- Martin Fridson, CFA
The Price of High Income
During the past two months, financial markets underwent one of their inevitable, periodic selloffs. From the October 3 peak to the November 23 low, the Standard & Poor’s 500 Index price change was -10.01%. Market commentators cited a variety of causes, including concerns about Fed interest rate hikes, signs of softness in the housing market, falling oil prices, and global trade tensions.
Income investors were not spared in the selloff. But portfolios that were diversified across a variety of income instruments (such as bonds, preferreds, REITs, MLPs, dividend growth stocks) did not suffer price declines as severe as the stock averages did. Furthermore, the income generated by those portfolios cushioned the decline. In fact, the income stream from a well-diversified income portfolio gave little or no indication of market upheaval. There were few bond defaults or dividends cuts during the period, so income investors’ primary objective of receiving a high, steady cash flow continued to be satisfied.
It’s important to keep that steady-income objective in mind during temporary setbacks like the recent one. Investors should understand at the outset that there’s a clear tradeoff between yield and price volatility. As our parents taught us, you don’t get something for nothing. In this case, the more income you generate from your investments, the bigger the price bumps you must endure along the way.
The accompanying table illustrates this point. It ranks four income classes by their yield at the beginning of the market decline (October 3). The third column shows that in terms of how badly they were hit in the downturn, the four classes ranked in the same order. Master Limited Partnerships, which began with the highest yield (7.67%), posted a -12.22% total return (Price Change + Income + Reinvestment Income). At the opposite extreme, three-month Treasury bills yielded just 2.22% and actually recorded a positive return, 0.38%, during the period.
But despite their superior short-term performance during the October-November selloff, T-Bills are not the solution for investors who rely on the income they earn on their savings. To begin with, there’s that yield of only 2.22%, which doesn’t go very far toward meeting living expenses. As the last column shows, T-Bills produced an annualized total return of less than 1% in the ten years ending November 23, 2018. By contrast, the other three asset classes each delivered double-digit annualized returns over the ten-year interval.
The rebound from the Great Recession helped those numbers, but the key point is that the figures in the last column have the same rank ordering as the other two columns. Higher yields paid off over the long run, even though the highest-yielding securities generally fell the most during downturns. As you might have guessed, the highest yielders also tended to rise the most during rallies.
A final point about the long-run returns is that you almost never receive anything close to the average return in any particular year. For example, during the ten-year period covered by the last column, investment grade preferred shares posted a return within +/- two percentage points of the annualized figure, i.e., 9.15% to 13.15%, only once. Successful income investing truly is a long-run commitment.
The lesson to draw from this analysis is that dwelling on short-term results can cost you dearly. Focusing on a one- or two-month downswing could lead you to conclude that cash (as represented by three-month T-Bills) is the best place to be. Over an extended period, that would be an extremely expensive error.
But the worst mistake of all would be to jump in and out of income investments in an attempt to escape the downturns and get in ahead of rallies. No professional money manager succeeds in timing the market with any consistency. The inevitable result of trying is to be late to the market recovery, thereby missing out on a significant portion of the long-run return.
For clients who are willing to sacrifice income in the near term in exchange for greater stability in the market value of their portfolios, we do reduce risk exposures when it becomes likely that the economy will soon slide into a recession. You should inform us whether you want to make that tradeoff. But under no circumstances should you abandon a basic strategy that is specifically designed to deliver high income in fair weather and foul.