Mon, JUN 6th, 2016
Until the financial crisis, many investors could meet their income needs simply by investing in high quality bonds backed by blue-chip companies. People found this to be an ideal match – they could meet their income goals without taking much risk. However, as interest rates dropped, investing for income became much more challenging. While the Federal Reserve has cautiously begun the process of re-normalizing rates, it could easily be several years until interest rates return to their pre-financial crisis levels.
This has created a real challenge for income investors. It is not just bonds that have been affected. Other commonly used income investments are experiencing their own systemic concerns. Oil and gas master limited partnerships have historically been a staple in many income portfolios. However, the drop in the price of oil over the past 2 years has made these investments as challenging as ever. Real estate investments face the opposite situation. In many parts of the country, real estate values are at all-time highs. As prices have gone up, real estate yields or “cap-rates” have gone down.
So what is an investor to do? Unfortunately, there is no perfect solution. As with most aspects of life, investing involves trade-offs. Short term, high-quality bonds have historically offered investors a great deal of stability. Stability is enormously valuable but it doesn’t pay much. The purpose of this article is to briefly explore four broad categories of income investments. Each has important risks associated with them. Readers are strongly advised to work with an investment professional to fully understand these risks.
The benchmark of a “safe and liquid” investment is a short term U.S. Treasury Bill. Unfortunately, the yield on three-month treasury bills is 0.27% or just $2,700 a year on a $1 million investment. As one moves away from bellwethers like this, bonds quickly become increasingly complex. As the world witnessed during the financial crisis, simply relying on a bond’s rating to understand its risk is insufficient. There can be financial engineering and gamesmanship behind the scenes that make it possible for bonds with very different risk profiles to hold identical ratings. Fundamentally, the strength of a bond is directly tied to the health of the issuing entity. Puerto Rico’s current inability to repay its municipal bonds highlights just how quickly and dramatically the health of the issuing entity can change. In addition, bonds from the same issuing entity can also have different risk profiles if they have different priority claims on the issuer’s cash flows.
Another risk is what is known as duration risk. The longer the duration of the bond, the more susceptible it is to interest rate risks. Simply put, you feel differently about interest rates rising if your bond matures in 12 months than you do if you must wait 10 years to be repaid. Theoretically, a 1% increase in interest rates will knock off close to 7% of the market value of a 10-year treasury bond, and close to 15% off the market value of a 30-year bond. It would take three to five years of bond interest payments just to get back to where you started.
Dividend paying stocks (yield: 2-4% per year)
Quality dividend paying stocks tend to increase their dividend payments at a rate faster than inflation. Over the past 10 years, inflation has averaged just a bit more than 2%, while dividend paying stocks in the S&P 500 have increased their dividends by over 5% per year – more than double the pace of inflation. A retiree living off of dividends from high quality stocks has seen his or her purchasing power dramatically increase over time. Yet there is a tradeoff: dividend stocks are subject to stock market volatility. Additionally, there is no guarantee that a company will continue to pay dividends at its current level.
Real Estate Funds (yield: 4% – 7% per year)
Most readers are familiar with the basics of real estate investing. In positive economic cycles, real estate investments tend to do fairly well. Done wisely, real estate produces reasonable cash flows and the opportunity for capital appreciation. Real estate funds are attractive to many investors because they eliminate the time consuming aspects of owning real estate directly. Unfortunately, many fund managers take much of the economic upside as well. These funds take as much as 50% of the profit on top of annual fees. A major risk for any real estate investor is buying at the wrong time. Are we now close to a real estate market high? Our crystal ball is broken but many smart real estate investors are currently choosing to be sellers rather than buyers.
Master Limited Partnerships, MLPs (yield: 5-8% per year)
MLPs are tax efficient investments that typically involve the transportation, processing or storage of oil and gas – such as pipelines. Pipelines function as a toll road and most of their revenues are derived from the total volume of material they transport. They are somewhat indifferent to the price of that material. That said – supply and demand does have an impact. If either drops, so will revenues – reducing cash flows available to investors and negatively impacting the firm’s stock price. They are also subject to the credit risks of their underlying customers (energy companies) which is one of the reasons MLPs have seen their market values decline materially as the price of oil has fallen. Like dividend stocks and publicly traded real estate funds, MLPs are subject to market volatility.
Private Debt Business Development Companies or BDCs (yield: 6-9% per year)
BDCs are funds that pursue a variety of strategies. One is providing debt financing to privately held, medium-sized companies. These firms typically pay higher interest rates on their loans than would larger public companies. BDC investments may include leverage and pursue a wide range of businesses from risky start-ups to safer, more mature companies. Because of this, the market price of BDCs can be volatile. Look for BDCs that have a long track record and that provide floating rate loans to larger companies; floating rates will help protect you from rising interest rates and larger companies tend to have more alternatives if difficult economic times return. Analyzing the health of any lender’s portfolio of outstanding loans is difficult but critically important. A long track record gives investors some insight into a fund’s past underwriting success.
We began this article with the advice to keep risks in mind when analyzing any investment. We close with the sometimes counter-intuitive advice to consider including some risks in your investment strategy. A portfolio of just short term high quality bonds has its own risk – the risk of underperformance. If an investor needs a 5% per year return to achieve his or her goals, investing only in short-term treasuries guarantees this investor will fall short (1-year treasuries yield just 0.54%).
That is the challenge with “safe” investments – you sleep soundly each night as you drift further and further away from reaching your investment goals. Most investors need some exposure to stocks/equities to reach their goals. The challenge is determining what asset allocation – what mix of stocks and bonds – is right for you. Asset allocation is one of the most important factors in determining your investment success. Touch base with your financial advisor and have this discussion. If you don’t have a financial advisor, give Albion Financial Group a call. We’d be happy to discuss this with you.
Doug Wells, MBA, CFA, CFP
Albion Financial Group