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Yields on traditionally safe fixed income assets have been collapsing across the world. US ten-year bond yields are below 2%. Japan recently sold new ten-year bonds with a negative yield (-0.02%) for the first time, following Switzerland (which did the same last year) across the financial rubicon. Yes, you now have to pay the Japanese government for the privilege of lending them money. German ten-year bond yields offered a measly 0.11% at the end of February.
Corporate bonds offer no respite to an investor in search of yield. As the next chart illustrates, yields on AAA and AA U.S. corporate bonds have also collapsed since the end of the Great Recession. Effective yields on U.S. Corporate AAA bonds averaged 2.5% between 2010 and 2015, compared to 4.8% during the six years prior to the last recession (2002 through 2007).
So what is an investor who is hunting for yield to do?
Investing in higher yielding corporate bonds (junk bonds) is significantly more riskier than their higher-rated counterparts. The spread between quality and junk yields has widened considerably thanks to the dominance of energy companies in the high yield sector.
At the same time, investors have become increasingly concerned about interest rate risk, especially concerns over bond prices plummeting as yields begin to rise from all-time lows. This was brought to the forefront during the taper-tantrum that started in May 2013, when the former chair of the Federal Reserve, Ben Bernanke, suggested the Fed might begin to taper their bond-buying stimulus program. Fixed income volatility rose significantly as the yield on the ten-year bond climbed from 1.66 on May 1st to 3.04 by December 31st, 2013. Yet, yields have fallen since then, despite the Fed ending its quantitative easing program and even increasing the short-term rate in December 2015 for the first time in a decade. We discussed a few reasons behind falling yields in a prior post .
Alternative Income
The dual concerns over low yields and interest rate risk has led investors to look for alternative sources of income that are uncorrelated with traditional fixed income assets. These include high dividend paying stocks in the U.S. and abroad, real-estate investment trusts (REITs) and master-limited partnerships (MLPs).
The financial industry has responded to this siren call for income with a raft of new funds that focus on building income from alternative sources. Investment strategies that use diversified sources of yield are certainly not a new phenomena but the rise in popularity of non-traditional income sources is more recent. We believe a simple methodology that evaluates these within the context of an investor who would otherwise be looking for income from a traditionally safe fixed income vehicle.
We consider two funds, a mutual fund and an ETF, with long track records (> 3 years) and with the stated goal of generating income from diversified sources.
The first is Blackrock’s Multi-Asset Income mutual fund (ticker: BAICX), which tactically manages a portfolio of equities, fixed income and non-traditional sources of income like REITs, MLPs, preferred stocks and covered calls. The goal is to provide higher income with lower volatility. The fund has more than $12 billion in assets with an expense ratio of 0.80% and a not insignificant upfront load of 5.25%.
The second is Guggenheim’s Multi-Asset Income ETF (ticker: CVY), which follows a proprietary model that invests in multiple high yielding asset classes including stocks, REITs, MLPs, closed-end funds and preferred stocks. The ETF has more than $450 million in assets with an expense ratio of 0.83%.
We analyze these funds over the four-year period between 2012 and 2015, compared to similar investments in the iShares 7-10 year treasury bond ETF (ticker: IEF, expense ratio: 0.15%) and the SPDR Barclays high yield bond ETF (ticker: JNK, expense ratio: 0.40%), two proxies of traditional fixed income funds. Also included is the iShares select dividend ETF (ticker: DVY, expense ratio: 0.39%) as a proxy for a basket of high dividend paying stocks.
So let’s walk through three questions we would ask of an alternative income manager.
How much yield can I expect?
The obvious question but consider why the answer may not be as simple as it may seem.
When you purchase a 10-year U.S. treasury bond, the payout is predictable, at least for the next ten years. For example, a 10-year bond purchased at auction in December 2010 had a yield (“coupon rate”) of 3.26% . That means the bond pays $3,260.00 annually for every $100,000 of principal, and this does not change, at least until the bond matures and the principal has to be re-invested.
However, a couple of challenges crop up when looking at the stated yield for a fund:
Take the case of our two example alternative income funds.
The factsheet for the BlackRock income fund tells us that the ’30-day SEC yield’ is 4.66% as of 02/29/16. What does this mean? The 30-day SEC yield is a standardized calculation of yield introduced by the SEC to help investors compare “apples-to-apples” and eliminate misleading performance and income claims. The details of the calculation are included at the end of this post, but suffice to say, the measure tells us what the fund would yield if it continued to distribute income exactly as it did over the past thirty days. The formula for the 30-day SEC yield includes both the dividend as well as the fund’s NAV (close price) at the end of the period, both of which vary considerably from one month to another. So this measure gives you an incomplete story.
Guggenheim reports a different measure for its multi-asset income ETF – the ’12 month yield’ – which stood at 5.91% as of 03/04/2016. This measure is calculated by adding all the interest and dividend payments over the last twelve months and dividing by the fund’s NAV (close price) on the as-of date. It tells us how much income to expectif dividend payments remain exactly the same going forward. Once again, the problem is that the dividend varies quite significantly from one twelve month period to another. The fund’s NAV varies as well. For example, the 12 month yield as of 02/29/2016 would have been calculated as 6.17%, which is different from 5.91% only because the denominator (NAV) changed.
It is curious that you always see historical returns listed for each calendar year but you hardly ever see the same for dividend yields. Morningstar lists the annual dividend paid out in the case of ETFs but not yield. While historical yields will not precisely tell you how much yield to expect in the future, it will show you how a fund’s yield varied in the past. Simply looking at a single stated yield number for a fund is akin to looking at just the average historical return for the fund, or perhaps more accurately, the return over the past year.
Below we show historical annual dividend yields for our two alternative income funds, as well as the treasury and high yield bond ETFs, between 2012 and 2015. Note that the obvious disclaimer that applies to return measures –past performance is not indicative of future results – should apply for historical dividend yields as well.
Historical annual dividend yields. Dividend and price data were obtained from Yahoo! Finance .
In each case we calculated yield by adding all distributed income for the fund over an entire calendar year and dividing by the fund’s NAV (close price) on the last trading day of the previous year. For example, the 4.74% yield for the BlackRock income fund in 2015 indicates that you would have received $4,740 in income for every $100,000 invested in this fund on 12/31/2014.
The table clearly illustrates how the yield for each fund changed over the years, with the two alternative income funds exhibiting a greater range. This is something that does not come across on any of their factsheets, which typically state a single number.
How often is the dividend paid and how do payouts fluctuate?
Most investors searching for an income product probably require dividend payouts more than once a year and so it helps to know the payout schedule of an income fund. The next table shows how often the five income funds paid out dividends between 2012 and 2015.
Dividend payout schedule between 2012 and 2015. Dividend data was obtained from Yahoo! Finance .
At the same time, an income seeker should also know how consistent the dividends have been. Frequently, the payout from one period to another varies quite sharply. An investor who is reliant on a specific quarterly payout is presumably not going to be pleased by large fluctuations in their income.
To get an idea of how payouts vary from quarter to quarter, we calculated the average quarterly yield for each of the four income funds and used standard deviation as a measure of variation. These statistics, along with the minimum and maximum quarterly yields during the four-year period 2012-2015, are shown below.
Quarterly dividend payout statistics between 2012 and 2015. Dividend and price data were obtained from Yahoo! Finance . Note that the quarterly yields are not annualized.
The yield in each quarter is calculated by adding all the income distributed by the fund over an entire quarter and dividing by the fund’s NAV (close price) on the last trading day of the previous year.
The yield clearly varies quite significantly from one quarter to the next. For example, the average quarterly yield on Guggenheim’s income ETF was 1.39%, i.e. $1,390 paid out on average per quarter for every $100,000 invested at the beginning of the year. However, the standard deviation is 0.22%, or $220 for every $100,000 invested. This is not insignificant, especially around an average payout of $1,390. In fact, an investor may have received a quarterly payout as low as $1,120 (1.12% of $100,000) to one as high as $1,970 (1.97% of $100,000) between 2012 and 2015. The variation is even larger for BlackRock’s income fund and the high-yield bond ETF. Interestingly, the variation is lowest for the dividend equity ETF (DVY).
The historical variation of quarterly, or even monthly, payouts would be helpful to an investor who may be dependent on a consistent stream of income generated by the investment.
What happens to my principal?
An investor who invests $100,000 in a 10-year bond at auction will receive the same principal at the end of the ten year period (in nominal terms). This is not necessarily going to be the case when you use a mutual fund or an ETF to generate income.
We saw above that yields on the two alternative funds, as well as the high yield fund, are significantly higher than that of the treasury bond or equity dividend ETFs. Yet it does not give you the entire story of your original investment. In other words, we need to see performance that includes the yield as well as any capital appreciation.
The wealth index chart below shows how $100,000 invested in each of the four funds at the end of 2011 would have performed over the next four years, after expenses and any load fees.
Wealth index showing growth of $100,000 invested on 12/31/2011. Monthly return data for the five funds were obtained from Zephyr StyleAdvisor.
The period we consider here has been an outstanding one for equities in particular and it shows, with the equity dividend ETF (DVY) out-performing by far when you include both yields and capital appreciation. The following table shows summary statistics for the five funds between 2012 and 2015. The maximum drawdown number is the drawdown in portfolio value from peak-to-trough.
Summary statistics for the period Jan 2012 – Dec 2015. Monthly return data for the five funds were obtained from Zephyr StyleAdvisor.
Guggenheim’s income ETF is the most volatile of the five, with a significant drawdown close to 24%. As the wealth index chart shows, an investment in the ETF would have lost considerable value after August 2014 thanks to its MLP positions, which were clobbered by falling energy prices. The equity dividend ETF out-performs even as it was less volatile than the Guggenheim ETF. BlackRock’s income fund is the next best performer, with slightly less volatility and lower drawdown than even the treasury bond ETF.
While looking at overall performance measures is crucial to understanding what would have happened to your original investment, there is an additional point to consider. These measures almost always assume that dividends are re-invested (as we did above). However, an investor who seeks income is probably not going to be re-investing that income back into the fund.
So let’s take a look at what would have happened to a principal investment of $100,000 in each of our five funds between 2012 and 2015. Just capital appreciation, no dividends.
Wealth index showing growth of $100,000 invested on 12/31/2011, excluding dividends. Monthly price data for the five funds were obtained from Yahoo! Finance .
With the exception of the dividend equity and treasury bond ETFs, your principal would have been worth less than its starting value of $100,000. While the BlackRock fund fell less than 1%, the principal would have sunk more than 10% with both the Guggenheim and high yield funds.
The next table shows summary statistics for the principal, with no dividend re-investment. The overall dividend yield on the original investment over four years is also shown in the last column.
Summary statistics for the period Jan 2012 – Dec 2015 (price only). Monthly price data for the five funds were obtained from Yahoo! Finance .
Compared to the earlier results which included re-invested dividends, volatility rises only slightly for all the five funds but the maximum drawdown value in each case is clearly larger. In the case of the BlackRock fund, the maximum drawdown of the principal is close to -10%, compared to less than 5% when we included dividend re-investment. The difference is even more stark for Guggenheim’s ETF, for which the principal experiences a drawdown of more than 30%, compared to a 24% maximum drawdown when dividends are re-invested.
Of course, it makes sense to add the total dividends you received over the entire period to the final value of your principal for a true measure of return. For example, the total yield for the BlackRock fund is 20.17%, which means you would have received $20,170 over four years on an original $100,000 investment. Adding this to the market value of the principal at the end of 2015, $99,388, gets you to $119,558 – for an overall return of 19.56% over the four years (less than the 20.50% you would have received if you re-invested dividends).
Yet, if an investor who regularly cashes out their dividend looks into their account, all they see is the current market value of their original principal investment. This is the sum of money available to them if they were to switch to another investment.
Circling back to the top of this post, investors are scrambling for higher yielding investment vehicles thanks to a low interest rate environment and concerns over the possibility of bond prices falling significantly if rates increase. At the same time, we highlight why it is important to dig a little deeper into the stated yield numbers for an investment. It is also critical to understand what may happen to your principal as you try and find income, balancing the trade-off between higher yield and more risk.
In a future post we will consider a simple quantitative approach to building a tactical income strategy using several diversified sources of yield.
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Additional notes:1. All performance measures and dividend yields are after expenses. The 5.25% upfront load for the BlackRock Multi-Asset Income fund (BAICX) is also taken into account.2. One thing we did not discuss in the section about dividend yields is the fact that sometimes mutual funds pay out short-term capital gains, which we treated as income above. For example, the BlackRock multi-asset income fund paid out $0.0262 per share as short-term capital gains on 12/23/2015, which would have a different tax treatment than regular dividend income.
3. Calculation of 30-day SEC yield