Blogs

Thinking Differently About Income

Investors and business owners continue to struggle with generating income in this low-interest environment. Traditional savings products no longer generate desired income, with yields on most fixed income products below inflation. This is clear from questions we continue to receive from businesses owners who are considering selling their businesses or have sold. In advance of a sale, they ask questions such as, “What do I need to sell my company for before taxes to generate sustainable cash flow?” After the sale, the questions mirror this concern: “Now that I have sold my business, will I be able to generate enough income to replace the cash flow I had from my company?”

Given these top-of-mind concerns, many income-seeking investors desire a portfolio that is focused more on yield than on capital appreciation. Much of the focus on yield enhancement stems from a common misconception that higher yields offer downside protection to a portfolio via the income offsetting the impact of a falling stock price on the portfolio. But this is not the case. The regular income generated by a high-yielding portfolio is not a “free lunch,” so to speak. When the company pays out cash, the market value of the capital base falls by a commensurate amount. In addition to the perceived shock absorber effects of yield, some investors desire yield for the stability provided by the “certainty” of income. However, while such a yield level was riskless years ago, it is no longer available in an environment with a 10-year Treasury rate of 1%. Even worse than the nominal yield, real yields (i.e., nominal yields less inflation) have compressed to 0% and, in some cases, have gone negative. In today’s world, because this income availability is relatively non-existent, investors have two options:

  1. invest in higher-yielding assets to obtain the level of absolute yield required to meet desired (or, in the case of foundations, regulatorily required) spending needs, or
  2. supplement yield with capital appreciation.

The former option leads to investors taking on more risk than desired, which often contrasts with other portfolio goals. The latter allows client to create their own streams of income while regularly rebalancing their portfolios. Of course, if the low interest rate dynamic reverses as interest rates move higher, then investors can tilt portfolios back toward more yield and reduce the emphasis on capital appreciation.

Unfortunately, investors desperate for yield often unwittingly compromise on their risk tolerance or needed liquidity in the quest to earn more income. Focusing on the portfolio’s total return offers a better path.

Recall that total return is the overall gain on an investment over a specified time period, contemplating both:

  1. gains on the capital deployed throughout the holding period (i.e., price appreciation), and
  2. income on that capital (typically in the form of dividends and interest).

For investors who choose to reinvest their income distributions as capital back into the investment, the return will contemplate gains and income on that reinvested capital as well, compounded over the investment period. Unfortunately, investors desperate for yield often unwittingly forgo stronger overall total return in order to get more yield.

This is because companies not focused on generating yield are generally companies with more growth opportunities and, thus, choose to allocate their earnings toward reinvestment in higher-returning projects rather than paying it out to shareholders as dividends.

Think of it this way: if a company’s management team has a choice to either pay out earnings or to invest earnings in a project that will return 10% annually over five years, the latter will generate more returns for the company and will serve to boost the company’s stock price higher. In such a case, the return generated by the stock would have less yield but likely higher total return. Think of taking a total-returns approach as targeting an annual return irrespective of whether that comes from income or across from all sources (interest, dividends and growth). In any given year, this may or may not involve tapping the original capital; of course, in a low interest rate environment, this is likely to be the case.

We continue to believe in two vitally important benefits to using a total return approach:

  1. Yield-focused portfolios constrict the universe of possible investments for the portfolio because many investments do not specifically target income generation. Focusing on total return allows for the portfolio to be allocated across a broader swath of securities, some of which may also serve to reduce overall portfolio risk as many higher-yielding securities are concentrated in relatively few sectors (e.g., Energy, Consumer Staples), and loading up on these positions may introduce a lack of diversification.
  2. This approach has the potential to offer superior tax efficiency and thus generate even better post-tax returns. For example, investors can hold higher-yielding investments in tax-deferred accounts and assets aimed at capital appreciation in taxable accounts.

Aside from those two considerations, there is another large factor that tilts the scales toward the total returns approach, where raising cash to meet spending needs could be accomplished, quite simply, by selling part of the portfolio. Such an approach would also allow investors to idiosyncratically time their sales to accommodate their cash flow needs rather than relying on a predetermined schedule as determined by the investment. By raising funds on demand, these sales can be timed with cash flow needs and/or when the investor finds the market conditions most appealing.

In summary, focusing too specifically on income generation may restrict portfolio return, potentially reduce diversification, and lower the opportunity for tax alpha opportunities. Investors should focus on total returns, not income, and fund their spending by selling part of their portfolios to align strategically with cash flow needs and market conditions.

This article is extracted from our 2021 Capital Markets Forecast. Click here for the full publication.

Contact Us

Looking for guidance managing your wealth? Balentine is committed to providing the education and advice our clients need to realize their goals.