Total Return vs. Income: Investing in an Age of Low Interest Rates

HIGHLIGHTS:

• Over time, the source of Investment Return has changed dramatically.
• A focus on Yield is common; it is a legacy from our parents’ era of investing.
• At Bragg Financial, our focus is on Total Return or Overall Return, which includes income and capital appreciation.           

You may have heard success stories of investors who were able to retire and live comfortably off of their stock dividends, or perhaps fund their retirement spending solely from interest payments from their bond portfolios. While that may have worked for some in your parents’ or grandparents’ generation, those success stories are rarely heard in 2019. Interest rates have fallen dramatically, as shown in the chart below. In 1981, the yield on a ten-year Treasury bond peaked at 15.84%, while on July 31, 2019, the ten-year Treasury yield was just 2.02%.

Source: BLS, FactSet, Federal Reserve, J.P. Morgan Asset Management. Real 10-year Treasury yields are calculated as the daily Treasury yield less year-over-year core CPI inflation for that month except for July 2019, where real yields are calculated by subtracting out June 2019 year-over-year core inflation.

Just as with bonds, yields on stocks were historically higher than yields on stocks are today. The chart below, provided by Multpl.com uses data compiled by Robert Shiller and goes back to 1880. While the current yield on the S&P 500 is approximately 1.97%, the long term average is 4.3%.

Current Yield: 1.97% as-of 12:00 PM August 15, 2019. Source: Standard & Poor’s for current S&P 500 Dividend Yield. Robert Shiller and his book Irrational Exuberance for historic S&P 500 Dividend Yields.

Shown below are the ten largest stocks in the S&P 500 ranked by total market capitalization or total market value.  Also shown is the current dividend yield of each stock, along with the five-year and ten-year annualized total return (dividend plus capital appreciation) for periods ending 7/31/2019. Four of the ten companies pay no dividend at all and the weighted average yield of the group is only 1.1%. Of note, the stock with the highest current yield (Exxon Mobil) has had the lowest total return over the last ten years. This table makes it clear that over the last ten years at least, dividends have been a small part of the total return of these companies.

Expanding our study from 10 companies to 500 companies and from 10 years to over 75 years, the following chart shows the components of stock returns by decade for the entire S&P 500. Over the last few decades, an increasing portion of the total return from equities has come from capital appreciation and a diminishing portion has come from income (dividends).

Source: Hartford Funds

There are a number of reasons for the dramatic change in the components of stock returns but the primary driver is stock valuation multiples. In general, stocks trade at higher multiples of their earnings and dividends than historically. Said another way, over the last twenty years or so, investors have been willing to pay a higher price for a dollar of earnings than historically was the case. Why? One explanation is that business cycle has become smoother. With fewer booms and busts, investors have simply become more confident about holding shares of companies for the long term. Perhaps the biggest driver of high multiples though, is today’s extremely low rate environment. Back in the seventies or eighties when bonds yielded 7-8%, an investor was less interested in enduring the volatility of the stock market. But with bonds yielding 2-3% today, stocks are a bit more attractive.

A Focus on Yield

A question we are often asked is “What does my portfolio yield?” Usually the question refers strictly to the income component of a portfolio return and ignores the return from capital appreciation. Interest and dividends will always be positive, while price movement can be either positive or negative. As a result, investors who consider themselves “conservative investors” tend to be more focused on income investing, not realizing the risks they may be taking or the return they are foregoing.

“As long as they keep paying their dividend, I don’t really care what the stock price does” is a common refrain from income investors. In our opinion, this ignores the pitfalls that this approach may bring. Locally, many people remember Bank of America cutting their dividend from 64 cents a quarter in 2008 to one cent a quarter for all of 2009 until September 2014. More recently, General Electric cut their quarterly dividend from 24 cents to one cent in December of last year. In addition to these blue chip companies cutting their dividend by over 95%, the stock price of each company also fell over 75% in the two-year period prior to the dividend reduction to one cent.

Let’s assume an investor plans to draw 4% from a portfolio annually to fund spending in retirement. Forty years ago, investors could have comfortably retired and lived off of the income from a conservatively allocated portfolio. That has changed. Per a recent Vanguard study, a 50% stock/50% bond portfolio hasn’t consistently yielded over 4% since the early 2000s, and a portfolio comprised solely of investment grade bonds hasn’t yielded over 4% since 2010.*

With interest rates at such low levels, yield investors are faced with a decision. Find a way to increase the yield on their portfolios, or focus on total return investing. The first option, “reaching for higher yields,” inevitably means taking on significantly more risk. The risk/reward relationship is very much intact when it comes to fixed income securities.

Risks with Yield Approach

There are several ways investors can increase the income in their portfolio. Within equities, they could shift to higher-yielding stocks. They could accomplish this by shifting out of smaller companies into larger companies, as larger, more established companies are more likely to pay dividends. They could also focus on higher-yielding sectors such as real estate, utilities, telecom, energy and consumer staples. These moves to increase income within stocks will lead to a more concentrated, less diversified portfolio and may neglect major sectors of the stock market, such as technology and consumer discretionary stocks. Income-only equity investing would have missed the great runs of companies such as Facebook, Amazon, Alphabet (Google) and Berkshire Hathaway.

Within bonds, there are two primary ways to increase income. The most common way is to increase the credit risk of your portfolio. For example, instead of buying a five year US Treasury bond, you could buy a higher-yielding five year bond of Gannett Company (the largest US newspaper publisher). The Gannett bond has a higher yield because there is more risk. In the digital age, newspapers are in decline; the Gannett bond yields more because there is a much higher likelihood of default. The other way you could increase the yield on a bond portfolio is to increase the duration, or maturity, of your bonds. Instead of buying a five-year Gannett bond, you could buy a ten-year Gannett bond. In this case, you would have to wait ten years for Gannett to pay back the money you loaned them instead of five.

At Bragg Our Focus is on Total Return

We focus on total return or the overall return, which includes income and capital appreciation. Said another way, total return factors in the interest and dividends of a security or portfolio as well as each security’s price movement. Unlike income-only investors, we diversify among all sectors, recognizing that some growth companies such as Amazon and Facebook don’t pay dividends but have provided attractive total returns over time. We believe dividends and income are an important part of an investor’s total return; over 90% of the individual stocks we buy pay dividends and our large cap equity dividend yield is approximately 2.5%, slightly higher than the yield on the S&P 500. Our fixed income portfolio yields around 2.5-3%, depending on the mix of taxable to tax-free bonds. Much like the trends mentioned by Vanguard, our portfolios yield under 4%.

As we like to say at Bragg, “We can easily increase the income yield on your portfolio, but higher yields come with higher risk. There is no free lunch.”  “Reaching for yield” can result in disappointment when the bond issuer defaults or when the stock of a risky company plummets. The low yield of a Treasury bond today reflects the fact that there is minimal risk…the US Government can always print money to pay you back. The high yield of an emerging market bond reflects the fact that there is much more uncertainty that you’ll be repaid. At Bragg, we do not chase yield and prefer to focus on total return investing over income investing. We feel that income investing only covers part of the equation, as it fails to address price fluctuation. Income investing is subject to price increases and decreases just like total return investing.

Total return investing views all of the assets in the portfolio as fungible. It is not important whether the money required to fund or supplement your living expenses comes from interest income, dividends or from selling a security. We have found our clients prefer receiving a fixed monthly draw, instead of the income from the portfolio, which is often lumpy from month to month, as income is paid monthly, quarterly, semi-annually or even annually.

We make conservative assumptions about the total returns of stocks and bonds over the long term. We project future total returns based on these assumptions. To create a sustainable income stream that will provide cash flow but also keep up with inflation, we recommend drawing a percentage of the account balance annually, based on these long-term assumptions.  Portfolio construction in total return investing therefore can be properly focused on building the optimal portfolio which favors diversification, low cost and tax efficiency over yield alone. Please let us know if you have questions about this article or your portfolio.

This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.