What Conservative Income Investors Should Do In The 'New Normal'

by: Parsimony Investment Research

Americans are getting more bad news to our lackluster recovery with data showing real median household income in 2010 down 2.3% from the prior year and figures showing that 46.2 million people in poverty in 2010, the most in 52 years. The so-called recovery that we have experienced has been frustratingly slow for the majority of Americans. Most upsetting is the lack of job creation due to the lack of aggregate demand. Due to years of excesses, the path to recovery will likely be slow and bumpy.

Lack of Safe Income in a Low Interest Rate Environment

An unintended consequence of the slow recovery has been a Federal Reserve policy that has remained stuck in the mud. Chairman Bernanke has indicated that he will keep rates at exceptionally low levels until 2013. This low interest rate policy is hurting savers that are looking for safe and reasonable nominal yields. Bill Gross at PIMCO believes that central bank policy is “picking the pockets of savers.”

That said, we think that investors should contemplate a “barbell investment strategy” for a low yield, uncertain environment.

Barbell Investment Strategy Overview

A Barbell Investment Strategy is a very simple strategy to implement. The strategy involves investing a high percentage of your portfolio in ultra safe short-term investments (like cash and T-Bills) and the remaining portion in risky assets. The theory is that the majority of your capital will be preserved under any market environment (even a complete market meltdown). In other words, you are only speculating (in risky assets) with a very small portion of your portfolio.

Note: A barbell strategy is most often used for fixed income portfolios, but we are adapting this strategy for a dividend stock portfolio.

Asset Allocation and Blended Yield

The key investment decision in a barbell strategy is asset allocation (i.e., how much of your portfolio do you want to allocate to risky assets?). Obviously, the higher the allocation of risky assets, the higher the blended yield.

Those of you who have been reading our recent articles know that we have been bullish on some of the more esoteric areas of dividend investing including master limited partnerships (MLPs), Real Estate Investment Trusts (REITs), and Business Development Companies (BDCs). These investments are not for all investors due to the specifics risk associated with them (see some of our recent articles for details). However, in the context of the right investment strategy, even the most conservative investors should consider these assets.

For this income strategy, we consider three asset classes: (1) Cash/T-Bills (risk-free assets), (2) High Quality, Large Cap Dividend Stocks, (3) Speculative High Yield Stocks (e.g., REITs, MLPs, and BDCs), with the following expected yields.

  • Cash/T-Bills – 1.00%
  • High Quality Dividend Stocks – 5.00%
  • Speculative High Yield Stocks – 13.00%

Using these three asset classes, income investors across the risk spectrum can formulate an investment strategy that works for them. The table below highlights blended expected yields across various asset allocation assumptions.

Recommendations for Each Asset Class

The below is list specific stocks that we would recommend for each asset class. As you can see, the blended yields of our recommendations for each asset class match the expected yields that we listed above. Investors can mix and match with a portfolio of names that provides the appropriate yield at the appropriate risk level.

Speculative Portfolio for a Conservative Income Investor

For a conservative income investor speculating in high yield dividend stocks, we currently recommend at least a 40% allocation of cash/risk-free securities. This will help limit the investor’s total drawdown if there is a prolonged decline in the equity market. Below is a sample portfolio based on the "Conservative 3" asset allocation and the recommendations above, which currently yields 5.15%.

Disclosure: I am long AGNC, NLY, MO, AEE.