It is difficult in general, to say what the best sources of yield or income are for retirees that are entering the drawdown stage of life. For many people, their investments provide the income they require to live life and pay their bills. However are the best sources of income the highest yielding investments? For individuals, is it as simple as owning the highest dividend or interest paying investments out there in the market place?
In my opinion, I don't believe that is the case. For example we know that the second tier of dividend payers (not the highest dividend payers) outperform the first tier on a regular basis. The highest dividend payers often run into problems maintaining the higher rate and thus, often have to reduce their payouts which can spell disaster for the share price of those companies. The second tier dividend payers maintain their dividend payouts more easily and thus exhibit less volatility in comparison. Thus, in many cases the best source of yield is not the highest yield.
Before an investor can decide the best source of yield for themselves, they have to decide on the risk they are willing to take. Are they more comfortable with low risk investments or are they okay with chasing a possible higher rate of return or dividend rate, but have to take on more risk to do so? A medium risk portfolio may yield more, but there will be more volatility as well.
There are always risks to any portfolio. With a lower risk portfolio that tends to gravitate to more fixed income like products, the risk is with interest rate fluctuation. As interest rates move higher, the price of investments such as bonds and preferred shares tend to fall. With medium or higher risk investments that are traded on the stock exchange, the risk is that the value of the investment can fall with the overall market sentiment. Thus medium risk investments that are invested in equities (you can have higher risk bonds as well) are subject to market risk, whereas low risk bonds have to be concerned with interest rate sensitivity.
Today, with interest rates so low, many believe that the only direction for interest rates is higher. Investors, including myself, believe that the 10 year government bond rate will rise above the 3% mark both here and in the US at some point in the not too distant future. Therefore are bonds or even preferred shares a good investment today for investors seeking lower risk knowing full well that the value of the bonds and preferred shares will fall in the future? Should investors, seeking higher yield, look to the equity or stock market for greater payouts but risk losing money with the ups and downs of the stock market?
In my opinion, with the environment that we are in today, a balanced approach makes most sense. Like many aspects of life such as lifestyle or diet, balance always makes sense. Thus, why would your investments be any different? If you are in the drawdown stage of life, you are probably no longer working and thus cannot or should not take the same risks as someone who is younger and earning an income. Thus inside the portfolio, there should be a large component of lower risk investments like preferred shares or corporate bonds. I would own corporate bonds over government bonds as the yields tend to be higher. Preferred shares (depending on what type of preferred shares) can pay out to investors 4% to 5% dividends on an annual basis. That is a great yield for those looking to stay in a low risk investment but want to maximize the yield as much as possible. Investment grade bonds (BBB+ or higher) depending on the length of the bond can pay in the 3% to 4% range (if you were to consider bonds that mature in the 6 to 10 year range).
On the equity side, I would consider dividend paying stocks in the utilities, bank, telecom and pipelines sector. There are companies in these sectors that tend to be a little less volatile than the market as a whole, but have yields that are higher than investment grade corporate or government bonds.
The risk that the retiree is willing to take will dictate the percentage of the portfolio that would be in dividend paying equities vs. fixed income bonds or preferred shares. The other factor that goes into determining the mix of assets in the portfolio is the desired yield or income the retiree requires. If the retiree needs a yield of 5%, they will not be able to attain this with government bonds or GIC's.
In today's environment, with equities in many cases paying out higher dividends than the interest rates bonds are paying and with interest rates rising at some point down the road, I think it is possible for retirees to incorporate income generating stocks into their portfolio. Income generating stocks will provide both a higher yield in many instances and help hedge the portfolio against higher interest rates. Perhaps a retiree should incorporate 20% or 25% into dividend paying equities in their portfolio (depending on their comfort level for risk). Bonds will fluctuate with interest rates, but eventually if the investor holds the bond to maturity, they will receive their money back plus interest. Thus in the long term, there is no risk of loss unless the bond defaults on the payment. By owning investment grade bonds, the risk of that happening is minimal. The type of preferred shares you own will dictate the volatility with this asset class. Perpetual preferred shares versus Reset preferred shares as an example. An investor must understand what type of preferred share they own and how it works if they are going to include this investment in their portfolio. In general, preferred shares can add good yield to a lower risk portfolio.
In summary, the best source of yield for retirees revolves around having a balanced portfolio made up of both equities and fixed income products to hedge against market risk and interest rate risk and to provide a higher average yield to the investor. Chasing the highest yielding investments is never a good strategy. Owning a mix of investments that have good yields and that are in different asset classes is the best way to make money and hedge against risk in the current investment environment.
This article was prepared solely by Allan Small who is a registered representative of HollisWealthTM (a division of Scotia Capital Inc., a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada). The views and opinions, including any recommendations, expressed in this article are those of Allan Small alone and not those of HollisWealth.