In a recent post, I presented a list of the ‘core asset classes’ that investors need in order to build portfolios that fully exploit available diversification opportunities. That article focused on portfolios designed for total return potential, the combined return from price appreciation and income generated by the assets in the portfolio. For investors focusing on building income-generating portfolios, the core asset classes are somewhat different. In this article, I present a proposed set of core asset classes for income-focused investors, along with examples of representative funds.
The dilemma for income investors is that there are large sectors of the security universe that generate little or no income. To be an income investor is to largely ignore these sectors. Ignoring specific sectors of the economy can reduce portfolio diversification. If financial markets are perfect (aka ‘efficient’), it is most sensible to hold an allocation to every sector. The problem is that markets are, apparently, not efficient. There are numerous studies that demonstrate that real markets behave more differently than efficient market theory suggests. Even with this body of research, however, it is indisputable that there is a substantial portion of the economy that will not be represented in an income-focused portfolio. On the other hand, once we start to target income-generating assets, certain asset classes come to our attention that are commonly ignored.
I am not going to explore the debate about an income vs. total-return strategy in this article. My focus here is simply to provide a list of the asset classes that generate substantial income streams and that are worth considering in an income portfolio.
While bonds are core asset classes in total-return portfolios and income portfolios, the sub-classes of bonds that are worth considering is somewhat different in these two cases.
- Short-, medium-, and long-term Treasury bonds: SHY (0.39% yield), IEF (1.8%), TLT (2.7%)
- Treasury inflation-protected securities: TIP (2.2% yield)
- Investment-grade corporate bonds: LQD (3.8%)
- High-yield corporate (aka junk) bonds: HYG (6.6% yield), JNK (6.7%)
- Muni bonds: PZA (4.0% yield), MUB (2.85% yield)
- High-yield muni bonds: HYD (4.85% yield)
- Emerging market bonds: PREMX (5.7% yield)
Treasury bonds have low yields in the current environment, but they end up with some allocation in my analysis of optimal income portfolios because of their diversification effects. A large part of the challenge for individual investors and advisors is becoming familiar and comfortable with less well-known asset classes. High-yield bonds are perhaps the most important of these. These are the bonds issued by firms that are not ‘investment grade’ and have meaningful risk of default. The long-term historical data suggests that high-yield bonds provide an attractive payoff relative to their risk levels.
Among stocks, a number of sectors and fund styles are consistent providers of dividend income:
- Utility stocks: XLU (4.0% yield), IPU (4.6% yield)
- Telecommunications stocks: IYZ (2.6% yield), IST (6.2% yield)
- Preferred share funds: PFF (5.8% yield), PFXF (5.98%)
- Dividend aristocrats / dividend achiever index funds: SDY (3.1%), PEY (3.96%)
At the current time, international dividend and telecom sectors (IPU, IST) are yielding considerably more than their domestic counterparts. I believe that this discrepancy is largely due to ongoing concerns with the Euro-zone economies.
Preferred shares have been an area of active interest on the part of investors, with substantial inflows. PFF, for example, has a one-year return of 18.9%. One of the most common critiques of funds that focus on preferred shares is that they tend to be heavily overweight in financial stocks. A new fund, PFXF, provides an alternative by specifically excluding financial stock. This fund has a yield of 5.98% vs. 5.8% for PFF.
There are indexes of stocks that have a long historical track record of maintaining and raising their dividends. One of the best-known of these lists is S&P’s Dividend Aristocrats. The companies that qualify as Dividend Aristocrats are typically consistent long-term performers, a feature that makes them attractive to income investors and total return investors alike.
A special class of investments for income investors is publicly-listed companies that pass their income to investors prior to being assessed any tax. The investors are taxed on the income, but the companies are not. These so-called Flow-Through Entities (FTEs) typically own and manage a portfolio of physical assets that generate income. This income is then passed along to investors, after expenses associated with managing the physical assets have been paid. The two most common forms of FTEs own and manage either real estate (Real Estate Investment Trusts or REITs) or energy production, refining, transport and storage facilities (Master Limited Partnerships or MLPs). A less prevalent type of FTE is a mortgage REIT that holds a portfolio of mortgage securities from which it generates income via repayment of the mortgage debt.
- Master Limited Partnerships (MLPs): KMP (6.4% yield), EPD (5.2% yield), CLMT (8.0% yield)
- Real Estate Investment Trusts (REITs): ICF (2.95% yield), VNQ (3.35% yield)
- Mortgage REITs (mREITs): NLY (13.8% yield), AGNC (15.9% yield)
Closed-end funds (CEFs) are a special type of investment vehicle that is quite different from its better-known open-end mutual fund counterparts (what most people simply think of as mutual funds). Like mutual funds, CEFs hold a portfolio of securities and employ portfolio managers to select these securities. Unlike open-end funds, CEFs have an IPO in which a specific number of shares are issued. The number of available shares of traditional mutual funds is not fixed, and the fund company can create or redeem shares as demand dictates. As a result of this difference, shares of a CEF can trade at a price greater than or less than the market value of the securities that the fund holds. For this reason, investors need to be very careful to examine the discount or premium on CEF shares (this is a standard metric). CEFs are a popular structure for income-focused funds because CEFs can employ leverage (something that traditional mutual funds cannot). In a low interest rate environment, a leveraged CEF can take advantage of cheap borrowing to create higher levels of income.
CEFs are somewhat complicated. I have written a detailed review article here. Two CEFs that this analysis found to have attractive income relative to their risk levels were EOD (10.9% yield) and HYV (8.4% yield).
There is some overlap between the set of core asset classes that I propose here and those for total return portfolios. While the core asset classes proposed for total return investors will be familiar to most investors, some of those included in the list for income investing are not terribly well-known.
Any investor attempting to create a portfolio out of these asset classes needs to have a sophisticated understanding of risk. Some of the investments listed above can be very risky.
The portfolios that result when we start with this palette of asset classes inevitably end up looking fairly unconventional. Here are two examples:
Investors and advisors who choose to pursue an income-oriented strategy need to understand that the resulting portfolios will tend to have higher tracking error relative to the broader markets than more conventional asset allocations. If the U.S. economy remains in a state of muted growth, however, the levels of income available from this type of portfolio could be hard to match.
- Investing for Income vs. Total Return
- Mel Lindauer on Income Investing
- Global Investing for Dividends
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