Income Investing: Equities, Bonds, or Both?

By Dr. Brian Jacobsen, CFA®, CFP and Sophie Careford, CFA®

The 10-year U.S. Treasury yield is so close to the dividend yield on the MSCI World High Dividend Yield Index, is equity income worth the risk? Why even bother with equities when bond yields are finally offering an alternative source of income? We see two reasons:

  1. You can aim for better-than-average yields.
  2. Real returns really matter.

Aiming for better-than-average yields

First, while the gap between the high dividend yield index and the Treasury yield has become much smaller, looking under the hood, we find significant dispersion in dividend yields. In the MSCI World High Dividend Yield Index, dividend yields range from 1.48% to 29.95%. This is a broad range, but roughly half of the securities in the index currently offer dividend yields of more than 3.50% (181 of 349 total securities in the index). With careful stock selection, it’s possible to identify better-than-average yielding companies. Investors also have the potential to add value and manage risk at the sector and industry levels.

Real returns really matter

The second reason to incorporate equities in an income-oriented portfolio is inflation. One problem with fixed income is that it is fixed—a bond’s contractual obligations don’t adapt to changing growth and inflationary contexts. Inflation-adjusted income and portfolio returns are important because they reflect purchasing power. Historically, equities—and especially dividend-paying equities—have provided attractive inflation-adjusted performance. Since July 1927, real returns on high-dividend-yielding equities outpaced real returns on the 10-year U.S. Treasury bond and on equities that do not pay dividends.

Comparison of cumulative total real returns

The higher the starting dividend yield, typically the better the 10-year total real return on equities. Conversely, we’ve seen little relationship between the starting yield on bonds and subsequent 10-year total real returns. This is because of inflation. The price volatility of bonds has been much lower than that of equities. But, higher inflation correlates with bond losses, while you can still have gains with equity prices. Even in inflation-adjusted terms, bonds have been less volatile than even high-dividend-yielding equities. However, consider the real return difference, especially in different inflationary environments. The chart below shows the real average annualized return and risk starting in high-inflation environments (≥3%) versus low-inflation environments. The difference between the 10-year U.S. Treasury and equities is stark, with negative average real returns on Treasuries over this time. All three performed better when inflation was low. But even in low-inflation environments, which portfolio is more likely to support an inflation-adjusted income target without dipping into the principal?

Real average annualized risk and return in high and low inflation

Correlation and volatility

Another thing we find encouraging about equity income is that, while the average total real return is not statistically different from the average total real return of non-dividend payers, the real volatility is statistically lower for higher-dividend payers. Caution must be exercised, however, because while the volatility of high-dividend payers is lower than non-dividend payers, high-dividend payers’ returns are more highly correlated to bond returns than are non-dividend payers’ returns.

Bringing it all together

Our view is that generating portfolio income requires a portfolio perspective, which means considering all asset classes and their correlations, along with individual income, return, and risk characteristics. While income is a little less scarce in the fixed income market now that rates have risen, investors may still be well served by considering equity income—not just to protect portfolio value but also to support the portfolio’s purchasing power.

PAR-1022-00271

Originally Posted October 26, 2022 – Income Investing: Equities, Bonds, or Both?

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