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Benefits of Total Return Investing in an Ultra-Low Interest Rate Environment

August 09, 2017

“In the land of the blind, the one-eyed man is king”

Desiderius Erasmus

The big picture…

A total return approach balances the two investing goals of income and capital appreciation based on market conditions. It does not take a rigid view that bonds are for income and stocks are for capital appreciation. Ultimately, the total return investor wants to meet his/her investment goals with a combination of income and capital appreciation (total return).

The market pays up for what is scarce…

From 2008 to now, we have been in an environment of ultra-low interest rates. Total return investors recognized that income would be scarce and that high-quality dividend paying stocks would be a better alternative than high quality bonds to generate income. This flexible approach of substituting stocks for bonds allowed total return investors to meet their income needs, led to capital appreciation and lowered risk.

Both high quality dividend stocks and bonds can provide income…

Prior to the financial crisis in late 2008, the 10-year US Treasury Bond (10- year USTB) offered a 4% yield (you got $40,000 in interest income for every $1 million invested) while the S&P 500 stock index had a 2% dividend yield ($20,000 in dividend income for every $1 million invested). After the financial crisis, the yields flipped as investors dumped stocks and fled to the 10-year USTB. The drop in stock prices drove up dividend yields to 4% while the increase in the price of the 10 year USTB pushed down yields to 2%. People retiring at that point in time who needed $40,000 in income would have had to invest $2 million in the 10-year USTB (2% on $2 million got you $40,000 in interest income), while stock investors needed to invest only $1 million (4% on $1 million got you $40,000).

So, at that point, high quality stocks gave you twice the income generating capability than of high quality bonds. This is not normal and total return investors took advantage of the panic and sold high quality bonds to buy high quality stocks.

Capital appreciation component of total return …

As the world recovered from the financial crisis, stock investors have garnered a tremendous amount of capital appreciation, the second component of total return. This reservoir of wealth can be tapped to boost one’s spending power whenever they want and is the primary benefit of total return investing. Although the income component from dividends rose to above average levels as dividend yields increased to 4% from 2%, the return from income pales in comparison to what investors got from capital appreciation.

All this capital appreciation has caused some to feel that there is a “bubble” in the stock market. However, the gains were mainly due to a recovery from the financial crisis, leading to a recovery in corporate earnings and hence stock prices. You can see this when you examine the dividend yield for the S&P 500. As the financial crisis unfolded, stock prices plummeted while dividends remained relatively stable (except for the financial sector which eliminated or cut their dividends), so dividend yields rose to 4% from the normal 2% prior to the crisis. What is the S&P 500 dividend yield today? It is 1.91%, back to normal or pre-crisis levels!!

A lower risk approach versus solely investing into bonds for income …

Note that total return investors bought high quality stocks to maintain their income levels in an ultra-low interest rate environment. What did rigid investors who only look to bonds for income do to maintain their income levels? They bought lower quality bonds (increased credit risk) and bonds with longer maturities (increased duration risk), greatly raising their probability of losing their original investment!!

So far the “credit risk” has hit the fan and it wasn’t pretty for investors of Puerto Rico bonds. Just as individuals refinanced their old mortgages with high interest rates to take advantage of lower interest rates, high quality bond issuers refinanced by calling (redeeming early) their old high coupon bonds to issue new bonds at much lower rates. Bond only investors got sticker shock and tried to maintain their income levels and bought lower quality bonds, such as those issued by Puerto Rico.

So far, the “duration risk” has NOT hit the fan yet. While stock dividend yields have normalized back to the pre-crisis level of 2%, the 10-year USTB currently is at 2.25%; clearly it has not normalized back to 4% where it was before the financial crisis. To maintain income levels, bond only investors invested into longer dated bonds, extending maturities to 20 - 30 years. This greatly increases the chance for principal loss when rates rise back to their pre-crisis levels of 4%. Longer dated maturities such as 20 – 30-year bonds will lose more value as rates rise than 2 - 3-year bonds; this is the essence of duration risk.

Recently, Alan Greenspan made news and here is what he said…

"By any measure, real long-term interest rates are much too low and therefore unsustainable. When they move higher they are likely to move reasonably fast. We are experiencing a bubble, not in stock prices but in bond prices. This is not discounted in the marketplace."

It isn’t too late for bond only investors with long dated maturities to eliminate their duration risk and avoid losing money when interest rates rise. However, it is too late for them to maintain their income levels as high- quality stocks yield less than 2% and shorter-term bonds yield less than 2%.