Investors have been finding it increasingly difficult to generate income in their investment portfolios. This is a problem that impacts many people who rely on portfolio income to live on or to supplement the income they receive from other sources, such as social security and pensions. When interest rates are higher, options for investment income are plentiful, and can include savings accounts, CDs, bonds, bond funds, and fixed annuities. But when rates are low, as they have been for some time now, creating a strategy to generate income can become more complicated.
In persistently low-rate environments, investors may be tempted to increase risk to generate a higher yield. With bonds or bond funds, that can be done by extending the average maturity of one's bond holdings, buying lower quality bonds, or some combination of both. However, this strategy could get tricky when rates eventually start to rise, due to the fact that lower quality bonds and longer dated bonds typically have heightened interest rate sensitivity.
After considering the risks within the current bond market, it's no surprise that some investors have been looking into stock dividends as an alternative to bond interest. Investors who made the decision to add stock positions to their portfolios since interest rates bottomed out have been rewarded with positive annual returns in the stock market (as measured by the S&P 500) from 2010-2014.
One concern with this approach may now be that stock valuations have risen too quickly. A strategy of increasing equity exposure for dividend income could backfire if stock prices experience a significant decline. This may be less of a concern if you have a longer time horizon and are primarily concerned with your portfolio's ability to generate income. However, if your time horizon is shorter and preserving capital is a high priority, allocating more heavily into stocks may not be the best option.
If an investor assesses the current risk in the equity markets and still chooses to follow this path, it may be helpful to browse through various ETF and mutual fund offerings to screen for investments that generate income and are still compelling from a valuation standpoint. Brian McMahon, CEO of Thornburg Investment Management, for example, recently wrote an article for Bottom Line magazine in which he outlines the opportunities in European markets. He notes that Europe is finally showing signs of a modest economic recovery after years of near-stagnation. With stock index valuations lower in Europe than they are here, some income investors are extending their search overseas to perhaps find a margin of safety that’s tougher to find here in the U.S.
Expanding the Reach of Your Investment Portfolio
With the concern that both stock and bond valuations may be stretched at the moment, income investors may try to mitigate that risk by using a multi-asset strategy. In addition to bond interest and stock dividends, investors may now consider alternative asset classes with the potential for consistent income generation. Some of those options may include preferred securities, real estate investment trusts (REITs), and master limited partnerships (MLPs).
Preferred securities are often viewed as hybrid investments, which maintain characteristics of both stocks and bonds. They typically offer less growth potential than stocks, but they also provide decreased volatility. REITs trade on major exchanges like stocks but invest directly in real estate. They often appeal to income investors because the structure of REITs require them to distribute at least 90% of their taxable income to shareholders. MLPs are similar to REITs in that they are also obligated to pay income to shareholders (and they receive special tax treatment as a result), although MLPs typically operate in the energy sector. There are also specialty ETFs and mutual funds that offer exposure to both REITs and MLPs, so an investor who may be looking into these investments has the option of buying a fund that is well diversified, rather than trying to pick individual securities within a potentially unfamiliar part of the market.
While income generation may be easier when interest rates are higher, investors have little choice but to do the best they can within the current economic climate. At a time when many stocks and bonds are looking expensive, investors may need to dig deeper to find the right portfolio holdings to help meet their income needs without pushing them too far outside of their comfort zone.