When Investing for Income, Diversification Matters

When Investing for Income, Diversification Matters

Investors generally seek income from familiar sources, such as bonds and dividend-paying stocks. But accommodative monetary policies and low interest rates over the past decade have created challenges for those types of assets. Interest rates and dividend yields remain near historical lows, despite recent Federal Reserve rate hikes. Outside the U.S., including in Europe and Japan, yields are even lower, as central banks maintain aggressive easing programs.

We believe investing for income in today’s low interest rate environment requires a broadly diversified strategy with a goal of providing sustainable income. Client Portfolio Manager Nancy Pilotte recently spoke with Portfolio Manager Radu Gabudean about income diversification and professional management.

Where can investors find attractive income opportunities in today’s rate environment?

We believe investors should consider a range of sources to achieve their income, total return and risk goals. Along with the familiar sources—bonds and dividend-paying stocks—investors have other options. High-yield bonds, convertible bonds, preferred stocks, real estate investment trusts (REITs), and others may offer attractive income-generating potential, but they also may be difficult to access, combine into a portfolio, and manage. This underscores the value of professionally managed income portfolios.

When constructing an income portfolio, should investors focus on the asset class that has provided the highest yield?

In our view, that strategy is shortsighted and risky. Income-generating securities not only vary in their average yield, they also vary in income consistency. That is, the level of income can fluctuate in response to risk and changing market and economic conditions. So what may be the highest-yielding security today may not be the highest-yielding security down the road.

Income investors need a steady stream of income, which is why yield stability is an important consideration. A portfolio of different types of income-generating securities may help provide a smoother, more consistent level of regular income than a single asset class whose yield may vary widely. 

Yields Are Not Stable Over Time

Yields are not stable over time.
Source: FactSet, Bloomberg. Data from 10/31/2004 – 3/31/2017.
Asset classes represented by the following indices: High Yield: Bloomberg Barclays US Corporate High Yield – 2% Issuer Cap; Preferreds: S&P Preferred Stock Index; Master Limited Partnerships (MLPs): Alerian MLP Index; EM Debt: JPMorgan Corporate EMBI Broad Diversified Composite Index; Real Estate: MSCI/USA Real Estate – IG; International Value: MSCI EAFE Value Index; Core Bond: Bloomberg Barclays U.S. Aggregate Bond Index; Utilities: Dow Jones U.S. Total Market Utilities Index; Mortgage-Backed Securities (MBS): Bloomberg Barclays U.S. Mortgage Backed Securities Index; Emerging Markets Value: MSCI Emerging Markets Value Index; Convertibles: Bloomberg Barclays U.S. Convertibles Composite Index; U.S. Large Value: Russell 1000 Value Index; U.S. Small Value: Russell 2000 Value Index; Cash: Bloomberg Barclays U.S. Treasury Bills 1-3 Mo. The Aggregate Portfolio is an equal-weighted portfolio including the same allocation (~7%) of all 14 asset classes.

Are there other potential benefits to investing in different sources of income?

Yes, it has the added important benefit of diversifying the sources of return and risk, which can potentially lead to a better risk/return trade-off over time. With a mix of investments, each asset class may respond differently to market and economic factors. This diversity helps boost return potential while tempering overall volatility.

Is the relationship between income and risk similar to the relationship between return and risk?

It’s not. Unlike the positive relationship between risk and return—essentially, more risk equals more return potential—our research shows that increasing risk beyond a certain level actually reduces income potential.

This represents a conundrum for income investors. Specifically, to effectively generate income over the long term, a portfolio needs more than income—it also needs total return. If total return falls below income, then income comes at the cost of diminishing capital. But, at the same time, focusing on earning higher returns generally leads to lower income and higher risk. A sustainable income portfolio must balance three distinct goals: stable income, total return, and risk management.

To sum up, what should investors consider when investing for sustainable income?

To achieve sustainable income, we recommend investors strike a balance between income and return potential and risk. This is a complex undertaking, but professionally managed solutions exist to help investors meet the challenge in a single, well-diversified portfolio.

Our approach includes researching and analyzing a range of income-generating asset classes and sources of risk. Based on this work, we invest dynamically across a range of income sources, with the goal of creating a sustainable, reliable income stream and attractive risk-adjusted returns over time.

Wondering which way to turn for income? Find resources to help you navigate today’s markets, or download Investing for Sustainable Income: Diversification Matters.

Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

Diversification does not assure a profit nor does it protect against loss of principal.

Generally, as interest rates rise, bond values will decline. The opposite is true when interest rates decline.

The opinions expressed are those of Radu C. Gabudean, Ph.D., and are no guarantee of the future performance of any American Century Investments fund. This information is for educational purposes only and is not intended as investment advice.