The Income Trap

Given the focus many investors have on portfolio income (rather than total return, which includes both income and capital appreciation), today’s historically low bond yields are forcing them to either dramatically reduce spending or find a means of increasing portfolio cash flow. Unfortunately, structuring a portfolio to maximize interest and/or dividend income often introduces hidden risks and inferior results.

Let’s explore how three common income-centric strategies may actually undermine the portfolio’s long-term potential:

• Overweighting bonds: Though the total returns produced by bonds are about half that of stocks historically, the interest income produced by bonds often meets or exceeds the dividend yield of a broadly diversified stock portfolio. As result, income-focused investors find the steady cash flows and stable values of bonds very appealing (particularly in light of heightened stock volatility over the last few years).  However, it is critical to recognize that reducing stocks in favor of bonds is simply trading one risk for another – while the portfolio value will experience less variability, the expected longevity and/or spending power of the assets is reduced as well. This risk is particularly acute given the depressed outlook for high-quality bond returns over the next decade.

• Focusing on high-yield bonds: The appeal of high-yield bonds is an obvious one: higher income. However, high-yield bonds are also known as “junk bonds” for a reason – a higher interest rate is paid because the probability of the company being unable to repay the principal is significantly greater than it is for issuers of “high-quality” bonds. And a more subtle, but equally important, implication is that the heightened uncertainty of high-yield bonds introduces additional portfolio volatility. This violates the primary role of bonds within the portfolio, which is to dampen the volatility introduced by stocks. Within a portfolio context, the risk-return combination delivered by stocks and high-quality bonds is typically superior to that of a portfolio that includes a significant allocation to high-yield bonds.

• Focusing on high-dividend-paying stocks: This approach carries a lot of intuitive appeal for investors regardless of the environment, but it can seem especially compelling when bond yields are low. There are two potential flaws with this strategy.First, focusing the stock holdings of a portfolio in dividend-paying companies can skew the portfolio heavily toward certain industries. This inhibits portfolio diversification and often exposes the investor to sector and/or company concentration. Unfortunately, 2008 proved particularly costly for investors with a concentration in the Financials sector, traditionally a favorite of many income-focused investors.Second, income-starved investors who may be re-allocating assets from bonds to dividend-paying stocks are drastically increasing portfolio risk. For example, the single worst 12-month return (since 1926) experienced by Five-Year U.S. Treasury Notes is -5.6%. In comparison, Vanguard’s High Dividend Yield Index Fund (VHDYX) posted a return of -44.7% for the 12-month period ending February 2009. In no way does an investor insulate the portfolio from equity risk by overweighting high-yielding stocks.

In addition to risks inherent in income-centric strategies, investors should not overlook the potential tax implications. While the tax rate advantage of capital gains and dividends could change in the future, the entire cash flow from a stock dividend or bond interest payment will always be subject to tax; alternatively, only part of the cash flow generated from the sale of appreciated shares is taxed (the portion in excess of cost basis). By favoring dividends or interest income simply to avoid spending portfolio principal, investors may be impairing their net-of-tax results.

The purpose of all investments is to acquire gain – the form of cash flow is less important than the size of wealth. Prudent investors strive to maximize return within an acceptable level of risk, regardless of whether it stems from interest, dividends or capital growth. By focusing on portfolio income and not total return, an investor is likely to alter the risk and return characteristics in ways that undermine the portfolio’s long-term viability.