Generating income in a world of low interest rates
The headline above asks a reasonable question, but not one with a satisfying answer. In today’s world the answer is “Next to nothing.”
For investors hoping to live off the income of their investments there’s never been a more difficult and potentially dangerous environment. The difficulty is illustrated in the following two charts. The first shows 13 years of yields on 10 Year Treasury bonds, the traditional risk free investment. The 10 year currently yields 0.64% or two thirds of a percent, in plain english.
The second is the typical yield on high grade municipal bonds, currently at 1.13%.
Both charts coincidentally start at a 5% yield. In those days, to produce $50,000 in annual income an investor needed $1,000,000 in assets. Today the municipal bond investor needs $4,425,ooo to produce that $50,000 of annual income, while the treasury bond investor needs $7.8 million for the same income result!
So much for difficulty, where’s the danger? It comes in two flavors: 1) If interest rates rise bond investors will suffer losses on the value of their bonds, and 2) low interest rates may tempt investors to search for higher yields in riskier assets.
The obvious riskier asset is the stock market. The S&P 500 is yielding 1.8% in dividends, three times the yield on the 10 year treasury bond.
In our view the even riskier bets involve high yield bonds or high yielding stocks, both of which risk capital loss and in the case of high yielding stocks, a reduction in dividends. In both cases it is possible for bankruptcy to take an investment to zero.
What’s our solution? Investors should be focused on “total return”— capital gains over time plus any dividend & interest income earned. That way an investor can get back to that 5% world. How? By setting up a plan to withdraw 5% (or less) of the value of an investment portfolio each year. The historic rate of return on a stock portfolio (0ver 5%), blended with interest on a low risk bond portfolio (under 5%) will cover those withdrawals over time.
This approach forms the backbone of any financial plan and we would be happy to review your current asset base, your historic returns, and make some educated guesses about the future. Let us know how we can help.
Daniel A. Ogden