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SAug 20, 2010

Searching for the Ultimate Income Portfolio

Scott Burns

Searching for the Ultimate Income Portfolio

Finding investment income is difficult. But it isn’t impossible.

The search will demand that many investors leave their comfort zone well behind.

If you are a CD investor, for instance, you’ll be hard pressed to find yields over 2 percent unless you (1) do a lot of searching and (2) make maturity commitments close to 5 years. Recently, for instance, the average yield on 5-year CDs in the Bankrate.com survey was 1.88 percent nationally and 2.38 percent on their site. At 2 percent, you would need to have retirement savings of $800,000 to produce the $16,000 a year earned in a full-time job at the minimum wage. How’s that for a new perspective on becoming a Wal-Mart greeter?

So what do you do?

You do what investors did in the post-OPEC 1970s— you build a portfolio with a “yield-tilt.” While most people own stocks because they are seeking investment growth, the reality is that many growth stocks are disappointing and overpriced. Many dividend stocks, on the other hand, will pay handsome dividends while you wait for a happier stock market.

Investment advisor Geoff Considine of Boulder, CO based Quantext, for instance, recently wrote about a high yield portfolio consisting of nine stocks and one high yield bond fund. He called it “The Ultimate Income Portfolio.”  Its holdings were 5 electric utility companies, 2 telephone companies, 2 pharmaceutical companies, and one high-yield bond fund. The average yield for the portfolio was a healthy 6.1 percent— a yield that would cover required minimum distributions (RMDs) from retirement accounts up to age 83.

He also found that while returns from the portfolio were essentially unrelated to interest rate changes, the volatility risk was about the same as the risk in long maturity government bonds. In other words, the portfolio provided half again as much yield as the 4 percent of long term bonds for about the same level of risk.

The stocks in his high yield portfolio are the electric utilities Con Ed (ED, 5.1 percent yield), Dominion (D, 4.4 percent yield), Duke (DUK, 5.7 percent yield), Pinnacle West (PNW, 5.5 percent yield) and Xcel (XEL, 4.5 percent yield); telecommunications companies AT&T (T, 6.5 percent yield) and Verizon (VZ, 6.6 percent yield); and pharmaceutical companies Glaxo (GSK, 5.2 percent yield) and Bristol Myers (BMY, 5.1 percent yield). The high yield bond fund is a closed end fund, Blackrock  High Yield Bond fund (COY, 8.9 percent yield). Like the Couch Potato Building Block portfolios or Craig Israelsen’s 7Twelve Balanced portfolio, all investments are made in equal amounts. This makes creating the portfolio really simple.
While this portfolio triples the income you can get from safe CDs, it comes at a price— real risk. It was only a few months ago that BP was a high yield energy stock. Calamities happen.

Selling covered calls against this portfolio, Considine found, would increase the yield another 3.6 percent— to a whopping 9.7 percent. Again, this is not “free” money. By selling calls you lose potential appreciation but retain full exposure to loss. This is one of the reasons investment advisor Larry Swedroe warned against call selling as a strategy in his book, “The Only Guide to Alternative Investments You’ll Ever Need: The Good, the Flawed, the Bad, and the Ugly” (Bloomberg, $26)

Is there a more diversified way to increase portfolio yield?

Yes, if you concentrate on portfolios of companies that have offered attractive dividends for a long time. Here is a list of the larger ETFs that focus on dividend paying equities.

  • Powershares FTSE RAFI Asia Pacific ex-Japan (ticker: PAF) is an exchange traded fund with a yield of about 4.9 percent.
  • Vanguard European exchange traded fund (ticker: VGK) has a yield of about 4.7 percent.
  • SPDR S&P Dividend exchange traded fund (ticker: SDY) has a yield of about 3.7 percent.
  • Vanguard REIT index exchange traded fund (ticker: VNQ) has a yield of about 3.95 percent.
  • iShares Dow Jones U.S. Utilities exchange traded fund (ticker: IDU) has a yield of about 4.0 percent.

Investing equal amounts in these funds would provide an average yield of about 4.25 percent while giving diversification across international and domestic equities as well as REITs and electric utilities.

 (Full disclosure: While 85 to 90 percent of all Burns household financial assets are in index fund based portfolios, shares of ATT and Verizon are owned in a taxable portfolio that invests in individual stocks.)

Filed Under: Government, Taxes & Other Disasters, Income Investing