As wealth managers, we intend to focus on our client’s investment returns over market cycles, not just quarterly positioning. Risk must be measured and factored in, just as much so as the potential for rewards. Additionally, we should not only be thinking about generating current income for our clients, but also about an increasing income stream to account for future inflation.
With equity markets hovering at or near all-time highs, and multiples reflecting a lot of good news, equity valuations appear to be quite full. Additionally, with the tailwind of easier Federal Reserve monetary policy likely behind us, at least for the foreseeable future, and credit spreads at or near cycle highs in corporate bond markets, a repeat of the strong returns investors enjoyed last year appears far less likely.
A traditional 60/40 blend of stocks and bonds works well to mitigate the volatility of a portfolio, but in this current low interest rate environment, too much growth is required from the equity portion, and too little income is generated from the bond side. We also would advise against taking too much risk by leveraging bonds to try and generate higher income.
We are not market timers, and do not want to guess when this bull market will end. We are, however, confident in the belief that interest rates may stay low for a long period of time, and therefore investors need to look elsewhere for income.
With this in mind, where should investors look?
One of the best sources of increasing income is to invest in stable companies with a history of increasing their annual dividend. An investor may start with a dividend of 2-3 percent, but over time is in line to receive an increasing income that will usually outpace inflation. Additionally, history shows that companies that do in fact raise their dividends over the years also show price appreciation. Conversely, owners of bonds simply hope to receive a fixed stream of income and their principle back at maturity, often diminished by the silent costs of inflation.
Another well-known source in income comes from a sector that is getting increasing attention: REITS, or real estate investment trusts. Within this broad category, there are several ways to diversify: mall operators, commercial building operators, medical buildings, even cell tower operators. If you are diligent, you can identify higher quality operators who also have a history of increasing dividends too.
Another interesting income producing opportunity was created by the financial crisis of 2007-2009, when banks were forced to change their lending practices, and loans to businesses were dramatically impacted. As a result, over the last 10 years another sector has emerged: BDCs, or business development corporations. Similar to REITs, BDCs also offer the opportunity to diversify: late stage capital leaders to mid-market corporations, early stage capital in high risk growth companies, collateralized based loans, and even loans that come with part ownership in the corporations the BDCs are loaning to. Like REITs and other common stocks, BDCs contain various levels of risk. Again, if you do the research, you can find the higher quality BDCs that have a history of raising their dividends.
The overriding message here is to find yourself in a position to receive increasing income over time, as well as a high current yield. This is attained by identifying the best opportunities for dividend increases through the highest quality common stocks, REITs, and BDCs. The other major consideration is to be fully diversified within your portfolio as to operations and locality.
With all of this in mind, we internally manage the FACTS® Income with Growth strategy: 50 US based companies that are collectively paying a 5% current yield dividend while averaging a 7% increase in their annual dividends over the last 3 years (as of the date this article was written). We would expect this strategy to provide an overall return that provides the current income investors are seeking, while also providing increasing income, and some appreciation of capital.