Source: St. Louis Fed
Low interest rate around the world are challenging investors and savers everywhere. And it isn’t just households: state and local pension funds—once fully funded—are now underfunded by almost $2 trillion. With expected returns so low, governments and employees are being called upon to increase their contributions to make up for the shortfall. The resulting strain on public budgets has led to credit-rating cuts in places as diverse as New Jersey, Kentucky, and Chicago.
But individuals are struggling, too. Balanced portfolios that used to yield 4% now only yield 2%. A ladder of bank CDs only yields 1%. So lots of investors have shifted to high-dividend stocks to make up for lost income. The rationale is that AAA-rated Johnson & Johnson has a stable and growing dividend, and even lower-rated companies like Verizon and AT&T have strong business models. Why not use them as proxies for bonds, and enhance your income with equities?
Ratio of high-dividend stocks to S&P 500. Source: Business Insider
This unconventional thinking has become so widespread it’s almost conventional by now. Almost ten years of ultra-low interest rates have changed investor expectations. The yield spread between high-yielding stocks and the overall stock market has narrowed dramatically. We won’t know how this works out until we go through a full market cycle. Until then I have three observations.
First, equities are more volatile than bonds. This is because they have a junior claim on corporate cash flow. This was the case even when rates rose in the ‘70s. If investors aren’t psychologically prepared for greater variability in their portfolio values, they will be tempted to sell when the market falls, turning a temporary market fluctuation into a permanent loss of capital. And most people become more risk-averse when the market falls.
S&P 500 vs. Lehman Aggregate Bond Index, 1972-1982. Source: Bloomberg
Second, many of the vehicles that investors are now using to capture market returns haven’t been thoroughly tested in the courts. We haven’t had many bankruptcy cases or shareholder lawsuits that involve ETFs, MLPs, REITs, or other alphabet-soup investment vehicles. We’re flying in airframes that have been designed and constructed by computers, but haven’t hit a lot of turbulence yet. Make sure a good portion of your investments is in direct holdings of stocks and bonds.
Finally, it’s not always the case the reaching for yield ends in tears, but it’s happened enough times to worry about. Looking for more income by shifting investments from senior bonds to junk bonds to preferred stock to common dividends is moving down in the capital structure. Traditional asset allocation looks to stocks for growth and bonds for stability, but we may need to re-think this—especially in a slow-growth low inflation world.
The indications are that long-term returns from all asset classes are going to be low for a while. Figuring out how to adapt is the biggest challenge this generation has faced. And what works for one investor probably won’t work for anyone else.
Douglas R. Tengdin, CFA
Chief Investment Officer