26 Jun I need income!
Since the global financial crisis, and now a global pandemic, low interest rates have become the norm so you might be faced with the problem that your long term investment portfolio doesn’t (or won’t) provide the income you need to fund your lifestyle.
Given historical rates, we would expect interest rates to change in the future, but when is not known. This is also causing difficulties for cash savers. If we consider the effect of inflation on cash deposits we can see that the value of savings is shrinking each year.
If you’re planning on using, or are using, the income from your investment portfolio to meet some of your expenditure needs then this can be a challenge. If you own a long-term, well-structured investment portfolio balancing bonds and equities, your bonds should have helped to reduce the equity volatility and protect your wealth, but for a number of years now bond yields have been at an all-time low. If they stay where they are, then returns going forward will be low. If yields rise, then returns will be poor due to the price of bonds falling. So why is this likely to happen?
Bonds are essentially IOU’s whereby the borrower – a government or a corporation – promises to pay investors their money back at a future point in time (the maturity date) and a fixed level of income up to that point (the coupon).
The bond market, made up of buyers and sellers trading bonds, decides the level of return that is required to own the bond (its yield), given the current perceived risks of lending the money to the bond issuer. Because the coupon is fixed, the price of the bond must move to accommodate the level of yield demanded by the market. If bond yields rise, prices fall and vice versa. The longer the time until a bond matures, the more the price moves in response to a given movement in yield.
So what do you do if you are planning on using your investment portfolio to fund your lifestyle expenditure? You might be tempted to look for higher yields and/or reduce your bonds and try to alter your investment portfolio to increase the natural income it produces.
If you take the approach of constructing your investment portfolio based on the natural yield of its holdings, which has been a popular approach, you are likely to look to hold bonds with higher yields and equities with higher dividends or just hold more equities than bonds. If we look at each of these in turn we can see the potential problems.
Higher yielding bonds
When trying to obtain higher yielding bonds an investor has two approaches to take. Firstly you can hold bonds with longer maturity dates but longer-dated bonds are more volatile than shorter-dated bonds. This price volatility is known as ‘interest rate risk’. The second approach is to invest in bonds from institutions with a lower financial strength. This affects the likelihood of being paid the regular coupons as they fall due and being repaid the principal at maturity. This is commonly referred to as ‘credit risk’.
The higher the risk that an investor might not be repaid, the more return they will demand from the borrower. Bonds are categorised into ‘investment grade’, whose credit ratings range from AAA to BBB, and ‘non-investment grade’, which have ratings of BB and below. The latter are often known as ‘high yield’ bonds or ‘junk bonds’.
The problem with investing in bonds that provide higher yields is that you are increasing the level of risk within your portfolio as these higher returns come with higher risks. Historically we have seen that high yield credit risk tends to be quite highly correlated with equities and thus provides poor diversification in a portfolio at a time of equity market trauma. High yield bonds, therefore, don’t help balance equity risk, so if you own equities and want to hold bonds to reduce the volatility of your portfolio these types of bonds might not help as much as you hoped.
High income equities
You could alter your equity exposure and try to focus on ‘equity income’ or higher yielding stocks that provide higher dividends. The main problem with this approach is that it tends to increase the risk of concentrating the portfolio with regard to the companies held and also the sectors you are investing in. It’s also worth remembering that the price of an equity falls when cash is distributed to shareholders, dividends can reduce and whether a company pays a dividend or not should make no material difference to the total return generated over time.
Another approach that you may be tempted to follow is to give up some of the low-yielding bond assets held in your portfolio for higher-yielding equities or just more equities. Equities are currently providing higher yields than bonds so when looking for income this would seem to make sense. However, if you’re trying to maintain a balance of equities and bonds in line with your risk profile increasing your exposure to equities will not maintain this balance. Even if you increase the income your portfolio provides, the additional equities you’re now holding will fall just as far at times of market trauma as your existing equities. You might also end up with a portfolio with a greater exposure to risk than you may feel comfortable with.
So what is the answer? Is there an approach to take when trying to use your portfolio to provide an income?
Unfortunately, there is no magic answer or even a single right approach to investing. You should always follow a strategy that you understand and are comfortable with, however, there is an approach which avoids chasing a higher ‘natural yield’.
A ‘total return’ approach delivers an income from dividends and coupon payments and makes up any expenditure gap from capital. The main advantage of this approach is that it allows the portfolio to remain properly diversified, rather than becoming concentrated around credit risk in bonds and increasing sector and company specific risks in equities. You can also maintain the risk level of your portfolio so that it matches your own preferences, needs and risk profile.
In addition to your investment portfolio, if you hold an adequate cash reserve to meet your expenditure needs for a set number of years, this should enable you to choose when to take capital withdrawals rather than be a forced seller of equities when markets have fallen.
If equity markets rise you can use some of the capital appreciation to provide any capital you need whilst still maintaining your preferred asset allocation by using the remaining gains to purchase bonds.
A total return approach combined with an adequate cash reserve and regular reviews of your portfolio’s mix of assets should enable you to meet your lifestyle needs without falling into one of the potential traps described above. However, as with all long tern investing, risk and return are related so the more return (income or capital growth) you need for your objectives the more risk you need to take.
This blog is intended for information purposes only and no action should be taken or refrained from being taken as a consequence without consulting a suitably qualified and regulated person. Your capital is at risk when investing. Past performance is not a reliable indicator of future results.