Of course, many dividend-focused investors say they’re not bothered by the share-price volatility, as long as they can continue to clip their dividends. But what if something happens to dividend-payers’ income production at the same time the portfolio drops in value? That happened during the financial crisis, when banks, which had previously been reliable dividend-payers, were forced to slash their dividends.

The bottom line: 
Dividends have composed a huge share of the market’s return over time, so it stands to reason that stocks that pay them should be a meaningful component of every investor’s portfolio--income-oriented or otherwise. But because of their price volatility and the potential for dividend cuts if the economy continues to worsen, my view is that dividend-paying stocks can be a component of investors’ income plans but shouldn’t be the whole plan.

In addition to diversifying across dividend-payers and prioritizing companies with stable dividends, I like the idea of building a contingency plan around a portfolio of dividend-payers. In a worst-case scenario in which dividend cuts occur around the same time those dividend-payers’ share prices drop, the retiree has another source of assets he can tap to meet cash flow needs. While dividend-focused retirees needn’t necessarily hold a full 10 years’ worth of cash flows in cash and bonds, as is the case with my model Bucket portfolios, holding at least a stake in such safe securities alongside the dividend-payers is a sensible practice. (How much depends on the retiree’s own risk preferences.)

Higher-yielding bonds
The Good: Even as high-quality bond yields have been plumbing new depths, yields on higher-yielding, lower-quality bonds have ticked up substantially in recent weeks. For example, on Monday the yield on the ICE Bank of America U.S. High-Yield Index spiked to 7% from just over 5% on Feb. 20. Yields on other lower-quality bond types, such as emerging-markets debt and floating-rate investments, have also trended up.

The Bad: Yields don’t go up for nothing, and the uptick in lower-quality bond prices is a reflection of the fact that investors are worried about how the coronavirus could affect the economy and, in turn, the ability of issuers to pay back their creditors. Even as high-yield bond yields have shot up, their prices have sunk. The typical high-yield fund in Morningstar’s database, for example, has lost about 6% over the past month through March 9. If conditions worsen, high-yield bonds could fall further still. During the period from October 2007 through early March, for example, high-yield bond funds lost between 20% and 25%. That was less than half of what stocks lost during the bear market, but it was directionally similar. Meanwhile, high-quality bonds gained about 6% over that same stretch.

That illustrates that higher-yielding bonds don’t do as good a job of diversifying against equity risk as high-quality bonds. In other words, investors shouldn’t pair them with equities and assume that they have a diversified portfolio. In my most recent run of correlations data, high-yield bond returns were closely correlated with the equity market, while high-quality bonds proved their mettle as diversifiers.

The Bottom Line: That doesn’t mean you should automatically avoid higher-yielding, higher-risk bond types. The bonds do provide some diversification benefit to high-quality bonds. But it's also a mistake to assume that a bond is a bond is a bond. If you're looking at mutual funds that delve into credit-sensitive sectors, it's crucial to thoroughly understand a prospective holding's strategy and downside potential before adding it to your portfolio. Morningstar's Fund Analyst Reports do a good job of providing an overview of these factors.

High-Quality Bonds 
The Good: The big plus for high-quality bonds is how useful they are as ballast during equity-market shocks; over the past decade and a half, they've been reliable diversifiers. The Aggregate Index has gained over the past month even as stocks have slid, and so have most funds in Morningstar’s intermediate-term core and core-plus groups. The presence of such holdings helps smooth out the performance bumps associated with equities, making the portfolio easier to own overall. 

The Bad: The big negative is that the income on high-quality bonds and bonds has shrunk to a negligible level; income-seekers won’t find much here. Moreover, high-quality bond prices react when interest rates move. Bondholders have recently been the beneficiaries of lower rates; they’ve enjoyed higher bond prices even as yields have fallen. If the economy shows signs of stabilizing and/or the Fed reverses course, high-quality bond prices could fall. And as with all fixed-rate investments, inflation will gobble up a portion of your purchasing power over time.

The Bottom Line: Given how low yields are today, investors who are using high-quality bonds as a component of their portfolios would do well to practice a total return approach rather than looking to them for current income. It's also worthwhile to adjust expectations; today’s low yields suggest that high-quality bonds are unlikely to be a major return driver over the next decade. That doesn’t diminish their role as shock absorbers for a broader portfolio, however--or as a source of liquidity for people who are actively drawing upon their portfolios.

Cash
The Good: Yields on cash investments are hardly exciting, but they’re close to--or in some cases in excess of--what bond investors are earning today. For example, a survey of high-yield savings accounts available on bankrate.com shows many accounts yielding 1.7% or more; that’s better than the yields on many bond funds. Cash also offers guaranteed stability of principal--something that bondholders don’t enjoy.

The Bad: Even though cash investments are sometimes described as “risk-free,” that’s not entirely accurate. Yes, FDIC-insured cash instruments promise guaranteed stability of principal, but as with bonds, inflation could gobble up part of or all of your income. (Of course, inflation is currently pretty low.) Moreover, investors who overdo cash will tend to confront an opportunity cost, as investments that have some risk attached to them have tended to outperform cash over time. Bonds have outperformed cash recently, for example, as declining yields have boosted bond prices.

The Bottom Line: Cash is a decent parking place for very near-term cash flow needs of a few years. Given the modest yield differential between cash and bonds today, it's not unreasonable for investors--especially retirees--to hold a bit more in cash than they otherwise would. But owing to the opportunity cost, inflation risk, and low return potential over the long haul, it's a mistake for investors to stake a significant share of their long-term portfolios in cash.