Build a Better Path to More Efficient Income
What You Need to Know
The search for income is getting harder, and there’s no shortage of suggestions on where to get a little bit more. But what about the cost? We think that focusing on creating a better return sequence can help investors access more efficient income.
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The baby boomer generation continues to move from its peak earning years into the retirement phase. As it does, it’s become much more income hungry. And this appetite is having a big impact on the demand for income-generating allocations. In target-date solutions, for instance, bond allocations for peak earners are typically in single-digit percentages; for retirement-age investors, bonds can make up as much as half of their overall portfolio.
LOOKING FOR INCOME IN AN INCOMELESS WORLD
But the search for income is a challenge today, and isn’t getting any easier. More and more baby boomers will be demanding income-generating bonds, and the income those bonds generate is now lower, thanks to years of Federal Reserve quantitative easing, which shrunk the market and reduced yields. As a result, yields are low today—and even lower after inflation and taxes.
At the same time, risks inside income-oriented indices are rising. The duration, or interest-rate sensitivity, of bond indices has grown by 30% since 2008. And with the US late in the credit cycle, credit quality is declining. On the equity side, dividend-paying stocks, based on price-to-earnings ratios, are trading at a valuation of 24.8 times earnings.
There’s no shortage of ideas and suggestions on where to squeeze out a little more income today, but there’s not much talk about the cost of that extra income. Many of the areas that people point to for an income boost face large drawdowns if things go wrong. Preferred stocks are a good example: Over the past 10 years, the average drawdown in Morningstar’s Preferred Stock category was 8%, and the biggest was about 44%.
