A decade ago, when an investor was looking for income, the solution was a “ladder” of government bonds. By spreading your money among bonds of various durations (typically one-tenth portions of one- to 10-year bonds), you could minimize interest rate risk. Each year, when 10% of the portfolio matured, you’d simply buy new 10-year bonds and continue on.
Times have changed. Interest rates are at or near generational lows, making yields on government bonds about as attractive as a pack of tofu at a Texas BBQ. In addition, talk of credit downgrades in the U.S., defaults in Europe and other macro-economic events have had a direct and tangible effect on the value of laddered bond portfolios.
While there’s still a place for the tried-and-true bond ladder (or its modern-day equivalent, the bond ETF), many high net worth (HNW) individuals have been taking a different approach to income.
Blue-chip equities
Increasingly, “mega-cap” stocks with years (or decades) of dividend history are becoming the building block of the “cash flow” portfolio. Currently, most dividend yields are way above government bond benchmark yields, and many have attractive valuations, so there’s some capital gains potential too. Canadian issues also enjoy favourable tax treatment, which is a way to add Tax Alpha (additional after-tax return attributable directly to tax minimization strategies) to the portfolio.
“High yield” corporations
My name for publicly traded companies (often former income trusts) throwing off steady cash flow and operating in mature industries. With yields in the mid to high single digits, this is a good place to look for yield enhancement. That said, not all dividends in this space are growing, and the business risks are higher here. An allocation of, say, 10% to 15% of the income portfolio is appropriate for most investors.
Income-generating property
Apartments, industrial and commercial properties can all be effective ways to add income to a portfolio. Many HNW individuals are turning to the U.S. for such properties, where the dynamics of the real estate market have shifted dramatically toward renting. You don’t need millions to follow a similar strategy: a number of apartment REITs (both in Canada and the U.S.) offer similar exposure and good yields.
High-yield corporate bonds
Worry about Europe has created a dislocation in the high-yield market: investors are exiting corporate issues in an effort to trim back risk. However, default rates remain about half of historical norms, as corporations have been aggressively paying down debt and pushing out maturities with refinancing. With pre-tax yields of 5% to 8%, high-yields look like a good yield enhancer. Just as important, they are typically less exposed to interest rate risk.
Covered calls
Options are commonly viewed as risky investments, but “covered call writing” can be an attractive income strategy for range-bound markets and a good way to mitigate downside risk in falling markets. In fact, a report just released by Goldman Sachs suggested selling 10% out-of-the-money one-month options on stocks with liquid options in the S&P 500 outperformed the index by 3.6% annually from 1996-2011.
Lending
Instead of buying equity, some HNW individuals prefer to become lenders, by participating in private financing pools, offering mortgage lending or backing companies that are in that line of business. Such a move offers protection for the investor, as lenders generally take precedence over owners in the event of a financial catastrophe. It’s also a good way to boost income. •
