Generating investment income is challenging, especially in the low-yield environment we have been living with for the past decade. We believe that combining dividend growth stocks with an allocation to shorter-duration non-investment grade bonds is an effective solution.
Generating investment income is an age-old challenge that has been particularly difficult recently, as bond yields have been stubbornly low since the Great Financial Crisis. Creating consistent cashflow is a top priority not only for retirees, but also for endowments, foundations, and family offices that need to fund their operations. For many investors (and their advisors), the standard playbook is to increase their fixed income allocation and reduce their equity allocation, creating a reliable cashflow stream and decreasing portfolio volatility.
The downside of this approach is that it makes it harder for portfolios to grow, as investors are spending (rather than reinvesting) the proceeds from their fixed income investments. At the same time, they are dipping into their equity portfolio to cover any shortfalls or unexpected expenses. The combination can result in a portfolio with both declining principal and income potential.
In managing assets for both high-net-worth individuals and institutions for nearly 40 years, we have found that a dividend growth strategy, which invests in the subset of dividend-paying stocks with growing earnings and dividends, combined with an allocation to shorter-term non-investment grade bonds is a compelling solution to this problem. It provides a combination of relatively high current income, future income growth, and capital appreciation, while still limiting volatility.
Dividend-Paying Stocks Are Diverse
Despite its reputation as a haven for antiquated, stodgy companies, the dividend-paying universe is fairly diverse, with over 75% of the S&P 500 paying dividends. Although many dividend-paying stocks fit the traditional stereotype – mature businesses with above-average yields and slow growth rates – there are also plenty of dividend growth stocks – dynamic companies that operate in expanding markets with favorable long-term growth prospects.
We feel that investors with a multi-year time horizon are far better off holding dividend growth stocks than slower growing stocks with a higher dividend payout. In the short run, dividend growth stocks may produce slightly less income, as they generally offer lower payout rates, but over time their faster top-line growth should provide investors with compound returns in both their income stream and their share price appreciation.
Dividend-Paying Stocks Perform Better in Down Markets
Another benefit of dividend-paying stocks is that they tend to perform better in difficult markets than stocks that do not pay a dividend. This makes sense because investors gravitate toward profitable companies when sentiment turns bearish, especially those that return a portion of their free cashflow directly to shareholders.
According to a recent research note from Credit Suisse, this is exactly what has happened since the onset of the pandemic:
“Companies that are returning more of their excess capital to shareholders in the form of dividends are continuing to see incredibly strong performance. This is in contrast to buybacks, which are often viewed by market participants as a driver of share prices.”
Dividend growth companies fared particularly well during the latest market selloff. In the past year, the S&P 500 Dividend Aristocrats Index has lost only -3.68%, compared to a much more substantial -10.62% loss for the broader S&P 500.
This feature is especially relevant today, given the current market volatility and the ongoing uncertainty in the economy. Of course, dividend-paying stocks can still decline in bear markets, and in extreme cases they can even skip a scheduled dividend payment, but their higher degree of profitability can provide protection in turbulent times.
Shorter-Term High Yield Bonds Are an Effective Complement
In our view, shorter-term high yield bonds pair particularly well with dividend growth stocks as part of an income generating strategy. They have two primary benefits. First, they dampen overall portfolio volatility. A pure dividend growth equity strategy might have more upside, but it also has substantially more downside. Layering in a fixed income buffer can help reduce drawdowns.
The second benefit is that they generally offer larger yields than dividend stocks, thus increasing current income. We particularly like shorter duration high yield bonds, as their coupons are higher than their investment grade counterparts. Their higher yields also translate into less interest rate risk than investment grade bonds of comparable maturity. (Interest rate risk, also known as duration, decreases as maturities fall and yields rise.) Likewise, they have less credit risk than similarly rated longer maturity issues, as the bondholder is exposed to the borrower for a shorter period of time.
Our Philosophy in Practice
Our views about generating investment income have been shaped by decades of helping both individuals and institutions reach their long-term financial goals. In our experience, the best outcomes occur when investors are able to position their portfolios to generate growing income streams without sacrificing capital appreciation or taking on too much risk. To help our clients achieve this, we have developed the Growth & Income Fund, which utilizes a flexible combination of our favorite dividend growth stocks with a selection of shorter-term non-investment grade bonds.
Stocks: Industry Leaders and Secular Growers
We believe the best way to deliver strong long-term performance is to build an equity portfolio of attractively valued stocks issued by leading or dominant companies in their respective industries. These firms are generally able to gain market share over time and enjoy higher margins. This enables them to grow revenues and free cash flow, which allows them to raise dividends faster than their competitors. Additionally, they are typically more durable and hence can be owned for many years, improving the tax efficiency of our strategy.
We also look for companies that benefit from secular tailwinds – firms that are selling products and services in sectors of the economy that are undergoing structural growth. Currently we are focusing on several areas, including the shift away from carbon-based fuels to alternative energy, the shift toward electric vehicles, the shift from brick-and-mortar retail to e-commerce, and the digitization of the economy, to name a few. We believe these sectors should grow over the long term, regardless of the business cycle, and the individual companies should be able to grow faster than the overall market.
Bonds: A Steady Source of Income
We supplement the income from our equities with a carefully selected portfolio of mostly shorter-duration high yield bonds. We emulate the philosophy of our Strategic Income fund within our fixed income allocation, which means we are always looking for the areas of the market that have the most attractive risk/reward characteristics, regardless of credit rating, sector, or maturity. At the same time, we are careful not to stretch for yield, which reduces our losses in weak markets.
As you can see from the scatterplot below, we have been successful with this approach. The x-axis plots the downside capture ratio , which measures how an investment performs during falling markets. A lower number is better, as it indicates the portfolio is less correlated with changes in the market. The y-axis plots the upside capture ratio , which of course is the opposite, and a higher number is better.
Since inception, the downside capture of the fixed income portion of the Growth & Income Fund is decidedly lower than both the high yield index and every high yield bond fund in the Lipper universe. At the same time, the upside capture is near the top of the peer group and almost identical to the high yield index.
Although no single portfolio is appropriate for everyone, we believe that most income-seeking investors would benefit from maintaining at least some exposure to dividend growth stocks and shorter-term high yield bonds. At Osterweis, we offer the Growth & Income Fund, which seeks to provide a combination of current income, future income growth, and capital appreciation.
1The Dividend Aristocrat Index is a subset of the S&P 500 that is made up of companies that have increased their dividend every year for at least 25 consecutive years.
2The downside market capture ratio is calculated by dividing the portfolio’s return when the benchmark (Bloomberg U.S. Aggregate) performance is negative by the return of the benchmark during the same periods.
3The upside market capture ratio is calculated by dividing the portfolio’s return when the benchmark (Bloomberg U.S. Aggregate) performance is positive by the return of the benchmark during the same periods.