In the current low-interest rate environment, and in light of continued stock market volatility, many investors have embraced high income‐oriented investment strategies. The expectation, or hope, is that a higher yielding portfolio will reduce volatility and generate enough income to meet cash needs, thereby allowing the investor to forego spending principal. Picking up on this trend, the financial press continues to provide guidance on how best to replace lost income in a zero‐yield world, and fund companies continue to rush new income‐oriented investment solutions to the market place.
In an effort to increase yield, investors may consider two common approaches or a combination thereof. Within fixed income segments, investors may lower credit quality or extend the average maturity of bond positions. Within equities, investors may exclude non‐dividend paying stocks in favor of large, mature companies that have a long history of distributing and increasing dividends over a specified period of time.
Yield-seeking within fixed‐income segments may have the underappreciated impact of increasing correlation and risk within the aggregate portfolio. Bonds of lower credit quality typically exhibit higher correlation to stocks and may not offer downside protection during periods of heightened volatility. The Barclays Capital U.S. Corporate High Yield Index, for example, fell as much as 33% during the height of the Credit Crisis in 2008. Also, given that interest rates have hit record lows, investors who now choose to extend the maturities of their bond holdings may be setting themselves up for future losses when interest rates eventually rise. While high‐yield bonds and long‐term bonds can be part of a well‐diversified portfolio, dollars that are earmarked for capital preservation should satisfy the criteria of being stable and available on a moment’s notice.
Market commentators and fund companies have also proposed that investors seeking safety look no further than well‐established mega‐cap companies with long track records of paying and increasing dividend distributions. Under this approach, the allocation decision seems to be as simple as identifying companies that have paid dividends over a specified period of time, often 20 years or longer. However, if the allocation decision truly is that simple, we should see actively managed, dividend‐focused funds have no problem outperforming the market indices. The facts do not support this theory. History suggests that investors are better off owning a more broadly diversified portfolio that includes both income and growth components.
We believe that high‐yield and long‐term bonds, as well as dividend‐paying stocks can be a part of a well‐diversified portfolio, but so are high‐quality bonds and small or growth companies that pay no dividends today but may turn out to be the mega‐cap dividend payers of tomorrow.