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Tired of rolling the dice?

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If we truly are in a period of low growth and low interest rates for the next several years, how do you invest for income? How much risk do you need to take to get a 5% yield?

The answer is not that much.

Today, many income investors tend to share the following traits:

  • Looking to generate income from their portfolio that will be at least 4%
  • Have no corporate pension
  • Are increasingly focused on capital preservation
  • Understand that 2% GICs/T-Bills are not a good long-term solution
  • Want to be tax efficient

In our discussions with clients, the general comment is that they don’t need a 10% return, they are fine with 5% or 6% returns, but they can’t have a -10% return or worse.

This type of focus leads to some new thinking on portfolio management and investment solutions.

Here is one fact that has supported this new thinking. According to a research study by BlackRock’s Richard Turnill and Stuart Reeve, 90% of U.S. equity returns over the last century have been delivered by dividends and dividend growth.

Turnill and Reeve head the global equity team for the world’s largest money manager. It kind of makes you wonder why you would ever own something that doesn’t pay any income.

Investing for income can be very simple. Only buy what has a big yield.

Sometimes that strategy can actually work, but usually in an environment where you are going from a high level of market jitters towards one of market confidence.

The problem is that big yields are usually a sign of greater risk. Either a company is paying a very high yield because they need to do so to get people to buy it, or what was once a modest yield has become a large yield because the price of the security fell a great amount.

The other problem is that with common stocks in particular, a company can easily cut or eliminate their dividend, and as with Yellow Media last year, you go from having a high yielding security to one with no yield.

I believe in five components that are needed to achieve solid income, with moderate risk:

Bonds – Any bonds with a BBB rating or better (although you can’t ever truly trust the credit agencies). All companies need to be closely analyzed on a free cash flow basis and their existing debt obligations need to be understood. No bonds are to be held with a yield to maturity of less than 2%. Bonds can be traded to adjust duration of the portfolio or to take advantage of lateral improvements in yield to maturity.
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High Interest Cash – Given the low interest rate environment, it makes little sense to hold a ‘risk’ asset like a bond when risk free daily interest bank accounts will pay 1.75%. This cash component is the bedrock of the portfolio, and by having it in place, it allows for some risk in the bond portfolio to achieve a reasonable yield return.

Preferred Shares – These holdings are used primarily for the tax advantage of dividend income in a taxable account. If someone has an income of $75,000, in Ontario they will get taxed at 33% on bond interest, but just 14% on dividends. In Alberta, the number goes from 32% on interest down to 10% on dividends. While not equal in risk to corporate bonds, they are close, especially if there is some form of redemption or rate reset feature. In some cases today, the yield on preferred shares is meaningfully higher than bonds with similar risks.

Stocks – The goal is to hold dividend “payers” and dividend “growers”, and to do the work necessary to identify companies at risk of dividend cuts, very early on. According to Ned Davis Research, based on the S&P 500 from January 1972 to April 2009, the annual gain for stocks of dividend growers and dividend initiators was 8.7%. Stocks which did not pay dividends returned less than 1%. Stocks that reduced their dividends at some point, earned 0.5% per year.

To build off of this information, one would start with the requirement that all stock holdings must pay a dividend. The companies should have a dividend yield that equals or exceeds its industry group. They must be growing earnings on a forward looking basis. They must be large cap companies. They must have a history of maintaining or growing dividends. They must have a payout ratio that is reasonable as compared to their industry peers, and not exceed 80% of earnings.

A US model that has followed a similar approach, has managed to average an 11.1% annual return over the past 18 years, while having meaningfully lower volatility (a Beta of 0.7 or 30% less volatile than the overall index) than the S&P 500.

Covered Call Writing – This strategy can be complicated, but in a nutshell it lowers risk and increases income. Exactly what the income investor likes. The downside is that it will lower returns in very strong markets, so if the TSX returns 20% in a year, your portfolio might return 15%. The net result of using covered calls is that you boost the income of the portfolio, you generally outperform in down markets, you generally outperform in flat to slightly improving markets, and underperform in strong markets.

It can be achieved using some new ETFs from companies such as BMO and Horizons, or you can find some investment counsellors and brokers that have a particular expertise in this area.

One of the big positives of this strategy is that the income generated is considered capital gains for tax purposes. Not only is this a lower taxed type of income, but for those with a build up of capital losses over the years, this is one of the only ways to ensure a capital gain – effectively getting income with no tax (until you use up your losses).

Given the objectives of the investor (protect capital, boost income, more stability), this covered call option strategy can be very effective.

With these five components, you are able to have an entire investment portfolio without going out too far on the risk front with any security, but generating an income yield easily exceeding 4%. The reason is that the yield on bonds, preferred shares and common stock dividends should be close to 4% on its own. When you add on the income from covered call options, it will easily move you close to the 5% mark.

The key benefits for income investors to this approach are:income yield somewhere between 4% and 5.5% without holding high risk investments; lower volatility; better tax efficiency; total flexibility on cash withdrawals to meet personal needs.

This portfolio is almost certain to outperform the stock market in a down year but just as certainly it will underperform in a strong stock market. However, if many pundits are correct, we may not be seeing many 15%+ years in the market in the near future.

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