The Chase For Higher Yields
Do you know the only thing that gives me pleasure? It's to see my dividends coming in.
— John Rockefeller
In 2021, A $1 Million deposit at the highest yielding account will only get you a meagre $7,000 in interest at the end of the year. Interest rates have been really low; a quick check online (latest May 2021 rates) showing that fixed deposit rates in Singapore range from 0.35% to 0.7%.
Fixed income investments generally provide the opportunity to generate low-levels of returns for low-levels of risk. After the COVID-19 pandemic jolted financial markets last year, the already minuscule yields on fixed income investments dropped lower. At its 2020 low, the 10-year Treasury note yielded 0.52%, a fraction of its historical levels. Singapore rates are very correlated to US rates and typically follow.
Many investors would usually try to match the dividend yields of their investments to their spending needs. However, in times of distress where companies reduce or cut out dividends completely and bond yields fall to the floor, this methodology will leave many shortchanged.
In the current low-yield environment, income-oriented investors may be tempted to seek out higher-yielding assets to support their spending requirements. Unfortunately, these strategies typically come with considerable risk. Some of these risks include a greater concentration in dividend-focused equities and a greater exposure to higher-yielding fixed income investments that behave more like equities. This is illustrated in the diagram below.
Strategies such as these, which reach for yield, often lead to heightened volatility and a higher possibility of losses, as seen in the diagram below. Investors who tilt towards these assets will experience magnified losses during times of market stress and, if emotions get the better of them, will inadvertently sell the assets at the worst possible time.
You can see that the higher yielding bonds have a drawdown and cumulative return similar or worse than a simple 50/50 portfolio. This shows that not all bonds provide the protection and buffer that investors assume during a market sell-off.
When focusing purely on dividends or coupons, a recurring problem and risk that presents itself is the lack of diversification. If you had the opportunity to dig into popular REIT or dividend funds, you may find that their top 5 to 10 holdings are extremely similar, if not the same. A look at high dividend yielding indices below shows that the top 10 holdings form a quarter to over a third of the index; this considerably increases the concentration risk.
So, is there a better way to invest?
Definitely. A superior way to invest for income is via a total-return investing strategy. In contrast to traditional income strategies, the total-return approach generates income from capital gains in addition to portfolio yield. This strategy proves to be especially beneficial for investors in the de-cumulation phase of retirement, providing them with increased spending flexibility that comes from the combination of two sources: capital gains and income, as seen in the diagram below.
The total-return portfolio, created in conjunction with your advisor, and combined with a prudent spending policy has the following benefits:
Portfolio diversification
Total-return strategies are much more diversified across asset classes. Diversified portfolios tend to be less volatile and hold up better during stock market shocks (as seen in the earlier graphic).Portfolio Control
Investors have more control over the size and timing of portfolio withdrawals - compared to dividend payouts which fluctuate both in size and timing of the payouts.Portfolio Tax Efficiency
At this point in time, IRAS does not tax investors on capital gains from investments in financial instruments.
So why do investors still persist in investing based purely on the headline payout numbers? It is likely due to a lack of knowledge in other more efficient forms of investment. A total-return approach to receiving income helps investors to minimise risks and increase portfolio longevity when compared to pure dividend investing.
We are strong advocates of this method especially during this period of low-yields which could stretch on for a while longer — making sure that you’ll be well taken care of in the long-run, regardless of the financial climate.
