Low Interest Rates
The Fed is likely to hold its short-term interest rate near zero for at least five years. This is a challenge for retirees and others who need stable sources of income.
Depressed bond yields are prompting investors to rethink their asset allocation. At current yields, bonds are “return-free risk”, according to Leon Cooperman, a billionaire investor and hedge fund manager. Leon used the phrase to highlight that bond investors don’t earn anything after inflation, but risk the value of their bonds falling if and when interest rates rise. In short, bonds are a bad bet now.
With 10-year Treasuries paying 0.69% and intermediate investment-grade corporate bonds paying about 2% to 3%, investors are unlikely to stay ahead of inflation with bonds. A better alternative could be a combination of stocks and FDIC-insured certificates of deposit (CDs).
Investing for Income
I constructed a stock portfolio yielding nearly 5% that was about 1/3 less volatile than the stock market during the past 3 years. The portfolio is diversified across eight of eleven industry sectors in the S&P 500 index, excluding financials, consumer discretionary, and materials because of low yields, high volatility, unfavorable business prospects, or a combination of these factors.
For an investor with $1 million, earning nearly $50,000 a year in dividends is far better than $25,000 from intermediate corporate bonds. The primary benefits of investing in stocks instead of bonds for income include:
- Higher current income.
- Stocks and dividends are likely to rise over long periods of time, whereas bonds mature at face value.
- Qualified dividends on stocks often receive favorable tax treatment.
Qualified dividends are taxable federally at the capital gains rate, ranging from 0% to 23.8%, depending on the investor’s modified adjusted gross income (AGI) and taxable income. In contrast, Interest income is taxed federally at an individual’s ordinary income tax rate, which can be as high as 37%.
Qualified dividends, as defined by the US Internal Revenue Code, are ordinary dividends from shares in domestic corporations and certain qualified foreign corporations that were held for at least 61 days of the 121-day period beginning 60 days before the ex-dividend date.
Another requirement is that the shares were unhedged, meaning there were no puts, calls, or short sales associated with the shares during the holding period. Fortunately, most brokerage firms track qualified and non-qualified dividends for investors.
Stocks are volatile and their value at any given future time is uncertain. As a result, funds needed for spending within five or so years should generally not be invested in stocks.
During times of market stress, asset values tend to move together more closely than normal. When the Covid-19-related lockdown triggered the market to fall from its February 19 peak to March 23 low, the 5% dividend portfolio had 20% less volatility instead of 1/3 less volatility experienced, on average, during the last three years versus the broader market.
To illustrate in dollar terms, $1 million invested in the S&P 500 index closing price on February 19 would have been worth $658,953 as of the March 23 closing for a decline of 34.1%. In contrast, the 5% dividend portfolio would have been worth $725,882 over the same period, for a decline of 27.4%. Although the value of the 5% dividend portfolio recovered to $956,023 (excluding $50,000 in annual dividends) by August 27, periods of depressed prices can last for a couple of years.
Another consideration is that companies can cut their dividend. Although companies commonly avoid cutting their dividend, they sometimes do so when experiencing financial pressure.
The optimal asset allocation for each investor depends on his or her circumstances and preferences. As an example, an investor with a $2 million portfolio that needs to support $50,000 in spending beyond all income sources, and a high tolerance for risk, might invest:
- $250,000 in one-year maturity FDIC insured CD’s that currently yield 1%, which is 5 years’ worth of withdrawals for lifestyle expenses.
- $1,750,000 in stocks that are tailored to the investor’s situation and preferences. If invested in the 5% dividend portfolio, it could generate about $87,500 in annual income.
This allocation is 12.5% in bank deposits and 87.5% in stocks on a $2 million portfolio, but applying the same approach would result in 25% bank deposits and 75% stocks on a $1 million portfolio.
The reason to own dividend stocks instead of low-yielding bonds is that, over long periods, stocks are likely to provide a significantly higher investment return. However, dividend stocks come with volatility, making them a poor fit for money that will be needed in the next few years. Money needed for near-term spending should be held in investments that don’t vary much in value, such as bank deposits, money market funds, or investment-grade bonds that mature before the funds are needed.
For more information or help managing your investments, contact Jeffrey Barnett at email@example.com or 201-266-6829. Jeffrey Barnett is the founding financial adviser of Fintegrity®, a Tenafly, New Jersey-based fiduciary registered investment adviser (RIA) that specializes in retirement investing and cash-flow-based financial planning.