Index Beating

The Bond Problem, the Income Solution

Most investors agree that yields are going to rise in the future, the only question is when.  Bonds are commonly viewed as safe investments, however they present more risk than most investors realize.  In the following article I will show you how to construct a safe portfolio that yields 6.7% while holding 25% in cash.

The challenge for many investors for the past few years has been finding attractive investments that generate income.  This has been difficult because the Federal Reserve has been depressing interest rates to artificially low levels as they try to stimulate the economy.

Bonds have been in a 30 year bull market as yields decline, which means prices increase.  The yield on the 10 year Treasury has declined from nearly 16% in 1981 to a recent low of 1.63% in May of 2013.  So, although yields are decreasing, investors have been able to generate an acceptable return through capital appreciation.

Recently, yields have started to increase as fears that the Fed will begin to slow its bond purchasing program known as quantitative easing, or QE, now that the economy is beginning to stabilize.  This is the start of what will happen in the coming years since yields cannot stay at these historically low rates forever.

This creates a problem - how do you generate income without buying an asset that is likely to depreciate in value?

I believe a low volatility income portfolio, in the current environment, should not hold bonds.  It should hold high quality stocks with increasing payouts, income properties, and cash.  The rationale for each is as follows;

Dividend Stocks (50% of model income portfolio)

Although equities present a higher degree of volatility relative to bonds, when selected carefully they produce far better returns in terms of current income as well as potential capital appreciation.  Stocks selected for this portfolio should have a track record of earnings growth, with the potential for future sustainable growth.  This means the company will be able to increase their dividend payout over time, and the yield off of your original cost basis grows continuously over time.  A diverse portfolio of ten or so high quality stocks can be assembled with a combined yield of between 4% and 5%.  A model portfolio will be published in next week’s post.

Investment Real Estate (25%)

As an investor you can use low interest rates to your advantage by borrowing at low rates and investing in income properties.  The current real estate market offers some great bargains in certain areas of the country with attractive cash on cash returns.  I believe the following example is representative of opportunities readily available in certain markets.  

A house I recently purchased produces an annual unlevered rental yield of 11.5%.  Adding a 5% mortgage with a 25% down payment increases the yield to 17.6%.  These numbers include 10% of gross rent reserved for management & maintenance costs, as well as actual insurance and tax costs. Returns include closing costs of 4.5% for the unlevered model and 15% for the levered model, which are both conservatively high estimates.

Investment real estate provides additional tax benefits.  Real estate investments can provide tax benefits through depreciation (writing off the cost of the building over time, offsetting taxable income) and interest expense (writing off the cost of mortgage interest against taxable income).  Please note that I am not a tax expert and you should contact a tax professional to learn more.

Rent prices are likely to increase with inflation as time passes, making your income increase every year.

Cash (25%)

Cash currently produces effectively zero return, but provides two essential benefits to a portfolio. First, cash reduces the volatility of stocks, which often trade up and down with the overall market while underlying company fundamentals remain strong.  Holding sufficient cash eliminates the need to sell stocks at a low point in the market.  The second benefit is to provide liquidity to offset the illiquid nature of real estate.  Investors are able to generate extraordinary returns by investing in illiquid assets (meaning they cannot be readily converted to cash at a desirable price).  Holding cash provides the liquidity necessary to make investments in illiquid assets prudent in a conservative portfolio. 

Summary

The overall current yield for the portfolio described above is 6.7% based on the following assumptions:

  • 50% in a portfolio of stocks yielding 4.5%
  • 25% in levered real estate returning 17.6%
  • 25% in cash earning 0.05%.  

These returns are pretax (both pre-expenses and pre-potential benefits) and do not account for appreciation of real estate and stock values, or increased income over time, which are likely to meaningfully increase total returns over the long run.

The three main benefits of a bond portfolio are addressed in the allocation outlined above:

Liquidity: 25% cash allocation provides immediate liquidity.

Safety: Given the risk I see in bonds, this portfolio appears to have far less downside volatility relative to bonds.

Income: As exhibited above, this portfolio produces significantly superior returns relative to bonds.