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Seeking Yield: Finding 7% Income in Today’s Market

Topic: Income
Publication Type: Investment Cases
Seeking Yield: Finding 7% Income in Today’s Market

While generating sustainable yield for income investing has never been an easy task, the latest shockwaves to reverberate through interest rate markets have only compounded this challenge.  The core of this problem for investors, whether retirees, long-term savers, or anyone looking to diversify their returns, is they are probably looking for yield in all the wrong places.

While all income is useful, many yield-focused strategies do not generate as much income mileage as may be imagined.  After imposing 22% dividend taxes (please check with tax professional) and 1.8% reinvestment to maintain purchasing power against inflation*, investors may potentially require nominal yields over 7% to approach even a modest 4% income stream.  Many conventional approaches, however, do not even remotely approach this threshold, which begs the question: What alternative income strategies can investors consider to hit these high yield numbers?

Down the Yield Rabbit Hole

For a full analysis of the yield ecosystem, we will proceed through progressively higher yielding asset classes, using industry-standard indices as outlined in the table below.  As a baseline, consider that after nine hikes in the federal funds rate (since 2015), the Bloomberg Barclays Aggregate Bond Index, commonly referred to as the Agg, still only yielded 2.77%. After an assumed 40% marginal income tax rate**, this number fell to a paltry 1.66% that failed to keep pace with inflation.  

Even large cap stocks such as represented by the S&P 500, maintained a 2.03% dividend yield as of 5/31/19, for 1.58% income on an after tax basis. This situation very much illustrated the “you can’t get there from here” problem inundating income investing. Even before the Fed cuts rates, bonds only held an eight basis point edge in yield over equities.

Show Me The Money: Yield by Asset Class

Asset Class Proxy Index Yield (%)
Equities S&P 500 2.03
Bonds Bloomberg Barclays Aggregate Bond Index 2.77
High Dividend Equity FTSE High Dividend Yield Index 3.25
Real Estate Dow Jones Equity REIT Index 3.78
High Yield Debt iBoxx USD Liquid High Yield Index 5.17
Closed-End Funds S-Network Composite Closed-End Fund Index 7.55
MLPs Alerian MLP Index 8.17
BDCs S&P BDC Index 9.54
Alternative Income TFMS HIPS 300 Index 7.95

Source: Bloomberg (as of 5/31/19)

Moving up the yield food chain, the next stop after fixed income is high dividend stocks, where the FTSE High Dividend Yield Index yielded 3.25%. While segmenting out the top echelons of dividend issuers increased yield by 60% over standard equity dividends, we are not yet even halfway to a sustainable 7%. Further along, real estate was commonly considered a yield-oriented investment, driven by rents and mortgage payments, but the Dow Jones Equity REIT Index managed only 3.78%—at least now we have crossed the 1% real after tax mark.

The final conventional income asset class is high yield or junk bonds, which achieve higher interest rates in exchange for the assumption of greater credit and potentially liquidity risk.  The iBoxx USD Liquid High Yield Index, for instance, produced a 5.17% income stream.  The less favorable tax treatment of interest income, however, reduced this seemingly impressive number to 3.1% on a real after tax standard, only 15 basis points higher than real estate.

The intractable problem facing any investor is this threshold is the upper limit, the event horizon, to income yields with mainstream strategies.  No combination or permutation of any of these asset classes can approach 7% income, even while assuming progressively greater levels of risk and volatility.  The question remains then, what out of the box strategies can investors consider for real income?

Getting Real About Income

The solution to this income stream problem may lie in an ecosystem of alternative investment beyond the frontier of conventional options.  The three prominent contenders in this high yield arena are Closed-End Funds (CEFs), Business Development Companies (BDCs) and Master Limited Partnerships (MLPs), having achieved yields of 7.55%, 9.54% and 8.17% – but how did they do it?

Notes: All yields are as of 5/31/19, and return (annualized return) and volatility (annualized standard deviation) measures are calculated over the 3-year period from 5/31/16-5/31/19.  The Agg is represented by the Bloomberg Barclays Aggregate Bond Index, High Dividend by the FTSE High Dividend Yield Index, Real Estate by the Dow Jones Equity REIT Index, High Yield by the iBoxx USD Liquid High Yield Index, MLPs by the Alerian MLP Index, BDCs by the S&P BDC Index and CEF’s by the S-Network Composite Closed-End Fund Index.  One cannot directly invest in an index. Past performance does not guarantee future returns.

What these assets have in common is they may exploit unique fund structures, or target specific risk profiles, seeking to hit income in excess of traditional methods.  Their pass-through structures typically avoid the double taxation phenomenon, enabling higher yields for the end investor.  The chart above depicts how the three alternative income strategies broke the low yield barrier, while also factoring in their risk and return attributes over the last 3 years; the difference was stark.  Let’s review their inner workings.

Related: Overcoming Human Fallacies in Income Investing

Foremost, Closed-End Funds can use the gambit of their own internal leverage—they are able to issue their own debt and preferred shares up to 50% and 100% of net assets, respectively—to augment their exposure to high yield debt. In exchange for increased volatility, the CEF structure enables investors to figuratively “double-down” on speculative grade yields, and the potential to purchase CEFs below Net Asset Value can further enhance this effect.

Next in line, Business Development Companies are investment firms that specialize in funding small, distressed or emerging ventures in either the public or private investment ecosystem.  Based out of a fund structure created in 1980, BDCs operate in a fashion not dissimilar to private equity or venture capital, leveraging their internal capital structure for the potential to distribute sizable yields to their equity stakeholders.

The final heavy-yield contender, Master Limited Partnerships, were first created in 1981 but restricted to only the energy and real estate sectors in 1987, as Congress thought the structure was too tax-advantaged.  MLPs are a unique cross between a partnership and a corporation that can be publicly traded and employ a pass thorough structure to avoid double-taxation.  Not only are most distributions return on capital, but depreciation and losses can even be passed on to investors as well.  Much as is the case with CEFs and BDCs, MLPs utilize unconventional frameworks to achieve yields beyond what can be countenanced by standard investments.

Combined Arms Investing

As may be surmised through their descriptions, these alternatives are willing to make unorthodox trade offs to earn their high-income status.  For instance, CEFs concentrate heavily on interest rate and credit risk, and BDCs by their nature focus on at-risk or immature companies.  Despite historically having been considered a conservative investment, recently energy-oriented MLPs have performed poorly after the shale oil revolution precipitated sharply lower crude prices.  Even the current tax regime has reduced the comparative attractiveness of MLPs.

The point is, each of these categories alone may be susceptible to specific shocks, whether in terms of overall market risk or even structure specific risk; MLPs attest to both categories of setback.  A diversified approach, combining these three alternative assets may present a solution to the search for +7% hunt for income while constraining category specific risk. 

To this end, the TFMS HIPS 300 Index, depicted in yellow in the diagram above, yielded 7.95% by blending securities from each of these high yield structures with additional REIT exposure for further diversification and capital growth potential.  With the swift, near overnight transformation in the rate environment, the Fed has thrown savers and retirees yet another curveball. 

As interest rate cuts start hitting the tape in the coming months, the search for sustainable, yet meaningful income is only going to intensify in challenge.  A diversified, strategic blend of alternative income structures may present investors an attractive solution.

*1.8% inflation number based upon CPI Index

**40% marginal tax rate is used as a standard tax rate for purposes of financial modeling. This varies by individual, so please consult your tax professional.

One cannot invest directly in an index. All investing involves risk including the possible loss of principal. Each of the products mentioned carry their own specific risks. There is no guarantee that any investment will maintain or increase its yield for income purposes.