Most investors who are searching for income from their investments look at one statistic: Yield. After all, in the race to your investment goals, you can take a look at the yield of a bond, stock, or fund and reasonably believe you’ll receive that in income, right?
I recently ran a marathon, not to finish in any great time, but just to do something challenging. I trained for several months, and when the time came to line up at the start I thought I had a pretty good idea of how long it would take me to finish. A couple of factors I did not count on, however, were the extreme heat and humidity during the race. About 15 miles into the 26.2 mile slog; I realized that my goal time just wasn’t going to happen. In order to stay in the race, and come out with a reasonable time, I had to slow down and change my perspective. I ended up doing ok, but only because I understood what was happening and readjusted my expectations in order to finish with an acceptable time.
This readjustment of expectations happens all the time in investing, and in particular with yield-producing securities. You may think you’re getting one yield or return, but suddenly an issuer runs into trouble or the market as a whole hits a rough patch. Even if your portfolio doesn’t sustain a default or significant principal loss, you may receive a very different total return from your original yield expectation. Similarly, if you invest at the start in just the highest yielding securities expecting to get that yield as a return over a long period, you might as well try to run a marathon at a sprint pace and hold on to the hope that you’ll finish quickly enough or at all.
The right approach to investing for income is not simple: you must look at other statistics besides just yield. With bond funds, you get a greatly diversified set of individual bonds. While the yield at purchase of those bonds might be high or low, and the corresponding reported yield on the fund might be high or low, the fund is subject to capital gains and losses, as well as the potential for default, just as individual bonds are. However, with a sufficient time horizon and a diversified portfolio, you are likely to get a reasonable return for a given level of risk. Exhibit 1 above demonstrates how a bond allocation lowered volatility and still delivered a good return.
Bonds play an important part in many portfolios, and not just because they provide an important source of income. Bond positions also typically have a low correlation with stocks and also generally have lower volatility. Though stocks over time have tended to outperform bonds, mixing bonds in with stocks historically has done very little to decrease return while lowering the volatility of that return significantly.
Stocks are Trickier
Funds with a high reported dividend yield may give you that yield, though you may or may not get much capital appreciation. But when taking a look at just dividend yields, it turns out that higher dividend-yielding stocks can actually outperform on a total return basis over time. A Merrill Lynch study (see Exhibit 2) showed that dividend yielding stocks with high dividend growth did significantly better on a total return basis than those that had a slower growth in their payout.
This means dividend-paying stocks that grow their dividend can be an important part not only of your income investment strategy, but also key to your need for total returns. Plus, dividends which grow over time are especially powerful. Not only do they provide you better total returns, but your yield on your original cost, as the stocks in your portfolio increase their dividends, can rise dramatically. Staying with the S&P 500 Index (not a particularly high dividend-yielding index), over time there is a significant gain in yield on original cost as stocks within the index raise their dividends over time.
Exhibit 3 shows the dividend growth of the S&P 500 from 1970 to 2007, with no reinvestment of dividend. The resulting yield on the original 1970 cost rose to an incredible 30.11% in 2007.
What About Global Diversification?
Global diversification is an important aspect to investing for income in both stocks and bonds. The correlation of global bonds to stocks can be even lower than domestic bonds, thereby increasing the already large benefit of diversification. Foreign bonds can also offer higher returns due to a smaller natural investor base. In fact, over the past three years (through 12/31/07), the correlation between the S&P 500 and the Citigroup World Government Bond Index (WGBI)* is negative 0.12. This means that, to a small degree, the returns on domestic stocks and global bonds tend to move in opposite directions. The correlation between the MSCI EAFE and the Citigroup WGBI is 0.29, still quite low. Finally, the correlation between the Citigroup WGBI and the Lehman U.S. Aggregate Bond Index was 0.45, showing that foreign bonds are effective diversifiers even within a fixed income allocation.
Global equity investment also expands diversification and improves portfolio yield. As we’ve seen, yield can lead you down the wrong path when used in isolation, but in this case the higher yield indicates greater willingness to pay out dividends as evidenced by the corresponding higher payout ratio as seen in Exhibit 2 (on page two). This greater willingness to pay in countries outside the U.S. can mean faster dividend growth and an expanding yield on cost.
We’ve seen that yield is a statistic that is computed as a snapshot, but income is something that you receive over a long period of time. The yield your portfolio generates at a moment in time may not be indicative of the income you receive over the course of the race. It is therefore vital that investors see the various factors which might impact their income, including defaults, capital gains, and dividend growth. By having a more comprehensive vision of what goes into that check you receive every month or quarter, you’ll have a better ability to evaluate which investment might best meet your needs over the long run.
The views expressed by the author reflects his professional opinions and should not be considered buy or sell recommendations. These views are subject to change.
This material is for financial advisors and institutional clients only.
