The Problem with Income Investing

150 150 Mia

I’ve written many times on these pages about the conventional wisdom of creating a retirement portfolio designed to generate income, through interest and dividends.  I find this strategy, while thoroughly conventional, isn’t exactly wise.

Just last month, I wrote about investors being far too conservative, particularly young investors who have many years to weather short-term market declines – and enjoy the high long-term expected returns of global capital markets.

Another important point on income strategies is it tends to be tax inefficient. Corporate dividends are taxed as income, not at the low long-term capital gains rate. Same thing with corporate and government bonds, except municipal bonds, which carry their own added risks.

Recently I ran across an article in Financial Advisor magazine that adds one more point to the argument. They reported that portfolios constructed to generate income tend to be dangerously undiversified. Online investment firm SigFig looked at 300,000 portfolios. Of the income portfolios of investors over 40, more than half got income from three or fewer stocks. Almost a third relied on just one stock for income.

Brokers seem to be taking notice of investors’ interest (pardon the pun) in conservative income-generating funds, and according to FINRA, the regulatory agency of the Securities and Exchange Commission, they are selling products that are expensive, complex and wrong for investors.

“Broker-dealers may be recommending unsuitable transactions” to senior citizens, a FINRA report recently concluded. They cited products like nontraded real estate investment trusts, variable annuities, alternative investments and leverage-inverse ETF’s. How complex are products like that? I have to admit I had to Google that last one.

Very low interest rates have been compounding (another pun!) the problem for income investors in recent years, by pushing them to riskier and riskier bonds to generate enough return to meet their income needs. This leads to a portfolio with the illusion of safety but the reality of high volatility.

In fact, the only two ways to increase bond returns is to 1) lower credit ratings or 2) lengthen maturity. There’s nothing else to it. A bond with a B rating is riskier than an A-rated bond and therefore pays more interest, and a bond with a 30 year maturity is bound to pay more than a bond with a 2 or 3 year maturity, also because of increased risk.

But as you lower credit quality and lengthen maturities, eventually you get bonds with all the volatility of stocks – or more – but a much lower expected return than stocks. And, of course, you still have the unfavorable taxation of the bond interest. All in all, the illusion of safety can prove very costly.

Steve

Source: “How ‘Safe’ Investment Could Destroy Your Portfolio,” Bloomberg News, Financial Advisor, April, 2015