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The Income Investing Obstacle Course Presented to
American Association of Individual InvestorsOctober 2018
Mart in Fr idson, CFAChief Investment Off icerLehmann L iv ian Fr idson Advisors , LLC
Topics
1. Income Investing: Problems and Solutions2. The Risk of Rising Interest Rates
Income Investing Problems and Solutions
OBSTACLE 1Super-safe investments no longer provide a living
Three-Month CD Rates 1965 – 2018*
*Through August 2018
Source: Federal Reserve Bank of St. Louis
The decline in CD rates has coincided with a drop in the inflation rate.
0.00
2.00
4.00
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1964
-06-
0119
65-0
7-01
1966
-08-
0119
67-0
9-01
1968
-10-
0119
69-1
1-01
1970
-12-
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72-0
1-01
1973
-02-
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74-0
3-01
1975
-04-
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76-0
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1977
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-08-
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80-0
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1981
-10-
0119
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-06-
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-08-
0119
93-0
9-01
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-10-
0119
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-12-
0119
98-0
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0120
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3-01
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02-0
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7-01
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-08-
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2007
-10-
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08-1
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2009
-12-
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11-0
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2012
-02-
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13-0
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2014
-04-
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15-0
5-01
2016
-06-
0120
17-0
7-01
2018
-08-
01
Perc
ent
OBSTACLE 2Stretching for yield exposes investor to greater market risk.
Based on BofA Merrill Lynch Fixed Rate Preferred Securities IndexPrice change for the total index = -2.51%Source: ICE BofA Merrill Lynch Global Research, used with permission.
In this one month, holders of preferreds with yields of 7% or greater saw 69% of their annual yield offset by price declines.
-0.31%
-1.29%-0.74%
-1.50%
-5.06%-5.90%
-7%
-6%
-5%
-4%
-3%
-2%
-1%
0%
0-3.999 4.000-4.999 5.000-5.999 6.000-6.999 7.000-7.999 8.000-8.999
Mea
n Re
turn
Price Decline by Beginning Yield Preferred Securities – September 2011
OBSTACLE 2Getting a higher yield requires taking more risk
*Standard Deviation / Average Price
Sources: Bloomberg; ICE BofA Merrill Lynch Index System, used with permission.
There is no free lunch in financial markets. The key point is to avoid stretching too far and incurring large losses of market value.
ASSET YieldSeptember 30, 2018
PRICE VOLATILITY*Monthly, 2007 - 2017
REITs 4.33% 23.7%
UTILITY STOCKS 3.49% 19.3%
“A” CORPORATE BONDS 3.88% 0.5%
TREASURY BILLS 2.17% 0.3%
OBSTACLE 3
Long life expectancy means many years for inflation to erode purchasing power.
US Life Expectancy at Age 65
The Society of Actuaries says there is a 25% chance that one spouse in a 65-year-old couple will live to 98.
In light of this, investors must consider how much purchasing power a completely fixed income portfolio will lose over two decades.
Source: Society of Actuaries
MALE FEMALE
18 Years 20.5 Years
Loss of Purchasing Power in Past 20 Years
$100,000 Annual Income as of December 1997
$65,643
$34,570
Lost purchasing power
Source: Economagic
Present purchasing powerWith inflation averaging only 2% per year over the last 20 years, people living on a fixed income have lost 35% of their purchasing power. The outcome over the next 20 years will be much worse if Fed policy returns CPI-based inflation to its 50-year average of 4% (= 56% loss of purchasing power over 20 years).
SOLUTION 1Utilize asset classes that offer higher current income
Example: Yield (September 30, 2018)
Master Limited Partnerships 7.86%
High Yield Bonds 6.23%
Real Estate Investment Trusts 4.16%
Sources: Bloomberg; ICE BofA Merrill Lynch Index System, used with permission
Based on Alerian MLP Index, ICE BofA Merrill Lynch US High Yield Index, MSCI US REIT Index, ICE BofA Merrill Lynch Preferred Stock Fixed Rate High Yield Index, ICE BofA Merrill Lynch Fixed Rate Preferred Securities Index, MSCI US REIT Index.
Limit price exposure through asset diversificationSOLUTION 2
A: IG Bonds1 D. HY Preferreds4 G. DIV Growth Stocks7
B. IG Preferreds2 E. MLP5
C. HY Bonds3 F. REIT6
Even when one sector’s fundamentals declined drastically, the temporary loss in market value was limited by diversifying by asset type.1 ICE BAML US Corporate Index 2 ICE BAML Fixed Rate Preferred Securities Index 3 ICE BAML US High Yield Index 4 BAML High Yield Fixed Rate Preferred Securities Index 5 Alerian MLP Index 6 MSCI US REIT Index 7 S&P500 Dividend Aristocrats IndexSources: ICE BofA Merrill Lynch Global Research, used with permission, Bloomberg
KEY
AB
CD
E
F
G
All
-15
-10
-5
0
5
10
15
20
25
2017
Pric
e Ch
ange
(%)
SOLUTION 3Mitigate risk through fine points of security selection.
Examples
REITs – Focus on nontraditional types such as assisted living, cellular towers.
MLPs – Concentrate on pipelines, with further selectivity based on low-cost production regions, contracts with users rather than producers, negotiated rather than regulated pricing.
Preferreds – Include non-financial issuers and pay close attention to call prices.
Closed End Funds – Take into account historical discount to Net Asset Value and manager’s past performance.
Diversification of types of riskAsset Key RiskIG Corporate Bonds Interest rates
IG Preferreds Financial institutions
High Yield Bonds Recession
High Yield Preferreds Financial institutions
Master Limited Partnerships Energy prices
Real Estate Investment Trusts Real estate prices
Dividend Growth Stocks Recession
In any given economic environment, weakness in one asset class will tend to be mitigated by
stability, or even strength, in others. For example, interest rates tend to decline during a
recession, boosting assets that are sensitive to that factor.
EXTRA! Harnessing technology to improve security selection
LLFA Rich-Cheap Model for Preferreds
• Universe of nearly 1,000 issues
• Four factors explain almost 77% of a preferred security’s yield:§ Coupon rate§ Credit rating§ Industry sector§ Price momentum
•Many other factors were tested and rejected, e.g., cumulative dividend, call features, tax-advantaged dividend, liquidity, trading volume, etc.
• Statistically cheap issues are subjected to fundamental analysis (business, financial statements, management).
EXTRA! Using valuation to enhance returns
Increase allocation to an asset class when its relative yield is high by historical standards.
Applying this analysis to several income categories (preferreds, REITs, municipals, etc.) enables the investor to overweight currently cheap market segments.
Source: Bloomberg; ICE BofA Merrill Lynch Index System, used with permission
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Perc
ent
Alerian MLP Index Yield minus 10-Year Treasury Yield
Difference
Mean
+1 Std. Dev.
-1 Std. Dev.
SOLUTION 4
Include a growing-income component to offset erosion in purchasing power.
Annual Dividend: Selected Dividend Growth Stocks*
Source: Bloomberg*Portfolio of 13 large-cap stocks that paid dividends as early as 2006
The income investor’s use of equities should focus on stocks with long records of raising dividends and good prospects for continuing to raise them.
10.46%Compound AnnualGrowth Rate
11.3413.18
14.2215.78
17.2519.3
21.523.64
26.27
30.0031.87
33.87
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2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Projected Purchasing Power at 3% Inflation
In this simulation, Dividend Growth overtakes Fixed Income in purchasing power in Year 7, despite lower initial yield. Income investors should assess this tradeoff in devising a portfolio that both provides high income and combats inflation.
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hasin
g Po
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e =
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1 ($
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0)
Year
Fixed Income @ 5% Yield Dividend Growth @ 4% Initial Yield, 4% Growth
ConclusionTo earn satisfactory income and preserve purchasing power in today’s low-interest-rate environment:
1) Look beyond super-safe bonds2) Diversify by asset class3) Provide for growth in income to preserve purchasing power
The Risk of
Rising Interest Rates
What Drives Interest Rates?Nominal Interest Rate
=
Real Interest Rate
+
Expected Inflation Rate
The real interest rate reflects such factors as savings rates, productivity of capital, and the riskiness of capital expenditures. An inflation premium exists because lenders demand compensation for their expected future loss of purchasing power. If neither component is about to escalate sharply, investors should not bet that nominal rates will skyrocket.
In the back of investors’ mind –Weimar Germany hyperinflation: 1921 - 1923
An attempt to get the currency to rise
U.S. real interest rate is historically low
The U.S. real interest rate has been declining since the 1980s. A global savings glut is one explanation that has been advanced.
Source: World Bank
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1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
Perc
ent
No breakout in U.S. inflation expectations
The yield difference between Treasury Inflation-Protected Securities and conventional Treasuries of the same maturity indicates investors’ future expected inflation rate. There is no current expectation of an impending takeoff in U.S. inflation.
*Through SeptemberSource: Bloomberg
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5 Year TIPS Breakeven Rate 2002 – 2018*, monthly
Long-Term Interest Rate Equilibrium
Source: Lehmann Livian Fridson Advisors LLC
Ben Bernanke’s Model Nominal GDP Growth RateForward one-year real rate 1.00% Real GDP growth rate 2.50%
+ Expected inflation rate 2.00% + Inflation rate 2.00%
+ Term spread 1.00% = Equilibrium 10-year rate 4.50%
= Equilibrium 10-year rate 4.00%
Globalization Has Restrained Inflation“One would expect the entry of lower-cost producers and of cheaper labor into the global economy to have put persistent downward pressure on inflation, especially in advanced economies and at least until costs converge.”
--Claudio Borio, Chief Economist,
Bank for International Settlements
Velocity of money has collapsed
Source: Bloomberg
The price level is a function not only of the quantity of money created by monetary policy, but also by its velocity, i.e., the rate of turnover. The Fed’s aggressive money creation has not created runaway inflation because velocity has fallen off a cliff.
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Velocity of Money – M2 Money Supply1960 – 2018, Quarterly
Conclusion
Long-term interest rates are likely to head upward, but investors should not gear their planning to dire inflation scenarios
Thank you
Marty [email protected]
212-319-8903 ext. 207For further information:
www.llfadvisors.com
ICE BofA Merrill Lynch index data is used by permission. Copyright © 2018 ICE. The use of the above in no way implies that ICE or any of its affiliates endorses the views or interpretation or the use of such information or acts as any endorsement of Lehmann, Livian, Fridson Advisors, LLC’s use of such information. The information is provided "as is" and none of ICE or any of its affiliates warrants the accuracy or completeness of the information.
