Investment Income—The Growing Problem

With bond and money market yields near all-time lows, investors who are trying to generate income feel like they are swimming upstream. Until recently, investors could always count on the bond market to provide them with a steady stream of consistent income. Yields were reasonably competitive, which made it easier for investors to live off of their investment income. The U. S. financial crisis and subsequent recession pushed interest rates to historically low levels.

During this difficult period, however, investors could still manage to find competitive yields, as risk was still rampant. For example, there was a period of time in late 2008 and early 2009 when the consensus view was that municipalities would default on their obligations. Yields spiked to very attractive levels as hedge funds dumped their municipal bonds. Also, corporate bonds maintained high yields throughout the crisis as they were considered very risky. The spread between corporate yields and Treasury yields reached an all-time high.

With the economic recovery, the perceived risk of both corporate and municipal bonds has fallen dramatically. Thus, their yields are now in line with historical levels versus Treasury yields. For the first time in 50 years, many companies’ bonds are yielding less than their common stock. With bond yields at record lows and money market rates near zero, investors are facing the unappealing proposition of replacing their maturing 5% coupon bonds with new bonds yielding 3% or less.

Simply put, after years of growing income streams, investors’ income generated by bonds and money market funds is being systematically reduced. But what can investors do to fix this problem? The answer may lie in the equity market. Diversified stock portfolios can be constructed with yields in excess of 4%. Because of the recent correction combined with companies’ willingness to increase dividends, stock yields have increased. We are not proponents of making a huge asset allocation shift, but are in favor of shifting some money from bonds to high yielding stocks to increase the portfolio’s income. Taking this action may allow investors to swim with the income current instead of against it.

—Dave Stepherson