A decade ago, when an investor was looking for income, there was a simple solution: a “ladder” of government bonds.
By spreading your money among bonds of various durations (typically one-tenth portions of 1- to 10-year bonds), you could minimize interest rate risk. Each year, when 10 per cent of the portfolio matured, you’d simply buy new 10-year bonds and continue on. Maybe you’d add some real-return bonds if you were concerned about inflation; maybe some corporates if you could afford to take on a little more risk. And for the most part, that was that.
Times have changed. Interest rates are at or near generational lows, making yields on government bonds about as attractive as a pack of tofu at a Texas BBQ. And although most analysts and market pundits believe rates will likely increase over the next five years, consensus suggests they won’t rise quickly, or very far—at least at first.
In addition, the security of sovereign debt has been seriously questioned over the past several years. True, this is less of a concern in Canada. Nevertheless, talk of credit downgrades in the U.S., defaults in Europe, and other macro-economic events have had a direct and tangible effect on the value of one’s laddered bond portfolio.
Let me be clear: I believe there’s still a place for the tried-and-true bond ladder (or its modern-day equivalent, the bond ETF). It’s simple, it’s easy to manage, and it’s inexpensive. That said, many High Net Worth (HNW) individuals have been taking a different approach to income lately.
Instead of putting their income portfolio into a single asset (bonds), the wealthy are diversifying their income stream. Partially this is a move to minimize exposure to interest rate risk and systemic risks. It’s also an attempt to deal with performance correlation, which has become something of a problem over the past couple of years.
Allow me to detail some of the income opportunities I’ve witnessed the wealthy looking at right now. Most of these are available to investors of more modest means, so there’s no reason why anyone can't use some or all of these opportunities to “round out” a more traditional income-generating portfolio.
Blue-chip equities Increasingly, equities are becoming the building block of the “cash flow” portfolio. Not just any equities, though: think "mega-cap" stocks with years (preferably decades) of dividend history, and a strong commitment to building that dividend over time. Many of these derive their income internationally, so cash flows tend to be a little more secure. Currently, most dividend yields are way above government bond benchmark yields, and many have attractive valuations, so there's some capital gains potential too. Canadian issues also enjoy favourable tax treatment, which is a way to add Tax Alpha™ (that is, additional after-tax return attributable directly to tax minimization strategies) to the portfolio.
"High-yield" corporations This is my name for publicly-traded companies (often former income trusts) throwing off steady cash flow and operating in mature industries. With yields in the mid- to high- single digits, this is a good place to look for yield-enhancement. That said, not all dividends in this space are growing, and the business risks are higher here. An allocation of, say, 10 per cent to 15 per cent of the income portfolio is likely appropriate for most investors.
Income-generating property Apartments, industrial and commercial properties (i.e., malls, warehouses, etc.) can all be effective ways to add income to the portfolio. Many HNW individuals are turning to the U.S. for such properties, where the dynamics of the real estate market have shifted dramatically toward renting. (Morgan Stanley head of U.S. housing strategy and research Oliver Chang recently dubbed 2012 "Year of the Landlord” – you can view an interview with Chang here. You don't need millions to follow a similar strategy: a number of apartment REITs (both in Canada and the U.S.) offer similar exposure and good yields.
High-yield corporate bonds Worry about Europe has created a dislocation in the high-yield market, and investors are exiting corporate issues in an effort to trim back risk. However, default rates remain about half of historical norms, as corporations have been aggressively paying down debt and pushing out maturities with refinancing. With pre-tax yields of 5 per cent to 8 per cent, high-yields look like a good yield enhancer. Just as important, they typically are less exposed to interest rate risk—an important point if rates rise (as they will eventually). Investors of more modest means can access this space with several ETFs, some of which provide exposure to U.S. market while hedging currency.
Covered calls Options are commonly viewed as risky investments, but “covered call writing” can be an attractive income strategy for range-bound markets, and a good way to mitigate downside risk in falling markets. In fact, a report just released by Goldman Sachs suggested selling 10 per cent out-of-the-money 1-month options on stocks with liquid options in the S&P 500 outperformed the index by 3.6 per cent annually from 1996-2011.
I recently explained the rationale for this strategy in detail here.
Lending Instead of buying equity (real estate, stocks, businesses, etc.) some HNW individuals prefer to become lenders, by participating in private financing pools, offering mortgage lending, or backing companies that are in that line of business. Such a move offers protection for the investor, as lenders generally take precedence over owners in the event of a financial catastrophe. It’s also a good way to boost income as well. Again, a number of ETFs now offer similar exposure for more modest portfolios.
Tax Alpha™ is a trademark of True Wealth Enterprises Inc.
Thane Stenner is founder of Stenner Investment Partners within Richardson GMP Ltd., as well as Director, Wealth Management. Thane is also Managing Director for TIGER 21 Canada (www.tiger21.com/canada). He is the bestselling author of ´True Wealth: an expert guide for high-net-worth individuals (and their advisors)’. (www.stennerinvestmentpartners.com) (Thane.Stenner@RichardsonGMP.com). The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Ltd. or its affiliates. Richardson GMP Limited, Member Canadian Investor Protection Fund.