Income Generation in a Low Interest Rate Environment

How to create portfolio income in a low interest rate environment?

Remember the good ‘ole days when FDIC insured CD’s with a 5 year maturity might yield anywhere from 4-6%?  As an investor in need of income production from your portfolio, wouldn’t you love to be able to go back in time and buy a staggered CD ladder that might produce an average rate north of 5% and be locked in for anywhere from  5-10 years?  Your income production goals might be met, you would have been invested in insured CD’s with little worry of default or subject to the extreme swings in the stock market, and you might have avoided much of the disaster of the 2008 financial crisis and subsequent trauma beyond that.  You might possibly still be holding good yielding investments in comparison to something of similar safety today.

Bonds have traditionally been the butter on the bread of income investors, providing decent income flows with little risk.  The financial crisis of 2008 made us all rethink the old adage of “riskless bonds”.   I believe investors, advisors, and other investment professionals may have under estimated the risk carried by bonds and now the pendulum might have swung too far the other way.   People are looking for bond investments that carry little default risk but a good yield, ever heard of having your cake and eating it too?  It unfortunately doesn’t work so easily.  Investors need to be rewarded for the risks their investments carry and having the safety of a Government backed bond, FDIC insured CD or AAA rating means that you are going to get less reward on average.

Where to look now?

Investors who rely on their portfolio to make much of their day-to-day income are now turning to other investment options outside the realm of bonds or fixed income.  People have, somewhat skittishly, looked  to non-traditional income investments like stocks, real estate investment trusts (REITs), master limited partnerships(MLP’s), and options to name a few.

The first thing to keep in mind when considering some of these income alternatives is to remember the point mentioned above, there is a risk vs. reward trade off.  Historically, stocks, REITS, LP’s, and options come with more price volatility when compared to fixed income or bond investments.  That point being made, if you have an asset allocation plan in place, your portfolio may have room for some or all of those types of investments.  Even very conservative investors need to give consideration to investments like stocks and REITs to actually reduce the long-term risk of their portfolio.   The other point to be made about the income alternatives we will discuss is that they have historically done better battling inflation compared to bonds. Bonds have traditionally been a poor investment against inflation, which has the potential to become a real issue sometime in the not-too-distant future.

Stocks

Your parents, or you yourself for that matter, may remember buying stocks for the very long-term and loved the dividends these big, blue-chip companies paid its shareholders.  It used to be you could buy a good company, hold it for many years, take in the dividend payments and watch the stock steadily appreciate in value (sometimes splitting many times over to increase the number of shares actually held).   Holding times for stocks has dramatically decreased in the last 40 plus years.  According to the NYSE Factbook, the average holding period for stocks in 1960 was 100 months (8 years).  By 1970 it had dropped to 63 months (5 years). By 1980 it had dropped to 330 months, by 1990 to 26 months, by 2000 to just 14 months and in 2010 just 6 months!

With bond yields being so low, dividend paying stocks have come back in favor.  Look at buying fairly valued companies that seem to be in favorable sectors that traditionally return a portion of earnings back to its shareholders.  There are plenty of stocks out there that would fit that criteria and pay from 2.5-5% dividend yields.  If the stock market was to have even modest gains, you have the potential for your stock to appreciate in value all the while producing income from the investment.  If you build a diversified basket of these types of companies for a portion of your portfolio, you can mitigate away some of the stock specific risk and build in some income payments from those stocks.  The tax status of dividends paid from corporations is often times considered qualified and subject to a lower rate than other income such as bond interest.

REITs

A real estate investment trust (REIT) is a tax designation for a corporation investing in real estate that reduces or eliminates corporate income taxes.  In order to avoid the taxes, the REIT is required to distribute 90% of their income, which may be taxable, to the shareholders.  Different REITs can hold different types of properties including, but not limited to, commercial and office properties, malls and strip malls, healthcare facilities, hotels, apartments, mortgages, etc.  Just like traditional stocks, these investments are not free of risk and can actually experience quite a bit of price volatility.  If you build a diversified basket of REITs (or use a mutual fund or exchange traded fund to do it for you), you manage away some of the risk and still take part in the good yield potential these investments offer.  The tax status of REIT income is not as favorable as corporate dividends should be sheltered in an IRA or other tax deferred/free account if possible.

Master Limited Partnerships (MLP)

MLPs are limited partnerships that are publicly traded on an exchange like a stock is.  Many of the MLPs pertain to certain business enterprises like natural resources (petroleum, natural gas, coal, timber) and the extraction and transportation of these commodities.  While many MLPs pay handsome distributions to investors, the taxes on these holdings can become somewhat cumbersome.  Some of the payout to investors is considered a return of capital and could reduce your cost basis and a portion could be considered k-1 income.  These investments could be another way to further diversify a portfolio and reap the income as well.

Options

Basic options strategies could be another way to generate extra income for an investor.  A couple of basic strategies (even basic strategies can be tough to grasp for someone inexperienced in options) would be writing covered calls or selling puts.  Writing covered calls is probably the most popular option strategy for investors.  You essentially agree to sell your stock at a certain price in the future and for that agreement, you take in income.  That option may never be exercised (have the stock “called” away from you) and you get to keep the stock and the income you generated.  Selling a put works in much the same way.  You will agree to pay a certain price for a stock and in return, you take in income.  If the stock moves higher, you will not likely be required to buy that stock but will get to keep the income you generated.   We could spend many hours discussing options and how they work but just understand that could be one more tool in the income investors’ tool belt.

Putting it all together

In summary, the use of the four aforementioned securities in combination can be an effective way to increase income generated from an investment portfolio.  In times of low interest rates we have to be a little more creative on options to boost overall yield.  One other side note, if you are an income investor that needs cash flow to live on, make sure all of your dividends and interest are paid to cash and not reinvested.  For non-income investors I am a proponent of reinvesting dividends and interest but for those who actually need the cash should take them in that form.

Kyle Hurt CFP®, MBA

Partner-Financial Advisor

Lifetime Capital Management

 

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