What You Need to Know

The search for income is getting harder, and there’s no shortage of suggestions on where to get a little bit more. But what about the cost? We think that focusing on creating a better return sequence can help investors access more efficient income.

Yield of Investment Grade Corporates After Taxes and Inflation

October 27, 2017

Maximum Drawdown of Preferred Stocks over 10 Years Ended

December 31, 2017

Up/Down Capture Ratio of Hedged Global Bonds vs. US Aggregate Over 10 Years ended

December 31, 2017

The baby boomer generation continues to move from its peak earning years into the retirement phase. As it does, it’s become much more income hungry. And this appetite is having a big impact on the demand for income-generating allocations. In target-date solutions, for instance, bond allocations for peak earners are typically in single-digit percentages; for retirement-age investors, bonds can make up as much as half of their overall portfolio.

LOOKING FOR INCOME IN AN INCOMELESS WORLD

But the search for income is a challenge today, and isn’t getting any easier. More and more baby boomers will be demanding income-generating bonds, and the income those bonds generate is now lower, thanks to years of Federal Reserve quantitative easing, which shrunk the market and reduced yields. As a result, yields are low today—and even lower after inflation and taxes.

At the same time, risks inside income-oriented indices are rising. The duration, or interest-rate sensitivity, of bond indices has grown by 30% since 2008. And with the US late in the credit cycle, credit quality is declining. On the equity side, dividend-paying stocks, based on price-to-earnings ratios, are trading at a valuation of 24.8 times earnings.

There’s no shortage of ideas and suggestions on where to squeeze out a little more income today, but there’s not much talk about the cost of that extra income. Many of the areas that people point to for an income boost face large drawdowns if things go wrong. Preferred stocks are a good example: Over the past 10 years, the average drawdown in Morningstar’s Preferred Stock category was 8%, and the biggest was about 44% (Display Below).

It’s clear that simply piling into higher-income trades isn’t the answer.

IMPROVING THE PATH OF RETURNS

It’s clear that simply piling into higher-income trades isn’t the answer.

We think there’s a better way to build solutions that can address some of the pitfalls investors face in the search for income. It starts with recognizing what the market landscape is likely to be in the years ahead.

Returns are expected to be lower, so simply trying to maximize returns can lead to unintended risks. One of the biggest challenges for investors is navigating a major drawdown early in their retirement-spending years, which can blow a hole in their savings that can’t be refilled. That’s where build a better path comes in: designing strategies that improve the sequence of returns, generating more efficient income.

We can do that using the lens of up/down capture. How much participation in up markets do you want from your portfolio? And how much can you tolerate losing in a down market?


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