The Long-Term Yield PuzzleThese are bargains so long as you keep in mind that the goals of fixed-income investing go beyond simply stuffing a portfolio with whatever instruments happen to be paying the highest yield right now. Fixed-income investments should also lower the volatility and the risk of the equity portion of a portfolio. And they're supposed to offer predictability of return to anyone planning for retirement. Any fixed-income strategy designed to respond to a potential yield famine in coming decades needs to keep these other goals in mind too. I wish I could be as certain about this long-term yield puzzle as those who believe this demographic scenario are. I certainly take the demographic facts seriously. The U.S. does face a huge retirement bubble in the coming decades. But the financial markets and the U.S. economy are complex systems in which the final results aren't determined by a single variable. We are, for example, at the end of an extraordinary 20-year period of falling interest rates built on, among other things, the willingness of vast numbers of non-U.S. residents to hold U.S. dollars and invest their savings in our financial markets. That puts some kind of floor on U.S. interest rates, because offshore investors won't be willing to hold billions and billions in our financial assets if the assets fail to pay a reasonable risk-adjusted return. (From a more global point of view, in fact, the assets controlled by retiring boomers do not represent the largest block of cash with power over the market.) The list of possible forces that could upset the doomsday yield scenario is lengthy. Inflation could kick up again in the U.S., for instance, as government deficits mount in the coming decade.
The Certainty of UncertaintyBut we don't know what will happen to the financial markets in the next decade. Many of the trends that ordered the 1990s have either ended -- such as the great bull market in stocks -- or seem to be drawing to a close -- like the great bull markets in bonds and in real estate. And it's not clear now what trends will replace them.
Fixed Income Offers StabilityTransforming the return from fixed-income investments into retirement income is relatively straightforward. $20,000 in bonds paying 8% a year produces $1,600 in income -- plus some potential capital gains in the bond if the market heads in the right direction. An investor in retirement can spend that entire $1,600 in income without dipping into capital or diminishing the income that investment will produce the next year.
Stocks offer Complexity and More AppreciationConverting the return from equities into retirement income is not nearly so simple. Most of the return comes from capital appreciation and can only be realized by selling the equity or some portion of it. But deciding how much to sell so you don't reduce future income -- or, worse, outlive that income stream -- requires that you can project future gains from the equity. If I have $110,000 of Cisco Systems ( CSCO), I can sell $10,000 this year without reducing my capital -- if I know that Cisco shares will appreciate 10% next year. Since no investor really knows what the return on a stock will be next year, you usually deal with this uncertainty by reducing the number of shares sold for income. Conservatively, I might only sell $8,000 in Cisco shares. I might build that into my retirement plan by increasing the amount of money that I believe I need to save for retirement. High-yielding fixed-income investments, thus, have two advantages to anyone building or living on a retirement portfolio: The high yield reduces the amount I need to accumulate for retirement. The predictability of that yield -- compared with the lower predictability of the return from the more volatile equity investments -- also reduces the amount I need to save and invest to reach my retirement income goal. That leads me to the core of my yield strategy. I want to maximize two variables at the same time: The income produced by my fixed-income investments and the predictability of that income.
Some Investments Don't Make SenseThese goals rule out certain kinds of fixed-income investments right from the get-go. Bond funds are a poor match because the yield on a fund varies over time as bond fund managers replace older bonds with newer issues. And a good portion of the return from bond funds consists of capital gains -- which are as unpredictable for bonds as they are for stocks.
Predictability and High YieldAmong common stocks, I think the pattern is well established. The goal is a stock paying a high dividend currently -- high for a stock, that is -- but also where the company has a history of regularly increasing the dividend each year. That will help make up for the gap between the yield on common stocks and on corporate bonds. And where the company's finances give investors good reason to believe that the dividend is safe and likely to increase. With these criteria, I'd prefer Duke Energy with its 5.5% yield to American Electric Power with its 8% yield because the predictability of Duke's yield is so much higher. American Electric Power has paid out a dividend of $2.40 a share during a period when earnings came to just $2.06 a share. Duke paid out $1.47 during the 12 months when it earned $1.91. I think it's clear which company has more latitude to boost its payout and which dividend is more in danger of a cut or stagnation.