Contributed by: Nick Defenthaler, CFP®, RICP®
Now more than ever, we find ourselves reminiscing. And if you’re like me, it’s usually about the simple things in life that were so easy to take for granted. Like going out to eat with a large group of friends, having a surprise birthday party for a loved one, or attending a sporting event or concert with a packed arena filled with 30,000 fans having a great time. COVID has caused this reminiscing to occur and it has also played a role in reminiscing of a world where investors used to receive a reasonable yield on portfolios for a relatively low level of risk.
Interest rates have been on a steady decline for several decades now, so COVID certainly isn’t the only culprit to blame here. That said, reductions in interest rates by the Federal Reserve when the pandemic occurred in spring 2020, certainly did not help. As an advisor who typically works with clients who are within 5 years of retirement or currently retired, it’s common to hear comments like, “When we’re drawing funds from our accounts, we can just live off of the interest which should be at least 4% - 5%!”. Given historical dividend and bond yield averages and the fact that if we go back to the late 90s, an investor could purchase a 10 year US treasury bond yielding roughly 7% (essentially risk-free being that the debt was backed by the US government), I can absolutely see why those who lived through this time frame and likely saw their parents living off this level of interest would make these sort of comments. The sad reality is this – the good old days of living off portfolio interest and yield are pretty much dead right now (unless of course, you have a very low portfolio withdrawal rate) and it will likely remain this way for an extended period.
One way to look at this is that the average, historical “cost” to generate $1,000 of annual income from a 50% stock, 50% bond balanced portfolio has been approximately $25,000 (translates into an average yield of 4%). Today, an investor utilizing the same balanced portfolio must invest $80,000 to achieve the $1,000 annual income goal. This is a 320% increase in the “cost” of creating portfolio income!
It’s worth noting that this is not an issue unique to the United States. The rising cost of portfolio income is a global conundrum as many countries are currently navigating negative interest rate environments (ex. Switzerland, Denmark and Japan). Click here to learn more about what this actually means and how negative interest rates affect investors. Below is a chart showing the history of the 10-year US government bond and US large cap equities from 1870 to 2020.
Source: Robert Shiller http://www.econ.yale.edu/~shiller/
The chart is a powerful visual and highlights how yields on financial assets have taken a nosedive, especially since the 1980s. The average bond yield over 150 years has been 4.5% and the average dividend yield has been 4.1%. As of December 2020, bond yields were at 0.9% and dividend yields stood at 1.6% - quite the difference from the historical average!
So why this dramatic reduction in yields? It’s a phenomenon likely caused by several factors that we could spend several hours talking about. Some experts suggest that companies have increasingly used stock repurchases to return money to shareholders which coupled with high equity valuations have decreased dividend yields globally. Bond yields have plummeted, in part from a flight to safety following the onset of the pandemic as well as the Federal Reserve’s asset purchasing program and reduction of rates that has been a decade-long trend.
The good news is that a low-interest rate environment has been favorable for stocks as many investors (especially large institutional endowments and hedge funds) are realizing that bonds yields and returns will not satisfy the return requirements for their clients which has led to more capital flowing into the equity markets, therefore, creating a tailwind for equities.
Investors must be cautious when “stretching for yield”, especially retirees in distribution mode. Lower quality, high yield bonds offer the yields they do for a reason – they carry significantly more risk than government and high quality corporate and mortgage-backed bonds. In fact, many “junk bonds” that offer much higher yields, typically have a very similar correlation to stocks which means that these bonds will not offer anywhere near the downside protection that high quality bonds will during bear markets and times of volatility. In 2020, it was not uncommon to see many well-respected high yield bond mutual funds down close to 25% amid the brief bear market we experienced. That said, many of these positions ended the year in positive territory but the ride along the way was a very bumpy one, especially for a bond holding!
The reality is simple – investors who wish to generate historical average yields in their portfolio must take on significantly more risk to do so. It’s also important to note that higher yields do not necessarily translate into higher returns. US large cap value stocks are a perfect example of this. Value stocks, which historically have outperformed growth stocks dating back to the 1920s, have underperformed growth stocks in a meaningful way over the last 5 years. This underperformance is actually part of a longer trend that has extended nearly 20 years. Value companies (think Warren Buffet style of investing) will pay dividends, but if stock price appreciation is muted, the total return for the stock will suffer. Some would argue that the underperformance has been partially caused by investors seeking yield thus causing many dividend-paying value companies to become overbought. In many cases, the risk to reward of “stretching for yield” just isn’t there right now for investors, especially for those in the distribution phase. It simply would not be prudent to meaningfully increase the risk of a client’s allocation for a slight increase in income generated from the portfolio.
As we’ve had to do so much over the past year with COVID, it’s important for investors, especially retirees, to shift their expectations and mindset when it comes to portfolio income. Viewing one’s principal as untouchable and believing yield and income will be sufficient in most cases to support spending in retirement is a mistake, in my opinion. Maximizing total return (price appreciation and income) with an appropriate level of risk will be even more critical in our new normal of low rates that, unfortunately, has no sign of leaving anytime soon.
Nick Defenthaler, CFP®, RICP®, is a Partner and CERTIFIED FINANCIAL PLANNER™ professional at Center for Financial Planning, Inc.® Nick specializes in tax-efficient retirement income and distribution planning for clients and serves as a trusted source for local and national media publications, including WXYZ, PBS, CNBC, MSN Money, Financial Planning Magazine and OnWallStreet.com.
Views expressed are not necessarily those of Raymond James and are subject to change without notice. Information provided is general in nature, and is not a complete statement of all information necessary for making an investment decision, and is not a recommendation or a solicitation to buy or sell any security. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise. Past performance is not indicative of future results. There is no assurance these trends will continue or that forecasts mentioned will occur. Investing always involves risk and you may incur a profit or loss. No investment strategy can guarantee success.