With Treasury yields at their lowest levels in 50 years, creating steady income is a high hurdle for income-seeking investors. Conventional wisdom suggests turning to safe, income-yielding investments, such as Treasuries or high-quality corporate bonds. And adding some dividend-paying stocks would achieve a little growth in addition to income.
Today, however, with 10-year Treasuries and the BarCap U.S. Aggregate both yielding less than 3%, and the S&P 500's dividend yield at 1.9%, the search for a consistent payment stream may seem daunting. Another complication is that bonds will face downward pressure on principle when interest rates eventually do rise.
Clients looking for portfolio solutions that provide dependable payment streams that simultaneously maintain or grow principle in perpetuity are turning to financial advisors for the help. By expanding the concept of where you can find income, you can create a portfolio designed to provide reliable distributions and the potential for capital appreciation. Below are ideas on how to achieve that.
Flexible and Durable
Begin by setting proper expectations around attainable distribution amounts. The objective is to avoid returning too much capital so principle can be maintained or grown over time. A flexible payment policy that resets the payment periodically can be based on solid guidelines and the current economic environment. For example, calculating the three-year average of a portfolio's monthly net asset value and resetting the distribution payment within a defined range—such as 5% to 7% of that value—would smooth market volatility.
Other factors to consider when setting the payment rate are expectations of future dividend yields, interest rates and volatility. Financial advisors can reset the payment annually to not only deliver a dependable payment stream but prepare their clients with a plan for their income needs for the upcoming year. Once a payment policy is established, advisors can start building a client's portfolio.
In modern portfolio theory, diversification improves the risk-adjusted return of a portfolio. This same concept can also be applied to generating income. A portfolio that blends multiple income sources can rely on different levers during various economic and market cycles to create a more dependable payment stream. And diverse income sources can be drawn from a robust list of assets classes beyond traditional stocks and bonds. For example, interest can be found in high- yield bonds, floating-rate loans and global bonds, while dividends can be sourced from international developed and emerging markets stocks, small-cap stocks and REITs.
Alternative investments may have lower correlations to classic asset classes and can also be used to further enhance diversification. Mutual funds are a simple and liquid way to access these asset classes relatively easily and efficiently. Yields from the funds and the asset classes can be reasonably estimated based on current averages, historical trends and market conditions to construct a relatively predictable "base case" portfolio yield. Additionally, capital gains from the underlying funds can also be tapped as a source of distributions.
We can further expand our income opportunity set to include premiums from writing call options. Many advisors and investors are familiar with using a covered-call option strategy to generate income in a portfolio. Writing call options on indices that closely track the underlying holdings in a portfolio or mutual fund can also help provide a source of distributions during volatile or down equity markets. The table above shows how a call-writing strategy can be applied to provide partial coverage (in this case 15%) relative to the market exposure in an underlying portfolio. The table highlights the potential premium available, while still allowing for possible appreciation of the underlying portfolio over time.
Returning capital can be an additional method to help support a steady payment stream if all other sources within a portfolio do not satisfy distribution needs. When the net asset value of the portfolio is rising, returning capital merely represents a return of unrealized gains, and the original principle is maintained or grown.
But if capital is returned to cover distributions and the net asset value falls, the capital returned actually reduces the investor's principle balance, in essence returning a portion of his original investment. In either scenario, the return of capital is considered a non-taxable event that may benefit investors in taxable accounts.
Funds Offer Simple Solution
Financial advisors will be increasingly called upon to create endowment-like portfolios that deliver consistent distributions while also maintaining or growing principle balances.
By combining several routine techniques, the approach and ideas discussed above may help provide a solution. For many advisors, however, time spent buildings and managing a diverse portfolio of mutual funds that includes the additional complexities of a call-option overlay and a flexible targeted payment policy means valuable time away from clients needed to build and foster relationships.
Fortunately, several investment management firms have created income solutions that encompass some or all of these techniques in easy-to-access mutual funds. While such products are not without risks, advisors have a variety of available options and can choose the right solution to meet their needs.