Can You Get 7% Per Year in Income with Only Moderate Risk?

With ten-year Treasury bonds yielding around 2%, many investors are looking for investments that can provide higher levels of yield. Barron’s just ran a cover story on this topic, titled:

“How to Get Safe Annual Payouts of 7%: Despite rock-bottom interest rates, you can still earn investment income of 7%-plus per year. How to keep money flowing during retirement.”

But is it really possible to create a low-risk portfolio with a yield of 7% or more?

The prevailing low yields on Treasury bonds are encouraging many income-oriented investors to look beyond the relative safety of government bonds.  The big challenge for income investors is not simply to find high-yield assets but to find high-yield assets with tolerable levels of risk.

As of this writing, Portugal’s 10-year government bond yield is 10.93%, but this high yield reflects the bond market’s perception that there is substantial default risk for bondholders.  Similarly, the Barron’s article identifies a series of well-known yield-generating asset classes, but does not do much to help investors solve the real problem which is how to determine the risk levels of these high-yield assets.  The title of the Barron’s article is “How to Get Safe Annual Payouts of 7%,” but the reader is left with the problem of determining the safety of building a portfolio out of these asset classes. We all know that junk bonds are yielding between 7% and 8%, but are these indeed “safe annual payouts” as the Barron’s article suggests?  The same question goes for REIT’s, another of the high-yield asset classes Barron’s proposes can be used to build safe high-yield portfolios.  The article also suggests leveraged bond funds as a candidate for safe income portfolios.  The same issues apply. The crux of the problem is that while yield is simple to obtain, estimating risk takes more effort.  Fortunately, there are objective, rational ways to quantify the risk in an asset class and (to a lesser extent) of an actively managed mutual fund.

In October of 2010,  I authored an article on this topic titled, “Yield vs. Risk” that appeared in Financial Planning magazine.  I have further developed this approach in a series of articles published in Advisor Perspectives.  When I look at the list of high-yield asset classes proposed for safe income in Barron’s, I am struck by the fact that some of them are anything but safe.  Vanguard’s REIT ETF (VNQ), lost 37% in 2008.  MarkWest Energy Partners (MWE) lost more than 69% in 2008.  That does not mean that these are not good investments—many of them are, in my opinion.  The challenge is figuring out who they are great investments for.  Given that income investors tend to be older, and the Barron’s article’s subtitle makes it clear that the approach is aimed at people in retirement, are these really plausible investments?

Measuring Risk

The starting point for measuring risk in an asset class is a measure called implied volatility.  For a review of the concept, see the article linked above.  Suffice it to say for the moment that implied volatility is a standard measure of future risk potential in an investment and it is available from many data providers including Morningstar.  So, for example, if we wanted to look at the expected risk in Vanguard’s REIT ETF (VNQ), we could easily obtain this.  The implied volatility for VNQ from now until the middle of next year, is about 37% and the yield is 3.4%. For reference, the implied volatility for the S&P500 (SPY) over the same period is about 31% and the yield fromSPY is 1.96%.  So, while the yield from VNQ is considerably higher than that of the S&P500, the expected risk in VNQ is markedly higher than an investment in the S&P 500 Index.  Implied volatility really can be thought of as relative risk, and the implied volatility numbers are telling us that VNQ is riskier than the S&P 500.

When we move from discussing risk in a single security to estimating risk in a portfolio with multiple holdings, the problem is more difficult.  We need not only to project risk levels for each security but also to calculate how the different securities move relative to one another.  This can be accomplished using computer models called Monte Carlo simulation.

Building a Portfolio

To explore this issue further, I decided to build a portfolio using the list of investment alternatives proposed in the Barron’s article.

Obviously, I can only use the listed securities such as mutual funds, ETFs, and MLPs.  My goal was to create a portfolio with the lowest possible risk level that would yield at least 7%.  The process of building this portfolio was exactly the same as the approach presented in my 2010 article in Financial Planning (and linked above).  Along with the list of securities proposed in the Barron’s article, I included two government bond ETFs: SHY (short-term) and IEF (intermediate-term).  While both of these ETFs have low yields, they can help to control the overall portfolio risk level.

The process of building a portfolio is more complex than simply selecting a set of high-yield securities.  The portfolio needs to combine investments with relatively low correlation to one another in order to control risk.  I ran an optimizer using projected risk levels for each of the possible investments, constraining the maximum investment in any single security to 10% of the portfolio, and the resulting portfolio is shown below:

Name Fund Ticker

Allocation

Yield

Expense Ratio

Annaly Capital Management NLY

10.0%

15.1[HM1] %

 
AllianceBernstein Income Fund ACG

10.0%

6.0%

0.71%

T. Rowe Price Emerging Markets Bond PREMX

10.0%

6.8%

0.95%

Neuberger Intermediate Muni NBH

10.0%

5.5%

1.30%

iShares High Yield Bond HYG

9.3%

7.8%

0.55%

BlackRock Muni BAF

9.2%

6.1%

0.00%

PIMCO Emerging Local Bond PELAX

9.1%

6.8%

1.35%

Eaton Vance Income Fund EVIBX

8.8%

7.9%

1.04%

Vanguard High Yield Tax Exempt Bond VWAHX

4.7%

4.4%

0.20%

Kinder Morgan KMP

4.0%

6.2%

 
BlackRock Credit Allocation BTZ

3.6%

7.7%

1.07%

Fidelity New Markets Income FNMIX

2.8%

5.4%

0.88%

iShares 7-10 Year Treasury Bond IEF

2.5%

2.7%

0.15%

PPLCorp PPL

2.3%

4.8%

 
iShares 1-3 Year Treasury Bond SHY

2.3%

0.9%

0.15%

BCEInc BCE

1.5%

5.2%

 

Model 7% Yield Portfolio

The portfolio has a yield of 7.1% and an expense ratio of 0.64%.  The projected and historical risk level of this portfolio is slightly less than the risk of a portfolio that is 50% allocated to Vanguard’s total stock market index (VTI) and 50% allocated to Vanguard’s aggregate bond ETF (BND).

Long-dated options on the S&P 500 suggest that the expected annualized volatility of the S&P 500 will be about 29% as of this writing.  When I calibrate my Monte Carlo simulations to reflect this level of volatility for the market, the projected volatility for the Model 7% Yield Portfolio is 15.5%.

I was somewhat surprised that it was possible to construct a portfolio with such a high level of yield at this relatively low risk level.  The high level of allocation to a risky asset such as NLY was something of a surprise.  The projected volatility of NLY is 26.7%.  There are also options traded on NLY and the implied volatility is right about 30%, so our projected volatility is very close to what the options market suggests.

Several of investment alternatives that were proposed in the Barron’s article are not included at any level of allocation.  Notable exclusions are Vanguard’s REIT ETF (VNQ), MarkWest Energy Partners (MWE), and Fidelity Real Estate Income (FRIFX).  The relative portfolio contribution to yield provided by allocations to these funds was not sufficient to justify the risk that they add to the portfolio.

A Low-Risk Portfolio With 7% Yield?

The Barron’s article that inspired this article is well worth reading.

Readers who may be unfamiliar with some of the asset classes discussed in this piece will find a good overview here.  My analysis usingMonte Carlo simulation suggests that it is, indeed, possible to build a fairly low-risk portfolio with a yield of 7%.  Accomplishing this feat requires a careful combination of these types of asset classes that can provide substantial yield.  You can still do quite well, however, even with a simple equal-weight combination of the assets in the portfolio I constructed shown above.  Allocating equally to each of the securities in that portfolio (6.25% allocated to each ticker) results in a portfolio with 6.2% yield and a very similar level of risk.

Given all of the uncertainties with the growth prospects of U.S. and global economies, it is hardly surprising that more attention is being given to asset classes beyond traditional stock and bond indexes that can be used to build a portfolio which generates substantial income at moderate risk levels.

Related Links:

 

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14 thoughts on “Can You Get 7% Per Year in Income with Only Moderate Risk?

  1. jack

    How far back in time were you able to look at this?
    What was the max drawdown?
    What was the longest period of time in drawdown to new high?
    Do you have an equity curve picture?

  2. Geoff Considine Post author

    Hi Jack:

    In this analysis, I focused on forward-looking simulations. Some of these funds have fairly limited histories and, of course, market conditions vary through time. Looking at historical performance is useful, of course, but not the focus here. I have written a great deal about forward-looking simulation and why it makes sense.

    Thanks for the your comment,

    GC

  3. Ray Peterson

    Compared to others (Barrons for example), where you get something to catch the eye and sell magazines, Geoff Considine is the Joe Friday of finance analysts. You get “just the facts, (ma’am)”.

  4. Cheryl Keys

    Thanks for the excellent analysis. I would be interested in implementing this approach inside an IRA and therefore do not need the tax-free benefit of muni’s. Would you suggest sticking with the plan as is or could you offer some alternatives to the muni’s listed?

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  6. don

    Here is a conservative equity comparison. I used Pimco’s PTTRX fund and looked at same time period that My Plan IQ used. (06-29-2007 thru 12-20-2011).
    The 7% yield portfolio starting with $10000, ended with $14253. It also had a massive drawdown of approx. -25% (equity high to equity low in 2008).

    Same time period of buy and hold PTTRX, no rebalance, no commissions starting with $10000, ended with $14622.40. A tad higher than the 7% plan. But the drawdown was only about -4.6% vs the -25% with the 7% plan.

    In my 50 years of doing this, drawdowns and time spent in drawdown are the killers of a plan. Emotions tend to try and find the greener grass of another plan when the pain of and length of drawdowns starts to hurt.

    I do like your work and am no in no way criticizing your plan over at My Plan IQ. I am not even a huge fan of PTTRX. I just like to use it with equity comparisons. PRPFX is another good one to use. It’s equity in this same time frame was about identical to the 7% plan. It’s worse drawdown in 2008 was about -19% vs the -25% on the 7% plan. PRPFX ended 2008 down about -8% where the 7% plan ended 2008 down about -18%. PTTRX ended 2008 with a GAIN of +4.8%

  7. Michael

    Is there such a plan that would involve only ETFs? Something suitable for an IRA as the lady previously asked.

  8. Geoff Considine Post author

    Hi Don:
    Thanks for the comments. You raise some interesting points. The main issue that I would take with your comparison of the ’7% yield’ portfolio to either of those funds is that they are simply going for something very different. PTTRX has a yield of 3.2% and 430% turnover. It also has a minimum investment of $1 Million. PRPFX, the mutual fund that is modeled on Harry Brown’s ‘Permanent Portfolio’ concept has a yield of 0.6%. I would not really classify these as income-focused portfolios. Both are impressive funds–no question–but certainly not high yield. Also, the whole issue of maximum drawdown is interesting for an income investor. Because he/she is not selling shares to fund income in a down market (e.g. the income investor simply takes the income produced by the portfolio), the price volatility should be less of an issue. On the other hand, there is the emotional element of this and individuals and their advisors need to spend serious effort understanding this side of the asset allocation process.

    Also, let’s be very clear that nobody (least of all me) is advocating for this specific portfolio–I simply took the funds in the Barron’s article and ran a portfolio analysis. The specific choices of what to hold in a portfolio are complex and personal and depend on many factors. Further, there is a much broader universe of possible investments than just those in the Barron’s piece.

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  10. don

    Hi Geoff,
    PTTDX could be used if $1 mil is not an option for using PTTRX. Many 401k’s have PTTRX with no minimum. My daughter’s does.

    For me there is a big ulcer index benchmark of what a yield based portfolio is compared to a growth portfolio. If someone is looking for 7% annual yield, they are probably also concerned with principal protection. The main point I was trying to make was that a -25% drawdown to principal while trying to adhere to a 7% yield plan, might be enough to abandon the plan. The -25% loss is really in the aggressive portfolio status, vs. a conservative yield one.

    In a taxable account, taking a smaller dividend/interest and a yearly long term cap gain, might do the same job without that huge drawdown pain. As in the example (example only) of using a combo of low drawdown funds like PTTRX, PRPFX, FPACX, DBLTX, etc…
    If done in a tax deferred account, all the better.

    Everyone is different and a theoretic drawdown is easier to think you can handle until you are really in one with real money. I know for me, -6% equity peak to trough drawdown is as much as I can handle. I have seen many investors gear their plan to a -20% max drawdown loss, and when it hit 1/3 of that, panic and moved on to something else.

    I do enjoy your work. Keep it up!
    Happy New Year.

  11. Geoff Considine Post author

    Hi Don:

    Thanks for the follow-up. The whole issue of yield and risk vs total return is perhaps one of the most important ones that investors face. Any portfolio with a 7% yield will have meaningful risk. The 15.5% volatility projected for the 7% yield portfolio is pretty close to the long-term historical volatility of the S&P500 (e.g. over 40 years or so). But we are in a high-volatility environment and the options market suggests that this will be the case for some time to come.

    Academic theory suggests that investors should not care whether they get their returns from dividends or from price appreciation (the famous Modigliani-Miller theorem):

    http://www.econ.uiuc.edu/~avillami/course-files/PalgraveRev_ModiglianiMiller_Villamil.pdf

    But, in real life there are differences. You are noting a series of psychological hurdles and these are not to be ignored. There is also hindsight bias. The largest documented hurdle for investors in terms of poor performance is the tendency to get in when the market is high and out when the market is low. This is, for example, one of the enduring concerns that I have had with the Permanent Portfolio concept. Money poured in after the strategy had enjoyed enormous gains. I wrote an article about the Permanent Portfolio in March of 2011:

    http://www.advisorperspectives.com/newsletters11/What_Investors_Should_Fear_in_the_Permanent_Portfolio.php

    Any portfolio with expected total return of 7% (note that I write expected rather than historical) will have meaningful risk. The income portfolio with a yield of 7% is no exception.

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