With rock-bottom interest rates unlikely to rise anytime soon and some stalwart companies cutting dividends, being an income-oriented investor has become that much more challenging.
Challenging, yes, but not impossible. Both fixed-income vehicles and dividend-paying stocks still have their roles in income-investors’ portfolios, but advisors say how to use these instruments requires thought and perhaps more due diligence in the current economic climate.
The Role of Bonds
Federal Reserve Chairman Jerome Powell said in June that the central bank is “not even thinking about raising rates,” which means fixed-income investors need to revisit how to use bonds in their portfolio.
Traditionally, bonds performed three roles in a diversified portfolio: income generation, low volatility and as a hedge against stocks, says James West, CEO of Principal Street Partners.
With the U.S. 10-year Treasury note under 1 percent and unlikely to rise anytime soon, bonds’ role as an income generator is all but gone, he says.
“For investors who were invested in bonds prior to the downturn, you have some of those higher-coupon bonds,” West says. “You definitely want to hold on to them because they’ll protect you better if rates go up.”
Bonds can still temper market volatility, although he says that role has been diminished somewhat. “If we do get rising interest rates, that volatility is going to increase,” he explains.
Despite bonds’ first two roles now less important, they are still a hedge against stocks, as seen in their first-quarter outperformance. Even with historically low rates, West says tax-exempt areas, such as in the municipal high-yield sector and short-duration muni bonds, remain attractive.
Steve Azoury, financial advisor and owner of Azoury Financial, says he still uses bond funds for income investors, but he diversifies holdings. He employs a mix of U.S. government, corporate, high-yield and global bonds. He spreads out holdings evenly across the sectors in a traditional 60 – 40 percent stocks-to-bonds portfolio. When considering bonds, he says, investors need to think about total return and not just income, as total return has been a significant driver of bond performance lately.
Revisiting Dividend Investing
Buying dividend-payer stocks has been an academically sound strategy for investors for decades, and in the era of low interest rates, dividend investing is a popular way to boost yield. However, even this strategy has come under strain due to the coronavirus.
The recession caused by the global economy shutting down to fight the virus hit certain sectors hard, such as energy and travel. Some favorite dividend-paying stocks for income investors include energy giants like Occidental Petroleum (OXY) and Royal Dutch Shell (RDS.A, RDS.B), whose share prices plummeted when oil prices cratered, causing them to slash dividend payments.
“The energy sector’s losses are really going to be staggering, and it’s going to take years to come back,” says Azoury. “Those dividends aren’t coming back. You’re not going to get the growth, and if you’re not going to get the dividends, then you really have to leave that sector.”