Investors Needn’t Reach for Yield

Lately, we have noticed several headlines lamenting bonds’ paltry yields, leaving individual mom-and-pop retirement investors and ginormous institutional pension funds alike scratching their heads. In this ultra-low interest rate world, what is there to meet their cash flow needs? Fortunately, we think there is an often overlooked but ready solution in retirement investors’ toolkits: what we call homegrown dividends.

With interest rates super low on virtually every type of bond imaginable, many see difficulty generating sufficient cash flow from a portfolio. They presume adequate, regular and dependable withdrawals require alternative, illiquid avenues like private investments—non-publicly traded assets with less reporting and disclosure requirements than ones that trade on regulated exchanges, potentially including things like non-traded REITs.

But there are a couple problems going this route as we see it. First, such hard-to-sell assets often carry high fees and may not match your financial goals and investment time horizon—how long you need your accumulated savings to support your endeavors. The illiquidity may also make them exceedingly hard to exit if you expect a market downturn. Second, the notion that you have to reach for exotic investments to get high yield plays into the myth that portfolio income is synonymous with cash flow.

From an investment perspective, income is interest and dividends coming from any security in your portfolio. It is a part of a security’s overall return—a part too many investors treat separately from price movement. But we think the two must be considered in concert. Together, interest, dividends and price movements constitute a portfolio’s total return. By contrast, cash flow is money you withdraw from your portfolio to meet expenses—regardless of how that withdrawal is funded.

When you remove the arbitrary halo shining over dividends and interest, you will find a simple answer to the alleged cash-flow conundrum: reaping homegrown dividends when needed by selling securities. As we explained before, selling stock is a perfectly legitimate way to get cash flow from an investment portfolio. Doing so allows you to control the timing and amount of capital you raise. It can also be as tax efficient or more so, depending on the amount of gain, whether it is long-term and the account’s tax status.

Now, many see this as problematic, arguing it eats into principal. But this overlooks two points: One, traditional dividends reduce stock prices, too—every single time a common stock pays a dividend, its price is reduced commensurately. Two, price appreciation over time means your principal likely isn’t static. Thinking cash flow can come only from interest or dividends is a needless straitjacket for investors.

Knowing you can use homegrown dividends to fund cash flow needs also allows you to make better investment choices, in our view. Restricting yourself to withdrawals from just interest and dividend income could lead you to disadvantageous decisions, like seeking yield in areas unlikely to maximize your portfolio’s longer-term total return. Devoting your portfolio to boost its income—loading up on bonds and dividend-oriented stocks—isn’t always optimal. It can lead to unintentional overweights to value-oriented sectors that typically pay higher dividends. It may even negatively affect diversification, increasing your portfolio’s risk. Being open to selling stock also lets you avoid pitfalls from all the idiosyncratic risks that come when pursuing income in less liquid or exotic alternatives. Homegrown dividends gives you a way out of the low interest rate trap without having to “reach for yield.”

In our view, picking an asset allocation should always be about the balance between your goals, time horizon, the total return you need to achieve those goals and managing the risks necessary to get there. Accordingly, prioritizing total return over portfolio income is crucial. A homegrown dividend strategy lets you focus on getting the growth you need in your portfolio as a whole to sustain your anticipated withdrawals over the entire time you need your portfolio to work. In contrast, a focus on yield alone is shortsighted—and can introduce unnecessary risks. You don’t need to plunge into exotic, high-fee, illiquid assets that generally lack transparency to fund your cash flow needs. Just viewing your portfolio as one holistic source of retirement funding can solve the problems posed by a yield drought. Rather than fret about cash flow with interest rates historically low, take comfort: With appropriate planning and forethought you can generate your own homegrown dividends as needed.